Question

Why is a sound capital budgeting policy critical to success in business? Should a firm focus on cash flows or accounting profits in making capital-budgeting decisions? Should they be interested in incremental cash flows, incremental profits, total free cash flow, or total profits? WHY?

Answer 1

Capital budgeting is the method of estimating the financial viability of the capital investment over the life of investment. so a good invester can estimate the contingent expenses in advance and also the cash flows.

the capital budgeting methods are NPV, IRR, Profitibility index etc. all are calculated using discounts for considering TVM (time value of money). the correct estimation of discounts is a critic in  decision making of capital budgeting.

Accounting profits are accurate profits. but it is time consuming to prepare. it is prepared on the terms and conditions at the end of the period like accounting methods, taxation policy and government policy. the decision making is made at the beginning of the selection of project. so it is good to have accounting profit for decision making.

The non-availbility of accounting statements like profit and loss account and balance sheet, leads the decision maker to relay on the incremental cah flows, incremental profits etc. So while preparing incremental cash flows estimation must be accurate. so well expertise is needed in decision making.