Author: Eli Benson
Major: Finance and Economics
Graduation: December 2026
Abstract: This article demonstrates how small businesses can apply corporate finance techniques to make informed decisions on future projects. By using the net present value (NPV) model and financial data provided by Newborn 2 School Education, I construct a free cash flow forecast, estimate a weighted average cost of capital, and perform a sensitivity analysis to evaluate a proposed outdoor nature-based classroom.
Introduction
Making large investments into a business can be daunting, especially for small businesses. Unlike large corporations, small businesses face riskier decisions due to limited resources, such as capital and time, which often scare many small business owners away from worthwhile projects. In this article, I show how the same financial modeling techniques used by major corporations can help small businesses make informed investment decisions. Below you can find the layout of the article:
- Background
- The Model
- Free Cash Flows
- The Discount Rate
- Conclusion & Sensitivity Analysis
Background
Newborn 2 School Education is a local childcare center located in Superior, WI, providing care for children from newborn through age 13 for families in the Duluth/Superior and surrounding areas. They have been in business since 2013, with two locations in Superior, the most recent of which opened in 2023. I interviewed the owner, Amy Benson, to learn more about her business and the proposed project. She believes in “a safe and fun learning environment with purposeful play and structured learning.” When asked to go in depth, she said, “by balancing fun and high-quality education, children develop problem-solving skills, social awareness, and a lifelong love of learning.”
The proposed project would be an outdoor nature-based classroom. “Outdoor play builds curiosity, imagination, and self-confidence,” said Amy. Other studies find that outdoor play in early childhood is important to promote cognitive, physical, social, and emotional well-being while also influencing a child’s confidence and self-esteem (Bento & Dias, 2017). When asked the main reason why Amy is pursuing this project, she said, “we have had some interest from current families, but most importantly, all of the benefits that come from having nature-based experiences. An outdoor classroom will allow children to be curious about their surroundings, participate in life skills, let their imagination run wild, and think outside of the box.” Using financial data provided by Newborn 2 School Education, I constructed a model to evaluate whether Amy should pursue the project.
The Model
I used the net present value (NPV) model, which evaluates a project by forecasting its future free cash flows, discounting those cash flows to their present value, estimating a terminal value, and subtracting the initial project cost. A project with a positive NPV should generally be accepted, while a negative NPV should generally be rejected. By focusing only on cash flows relevant to the project, the model helps reduce the influence of factors unrelated to the project. Shown below is the math behind the NPV model:
NPV = Net Present Value
WACC = Weighted Average Cost of Capital
FCF = Free Cash Flow
TV = Terminal Value
g = Growth Rate
Free Cash Flows
Free cash flow (FCF) represents the cash generated by a business after accounting for operating expenses and the investments needed to maintain and grow the business. Put simply, the actual cash moving in and out of the business after necessary business expenditures. I calculated the free cash flows generated by this project using the following equation:
FCF = Free Cash Flow
EBIT = Earnings Before Interest and Taxes
CAPEX = Capital Expenditures
ΔNWC = Change in Net Working Capital
NOPAT = EBIT(1-T)
The project is expected to generate some revenue while also incurring some expenses. These revenues and expenses are used to calculate Earnings Before Interest and Taxes (EBIT). After applying the average tax rate, I arrive at Net Operating Profit After Taxes (NOPAT). One common question is why taxes are deducted, but interest expense is excluded. The reason is that the interest expense will be reflected in the discount rate used later in the valuation. Deducting interest expense while calculating the project’s free cash flows will result in double-counting the cost of financing and lead to a less accurate model.
The next step is to add back depreciation expense. Although depreciation reduces accounting profits, it does not represent an actual cash outflow. Since the model is intended to measure the cash generated by the project, depreciation must be added back to NOPAT.
Next, any capital expenditures (CAPEX) that are required to operate and maintain the facility are subtracted. Because these expenditures represent cash leaving the business, they reduce the amount of free cash flow generated by the project.
Finally, the change in Net Working Capital (ΔNWC) is accounted for. Net working capital is calculated as current assets minus current liabilities. An increase in net working capital decreases cash flows because it represents additional short-term assets tied up in the business. Conversely, a decrease in net working capital increases free cash flow.
After completing these calculations, I determined the project’s first-year free cash flow. Working with the business owner, we developed assumptions regarding future revenue, expenses, and operating requirements. These assumptions were then used to estimate the project’s free cash flows for the following four years.
Forecasting cash flows far into the future becomes increasingly difficult and less accurate. To account for cash flows generated beyond the forecast period, the model incorporates a terminal value calculation using the following equation:
TV = Terminal Value
WACC = Weighted Average Cost of Capital
g = Constant Growth Rate
This equation calculates the present value of all future free cash flows beyond the forecast period by assuming a constant growth rate (g). Adding a terminal value allows the model to include all future cash flows of the project without requiring a detailed forecast for every year.
For simplicity, this project is expected to have no salvage value (proceeds from selling the asset at the end of its useful life). If it did, this value would be added to the project’s estimated cash flows in its final year.
The Discount Rate
After estimating future free cash flows, the next step is to discount those cash flows back to their present value. To accomplish this, I used the Weighted Average Cost of Capital (WACC), shown below:
WACC = Weighted Average Cost of Capital
wd = Target Weight of Debt
rd = Cost of Debt
(1 – T) = After Tax Cost of Debt
we = Target Weight of Equity
rs = Cost of Equity
The WACC represents the average required rate of return demanded by the investors of a company’s debt and equity capital, weighted according to the proportion of each financing source. The discount rate should reflect the specific risk and capital structure of the project being evaluated. However, because this information was not available, I used the business’s overall debt-to-equity ratio to determine the capital structure weights.
To estimate the cost of equity, I used the Capital Asset Pricing Model (CAPM), shown below:
rs = Cost of Equity
rRF = Risk-Free Rate
β = Beta
RPm = Market Risk Premium
SCP = Small Company Premium
For the risk-free rate, I used the yield on U.S. Treasury Securities, which are widely regarded as having minimal risk. For beta, I used a value of 1.0, representing the overall stock market, since there were very few publicly traded companies that could be compared to this small business. The market risk premium was estimated using the arithmetic average market return since 1926, less the risk-free rate (Asquith & Weiss, 2016, p. 374). Because the project is being pursued by a privately held small business, an additional small-company risk premium is added to the final cost of equity. After calculating the cost of equity, I estimated the cost of debt using the borrowing rate provided by the business’s creditors.
Conclusion & Sensitivity Analysis
The final step is combining all components to calculate the project’s net present value. Each forecasted cash flow is discounted back to its present value using the estimated discount rate and the timing of the cash flow. The discounted terminal value is then added to the present value of the forecasted cash flows. The initial project cost is subtracted from the total present value of the projected cash flows, which results in the net present value number. After completing the analysis, the project produced a positive NPV, indicating that it should be pursued.
For additional support, I performed a sensitivity analysis by testing how changes in key variables affected the project’s net present value. Holding all other assumptions constant, I found that first-year estimated revenue would need to decrease by 16% for the project’s NPV to become negative. I also found that first-year operating expenses would need to increase by 20% for the project to no longer be financially attractive. Surprisingly, changes in the discount rate had very little impact on the project’s decision.
The project’s model and sensitivity analysis were presented to Amy so she could feel confident in her decision. If you would like to learn more about the model or discuss building one for your own business, feel free to reach out: ebenny830@gmail.com.
Reference list
Asquith, P., & Weiss, L. A. (2016). Lessons in corporate finance: A case studies approach to financial tools, financial policies, and valuation. John Wiley & Sons, Incorporated.
Bento, G., & Dias, G. (2017). The importance of outdoor play for young children’s healthy development. Porto Biomedical Journal, 2(5), 157–160. https://doi.org/10.1016/j.pbj.2017.03.003
