Understanding Cash Flows and Capital-Budgeting DecisionsIndiana Wesleyan University FIN-310-01A
Dr. Sam OjoOctober 19, 2014
Understanding Cash Flows and Capital-Budgeting Decisions
When evaluating cash flows for determining whether or not to pursue constructing a building to manufacture cupcakes there are several things to consider. The most important would be looking at a Grammy’s incremental after tax cash flow. Then one needs to determine the projects initial outlay, the differential cash flows over the project’s life, and the terminal cash flow. Also what needs to be looked at is what is the net present value and its internal rate of return. When making the capital-budgeting decision for constructing a building to manufacture cupcakes one should focus on cash flows rather than accounting profits. Accounting profits cannot be reinvested. They are more like profits on paper. Cash flows can be reinvested as soon as it is received. So it is money in hand so to speak. After tax cash flows (also called free cash flows) are the most important to look at because they are the actual amount of money that is available for the company to work with. Looking at cash flows help to determine the timing of the benefits or costs of a constructing a building to manufacture the cupcakes. This is why accounting profits are not what one should look at when making capital-budgeting decisions. Also it is important to focus on incremental cash flows because when one looks at the construction project, incremental cash flows are benefits and therefore an increase to the company if they decide to accept the project. Annual depreciation is subtracted from profits because it is an expense. The higher the deprecation the lower the profits for the accounting profits. Depreciation is subtracted from income taxes and thus it helps reduce the amount of taxes Grammy’s company has to pay out. As the income taxes goes down it helps Grammy’s company cash flow increase. Sunk costs do not...
References: Keown, A. J., Martin, J. D., & Petty, J. W. (2014). Foundations of finance: The logic and practice of financial management. Boston: Pearson.
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