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Capital Budgeting Using Cash Flows

Operating cash flows, rather than accounting profits, are the basis for which capital budgeting projects are evaluated. What is the basis for this emphasis on cash flows as opposed to net income?

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The definition of a capital budgeting project is the process of comparing, evaluating, selecting and following up on capital expenditures to determine the real cost of a hard asset in terms of discounted cash values, or an internal rate of return calculation. The asset is expected to benefit the company for a period of time longer than a year and usually much longer.

One of the reasons that the process is so different from budgeting for results of operations is that the purchase of a capital asset is often a major financial undertaking which will effect the company for years to come; at least, for the life of the asset. In operations, a company buys or makes something, sells it, collects revenue and is done with the transaction. A capital purchase is with the company for years, for better or worse. A mistake can be costly, and this process is actually one of valuing an asset purchase over the expected life of the asset.

A capital asset is normally a ...

Solution Summary

A comprehensive 650 word discussion about the process of acquiring capital assets and the planning useful in doing so.