Introduction to Capital Budgeting

Capital budgeting requires a thorough understanding of cash flow and accounting principles, particularly regarding valuing processes and investments.

Accounting Flows

Accounting is the process of identifying and transposing business transactions into permanent legal records of a business's operations and capital flows. The International Accounting Standards (IAS) and the Generally Accepted Accounting Principles (GAAP) are legislative descriptions of expectations and norms within the accounting field.

When it comes to the capital flows in accounting, it is easiest to visualize it based on each type of item:

Accounting Flows This chart is useful for examining the trajectory of accounting flows as they apply to different types of line items.

This chart is useful for examining the trajectory of accounting flows as they apply to different types of line items. Understanding how to report each type of asset and the impacts these asset changes have on income statements, balance sheets, and cash flow statements is important in accurately depicting accounting flows.

Cash Flows

Cash flow is one element of accounting flows and is particularly important to understanding capital budgeting. A cash flow describes the transmission of payments and returns internally and/or externally as a byproduct of operations over time. Conducting cash flow analyses on current or potential projects and investments is a critical aspect of capital budgeting. It determines the profitability, cost of capital, and/or expected rate of return on a given project, organizational operation, or investment.

Cash flow analyses can reveal the rate of return, or value of the suggested project, by deriving the internal rate of return (IRR) and the net present value (NPV). They also indicate overall liquidity or a business's capacity to capture existing opportunities by freeing capital for future investments. Cash flows will also underline overall profitability, including, but not limited to, net income.

Cash flows consolidate inputs from the following activities:

• Investing activities – Payments related to mergers or acquisitions, loans made to suppliers or received from customers, and the purchase or sale of assets are all considered investing activities and tracked as incoming or outgoing cash flows.
  
  
• Operating activities – Operating activities can be quite broad, incorporating anything related to the production, sale, or delivery of a product or service. This includes raw materials, advertising, shipping, inventory, payments to suppliers and employees, interest payments, depreciation, deferred tax, and amortization.
  
  
• Financing activities – Financing activities primarily revolve around cash inflows from banks and shareholders and outflows via dividends to investors. This includes payment for the repurchase of company shares, dividends, net borrowing, and net repayment of debt.