Capital Budgeting is the planning process used to determine whether an organization’s long term investment’s such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm’s capitalization structure. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.
General Rules For Free Cash Flows :
? Include only cash flows in the calculation of free cash flow In the calculation of free cash flow, we should only be considering the cash flows relevant to the firm and nothing else. We should not be using the allocated costs or overheads except when they represent some sort of cash flows. Such costs do not represent a cash flow unless otherwise specifically stated and hence generally is not considered in free cash flow calculation. The free cash flow should basically represent to the firm, the cash available to the firm after considering the revenue and expense upon investing into the new project.
? Impact on cash flows from other product lines: Sometimes, the investment in a new capital expenditure like a machine or new technology might ensure that the product being produced by the technology is demanded in increased quantity by the consumers of this product. The company might have other products which are substitutes of this product. For example suppose a company manufactures toothpaste and invests in a new technology to produce a particular brand of toothpaste which makes it much more effective and costs less. Due to this the demand for this brand will increase but the demand for the other brands of toothpaste of the same company will decrease. This is called cannibalisation where in one product eats into the sales of another product of the same company. The cash flow lost in such a case by way of decreased revenue should be considered in calculation as it ultimately impacts the free cash flow of the firm at the firm level (Shrieves & Wachowicz, 2001).