As assistant financial manager of Caledonia Products the first priority is the shareholder. This analysis of free cash flow will help Caledonia determine the actual benefit and cost involved in the project. Capital Budgeting can decide which projects will help Caledonia Products achieve its objectives and worthy of funding and which should be rejected.
Caledonia Products must focus its attention on free cash flows the firm essentially receives cash flows, not profits, cash flow can be reinvested. These cash flows are beneficial on an after tax basis. The company should be interested in incremental cash flows. The acceptance of the project results in increased value of the firm while the cash flows are the marginal benefit. The decision of capital budgeting should be based on cash flows not accounting profits. Cash flow are examined and adjusted for the time value of money. Time value of money identifies that a dollar today is valued more than the same dollar in the future. Accounting profits are reported when they are earned, and expenses are matched to the periods of the revenue. This same cash is the will increase the wealth of the shareholders.
Depreciation is an expense; the more assets purchased the larger the expense. When you purchase capital asset cash will be used to purchase the item and will appear on the cash flow statement; it is affect free cash flow over the project life span due to taxation. The higher depreciation expenses can cause a lower taxable income which creates changes in cash outflow. Depreciation reduces earnings before tax (EBT) and will therefore reduce the tax expense.
Sunk costs do not affect the determination of cash flow. Sunk costs are a basically the cost of the past. These costs cannot and will not be recovered; even if the project is accepted it will not affect the future of cash flow. Differential cash flow will only