Clearing Up Confusion Over Calculation of Free Cash Flow

This paper addresses student confusion over the calculation of the key valuation measure of free cash flow. Confusion is shown to arise from the measure used to represent capital expenditures and from the treatment of depreciation expense. Even for students who have had a full complement of undergraduate finance courses, the former is clearly a point of confusion for many students and its handling has important implications for the latter. This paper illustrates the lack of clarity and consistency in standard textbook treatment of this issue, provides evidence of resulting student confusion and offers clear and easy-to-understand guidelines for students to follow to help avoid that confusion. By adhering to the guidelines presented, even beginning students should be better able to navigate through what can appear to be mystifying presentations of how to incorporate capital spending and depreciation into the computation of a firm’s free cash flow.