Pitfalls in identifying a project's incremental free cash flows

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 money would be spent elsewhere anyway. 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 and therefore valuable for the analysis.

There are two major issues with these future cash flows. The first is that because a lot of work must go into deriving accurate numbers, shortcuts may be taken, even to the point where the numbers are essentially a work of fiction. It is tempting, knowing that even the best numbers are subject to considerable change, to fail to take this part of the exercise seriously. However, any business that falls into this temptation will not be making its decision based on useful information.

The other major potential issue with these future cash flows is that they are subject to being massaged or fudged by project supporters. Project supporters are likely to present optimistic figures into management, knowing that the better the numbers look the more likely it is that the project will be accepted. As such, the business needs to have a process whereby the numbers are reviewed, if not produced, by independent people within the company.

It is important for businesses to recognize that the estimates of incremental free cash flow are critical to effective capital budgeting. They are also, however, very challenging to put together, specifically because to do so relies on speculation about the future. Knowing the pitfalls, however, is critical to delivering better calculations and better capital budgeting decisions.