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Why is it important to evaluate capital investments based on the expected future cash flows and...

Why is it important to evaluate capital investments based on the expected future cash flows and not the expected future profits to be generated by the potential investment opportunity?

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Answer #1

Firstly the use of cash flows considers only the operating gains of the proposal. The profits consider the non operating incomes and expenses also which are irrelevant to the analysis. Also the net profits consider non cash expenses such as depreciation which need to be eliminated.

The analysis is based on cash flow because it is cash flows that change the value of a firm and not net income. The value of firms is base on free cash flows. Cash flows are also easier to forecast and represents actual cash generation and expenditure due to a proposal.

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