Question

based on any capital budgeting journa

Discuss why do managers focus on the impact that an investment will have on reported earnings rather than on the investment’s cash flow consequences? please explain in detail with examples for 3-4 paragraph.

Answer 1

There is no right or wrong answer. I have put together my thoughts below to show you the direction. Please add your thoughts around what I have written below and create an answer of desired length.

Despite finance world fully understanding the importance of cash flows, traditionally finance managers have and probably will continue to focus on reported earnings rather than investment's cash flow consequences. The basic reasons being shown below

• Earnings after tax, or net income is what belongs to the shareholders. They are keenly interest in watching reported earnings because this is the residual earnings that belong to them. Managers, acting in line with what shareholders want, therefore place a high degree of importance to reported earnings. They believe that's what will keep shareholders happy.
• At times, valuation of the firm or equity is linked to the earnings. Relative valuation based on P/E multiplies a factor to the EPS (or earnings) of the company and derive the valuation. Needless to say, reported earnings take prime importance for the managers because valuation of the firm is dependent on the same.
• At times, compensation of the managers are linked to profits or net income generated by the firm. Hence, they automatically gets an incentive to focus on the profits or reported income rather than the cash flows.
• Many a times, creditworthiness of the firm is judged by the suppliers, creditors, lenders. A higher reported earning on the income statement adds to the creditworthiness of the firm. Needless to say, managers pay special attention to reported earnings.

Hence, managers tend to focus on the impact that an investment will have on reported earnings rather than on the investment’s cash flow consequences.