Why capital budgeting focuses on cash flows rather than profits

Capital budgeting analysis considers only the incremental cash flows that result from accepting a project, so estimating them is one of its most important tasks. The discounted cash flow methods do not use accounting profit as the measure of a project's benefit (only the accounting rate of return does), for these reasons:

1. Timing. The timing of cash flows need not match the period in which profit is recorded. Sales may be booked before the cash is collected and expenses before they are paid. What the firm can reinvest or distribute is the cash it actually receives, when it receives it.
2. Non-cash items. Profit is struck after charging non-cash items such as depreciation, which involve no cash outflow. Depreciation matters only through the tax it saves: it reduces taxable profit, so the tax shield it creates is counted as a cash inflow.
3. Time value of money. Discounting needs to know exactly when each rupee arrives. Cash flows give that; accrual profit does not.
4. Wealth maximisation. The goal of financial management is the economic value of the firm, which is the present value of the future cash flows a decision generates, discounted for risk. This measure is based on cash flows rather than profit.
5. Objectivity. Profit depends on accounting policies (depreciation method, stock valuation), while cash flows are a matter of fact and are not changed by a change of policy.

Conclusion. A project's worth to the shareholders lies in the cash it returns over its life and when it returns it. Capital budgeting decisions are therefore based on incremental after-tax cash flows, with depreciation counted only through its tax shield, rather than on accounting profit.