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n Management Dynamics : Journal of the Southern African Institute for Management Scientists - The calculation of free cash flow, using the real replacement cost of capital expenditure required to maintain productive capacity
The generation of a positive free cash flow is vital for the long-term success of an enterprise. The amount of free cash flow available after providing for the maintenance of the productive capacity of the enterprise is a measure which management can use to determine how much cash can be distributed to shareholders or used for other discretionary purposes.
However, it should be borne in mind that the amount required for the maintenance of the productive capacity when based on actual figures from the financial statements may reflect neither price increases to replace the non-current assets, nor present the actual replacement necessary to support the current productive capacity. The reason may, for instance, be that management have managed their scarce cash resources sparingly during an economic downturn.
In this study, a proxy for replacement investment is developed which management can use in the calculation of free cash flow. This proxy takes price level increases as well as required replacements into consideration. The model developed in this study can be used by management for different categories of non-current assets, using actual and estimated price increases for the specific types of non-current assets. The application of this model will result in a smoothing effect in the calculation of free cash flow.
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