Question

The book states that the capital budgeting decision involves the planning of expenditures for a project with a life of at least one year and usually considerably longer. Figure 12-1 provides a flow chart of the decision-making process. The book quickly goes into the importance of cash flow. I have said it before and I'll probably say it again, cash is king. Cash flow is the backbone of a company and should be the center piece to decisions. What is the difference between cash flow and accounting flow? Why is cash flow more important than reported earnings? How do we get from reported earnings to cash flow?

Answer 1

It is totally correct that cash is king. We follow accrual basis of accounting means we record the revenue when earned not at the time of recieved. Let me explain with an example, say a manufacturer sells phones and recieves the payments on average of 90 days from the distributors. His actual cash from the sales of phones comes after 90 days from the date of revenue recorded. Comapny has manage this cashflows wisely to mitigate the cash crunch.

Capital budgeting will take the cashflows infact after tax cash flows whether to take up the project or not.

From accounting profit to actual cashflow, we can use the below formula

FCFF=Net Income+Depreciation+(Interest*(1-tax rate))-Capex-Working capital investments