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Should capital budgeting decisions be based on cash flows or revenues and expenses?

Author:
Harold Averkamp, CPA, MBA

Definition of Capital Budgeting Decisions

Capital budgeting assists in the investment decisions regarding assets that will have an impact on more than one year.

Some capital budgeting models use cash flows that are discounted for the time value of money. The time value of money recognizes that a dollar today is more valuable than a dollar received in the future. Other capital budgeting models use cash flows without discounting them, while others use the accrual accounting revenues and expenses and also ignore the time value of money.

Since the investments have an impact over many years, the preferred methods for capital budgeting decisions are those which use discounted cash flows. (In addition to using the discounted cash flow models, a company is likely to also calculate some non-discounted accrual accounting amounts to see how the investments will impact its future

  • Internal rate of return
  • Net present value
  • The discounting of cash flows can be done using computer software, financial calculators, or present value factors.

    The capital budgeting models that do not recognize the time value of money include the following:

    • Payback period which uses the cash flow amounts but ignores the time value of money by not discounting the future cash flows
    • Return on investment (ROI) which uses the accrual accounting revenues and expenses (not the cash flows) and also ignores the time value of money
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    About the Author

    Harold Averkamp

    For the past 52 years, Harold Averkamp (CPA, MBA) has
    worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

    Learn More About Harold

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