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Business Finance Reasoning: Cash Flows and Capital Structure

Explain the reasoning behind the focus on cash flows rather than accounting profits in making our capital-budgeting decisions. Why are we interested only in incremental cash flows rather than total cash flows?

If depreciation is not a cash flow item, why does it affect the level of cash flows from a project in any way?

What makes up a company's capital structure? Explain the purpose of determining the weighted average cost of capital for a company.

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Dear student,

Explain the reasoning behind the focus on cash flows rather than accounting profits in making our capital-budgeting decisions.
Cash flows are important than the accounting profits because the accounting profits recognize the revenue as soon as it is earned and it does not take into the fact that whether they are realized in cash or not. Likewise, the accounting profits are arrived at after taking into account the expenses in respect of which liability to pay arises and it does not consider whether payment has been really made during that year. Further, accounting profit is arrived at after deducting depreciation which in fact does not result in any outflow of cash. Therefore, it is essential to value the projects on the basis of what the company will actually get as cash and what the company actually pay as expenses for judging the acceptability or ...

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