A capacity plan is an investment proposal that pays us (cash inflow) over a period of time in future. The future cash flows are however discounted at a particular rate to get their present value. The initial investment minus the sum of present values of future cash inflows is NPV: Net Present Value. The capacity plan with a higher net positive NPV is more attractive.
DCF (discounted cash flow) can also be extended to analysis of multi location projects, and integrated projects that is forward or backward integration.
Financial analysis for outputs where demand is uncertain: DCF can be applied here too, with the additional information of probability distribution of demand (pessimistic, optimistic and expected distribution), as NPV is calculated for each distribution separately. Decision free technique, a graphical description of sequential decisional problems, is also useful.
Risk Analysis: The predicted demand may not always turn out to be true, the actual demand may be higher than it or lower than it. If higher, there is under capacity, if lower, there is over capacity. Let us examine both the consequences of both these situations.
Factors which favor over-capacity (rather than under-capacity)
1. When there is an economic capacity size, below which the process is uneconomic.
2. Building capacity is not so costly.
3. Buying outside is not feasible.
4. Lead time to add capacity is long.
5. Demand growth approximates to the optimistic prediction.
6. Lost sales are viewed very negatively by trading circles, resulting in a big dip in the demand.
Factors which favor addition of capacity on conservative basis
1. Alternative capacity plans are easily available.
2. Build up cost of capacity is low.
3. Lead time to build new capacity is short.
4. Lost sales have no disastrous results or the customers are prepared to wait.
Some of the factors could not be quantified. Judgment is taken as to how these affect the competitive position of the organization.