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Free Cash Flow
In order to make a capital budgeting decision, the company must identify the incremental free cash flows associated with the project, particular for long-term projects that require the cash flows to be treated to account for the time value of money (NetMBA, 2010). A free cash flow is defined as "the cash that a company is able to generate after…" the initial expenditure (Investopedia, 2012). The first step is to eliminate the obvious non-incremental flows such as pre-existing overhead, sunk costs and non-cash flows like depreciation.
Within these issues, the process is not always simple. For example, many managers find overhead determinations to be difficult. The underlying principle is that the overhead the manager needs to take into account is the overhead that is incremental to the project, for example if new support staff are added. Diversion is an area that is tricky, however. Resources diverted from other areas of the company can be difficult to treat (Keown, 2012). For example, it is clear that the cost component of such flows is not incremental, because that...
However, the revenues might be different between the two uses of the resources. So to find the incremental cash flow of the new project, the difference between the revenue of the new project relating to the diverted assets must be compared with the revenue those assets would generate in their existing uses.
Peavler (2012) notes that there are significant challenges in estimating cash flows far into the future. For the most part, any future cash flows are inherently speculative. The farther into the future the flows are, the most speculative they are. The company can only truly derive rough estimates of the future cash flows that it is using to make the capital budgeting decision. Some of the risk inherent in using such projections can be addressed with a thorough sensitivity analysis. Beyond that, however, this part of the process is of a 'garbage in, garbage out' nature. The more detailed the research that goes into those estimates, the more thorough the analysis of the different factors, the more likely that the output is going to be realistic…
Works Cited:
Investopedia. (2012). Free cash flow. Investopedia. Retrieved February 17, 2012 from http://www.investopedia.com/terms/f/freecashflow.asp#axzz1mTnfyQdS
Keown, (2012). Cash flows and other topics in capital budgeting. Chapter 10. Retrieved February 17, 2012 from https://docs.google.com/viewer?a=v&q=cache:6f_R0tsMBWwJ:www.cob.sjsu.edu/zaima_j/spring09/Keown_FinMgmt10_IM/Chapter%252010%2520IM%252010th%2520Ed.doc+capital+budgeting+free+cash+flow&hl=en&gl=us&pid=bl&srcid=ADGEESigsLsTtrVXj4pRLVKg4BfHeinQasOYbkhaiwqphSsdXEqvXmGpx_H649yELoXObPW99ui6BUSV6tI8RMadlJQLbq-z9obcgpf7IT7PXq3Tfibv7QS6PZs-ZF1G_9ZPwNmhWuql&sig=AHIEtbQTcZ0ZxCKJ8rnmdNHk6No_XAWj8g
NetMBA.com. (2010). Capital budgeting. NetMBA.com. Retrieved February 17, 2012 from http://www.netmba.com/finance/capital/budgeting/
Peavler, R. (2012). Capital budgeting and its importance in business. About.com. Retrieved February 17, 2012 from http://bizfinance.about.com/od/Capital-Budgeting/a/capital-budgeting-overview.htm
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