Question 1 OR (a)
Cash flow versus accounting profit in capital budgeting
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 1 OR (a) · 8 marksHow does cash flow differ from accounting profit ? For capital budgeting decisions, which one is better ? Why ? 8
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- How…?Which…?2 asks, each with its own marks below. Answer both. Where it asks why, give reasons, not a description.
- How does cash flow differSet the differences out in a table, basis by basis, not as two separate essays.
- which one is betterEnd with a clear choice and the reason for it.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Meaning of each and the differences 4 marks 7 min
- 2 Which is better, with reasons 4 marks 7 min
- Check: every ask answered, key terms underlined 1 min
Easy marks
- Step 1 opens with the meaning: a one-line definition, the quickest mark in it.
Short on time? Trim steps 1 and 2 evenly rather than skip one: each is capped at its own marks.
Try it first. About 16 minutes for 8 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
How they differ. Accounting profit is revenue less expenses on the accrual basis: income is recorded when earned and expenses when incurred, and non-cash charges such as depreciation are deducted. Cash flow is the actual cash received and paid. In measuring value, financial management uses cash flows, not accounting profits, because what matters is when the money is actually in hand and can be reinvested; accounting profits appear when they are earned rather than when the money is received, so the two may not be the same.
| Basis | Accounting profit | Cash flow |
|---|---|---|
| Recognition | Accrual: when earned or incurred | When cash is received or paid |
| Depreciation and other non-cash items | Deducted | Not an outflow (only its tax saving matters) |
| Capital expenditure | Spread over the asset's life as depreciation | An outflow when incurred |
| Working capital | Not shown | Investment is an outflow; its release an inflow |
| Accounting policies | Affected by choices (stock valuation, depreciation method) | Not affected |
Which is better for capital budgeting? Cash flow.
- Timing. The value of a project depends on when the money comes in, and only cash can be reinvested; the timing of cash flows may not match the period of profit, and non-cash items like depreciation involve no immediate cash outflow.
- Time value of money. Discounting methods (NPV, IRR, PI) need the timing of each receipt and payment, which only cash flows give.
- Objectivity. Cash flows are free of the arbitrary accounting conventions that change reported profit.
- Completeness. The outlay on the asset and on working capital, and their recovery, are captured when they occur.
So capital budgeting considers only the incremental cash flows that result from accepting a project. The accounting rate of return, the one technique based on profit, is criticised for exactly this reason.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Meaning of each and the differences | 4 |
| 2 | Which is better, with reasons | 4 |
| Total | 8 |
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