Question

Why does capital budgeting rely on analysis of cash flows rather than on net income? Explain why the concept of risk can be incorporated into the capital budgeting process. When is the coefficient of variation (CV) a better measure of risk than the standard deviation (SD)

Answer 1

Capital budgeting rely on analysis of cash flows rather than on net income because the net income of the company is calculated after deducting the depreciation from it if the depreciation rate of the company differ, it will impact net income of the company but cash flow will not change due to that. Net income is the income that belongs to the stockholders of the company but the cash flow is the available cash to the business as non-cash expenses are added back in cash flow calculation. Therefore for capital budgeting purposes, the company’s cash flow is more relevant than its net income.

The concept of risk can be incorporated into the capital budgeting process by risk-adjusted discount rate approach where discount rates should be different for different risk categories. For example, discount rate should be higher for more risky projects.

The coefficient of variation (CV) is a better measure of risk than the standard deviation (SD) while evaluating the risk of capital budgeting projects. It is because the coefficient of variation adjusts for the size of the project as it is relative measures of dispersion while the standard deviation is an absolute measure of dispersion. Therefore the coefficient of variation is more suitable for evaluating the projects of different size.