Caledonia Understanding of Capital Budgeting

Caledonia Understanding of Capital Budgeting

La Wanda Holland

BUS401: Principles of Finance (BAO1237A)

Instructor:  Tekeria Watson

October 15, 2012

Capital budgeting is the decision process that managers use to identify those projects that add value to the firm’s value. The success of a business depends on the capital budgeting decisions taken by management. The management of a company should analyze various factors before taking on a large project. The importance of capital budgeting is the mechanics used, such as NPV ,IRR, and other varying mechanics key involved in forecasting cash flow.

Caledonia focus on cash flows or accounting profits in making its capital-budgeting decisions should focus on cash flows, not accounting profits. Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profits? Cash flow will allow Caledonia to see the profits or losses of a project by comparing cash flows with and without the project on an after tax basis “Incremental cash flow to the company as a whole is the difference between the cash flows the company will produce both with and without the investment it’s thinking about making.” (Keown 4) Free cash flow allots the ability of reinvesting, whereas accounting profits are shown when they are earned, not when the cash is actually received. “Cash flows, not profits, represent money that can be spent.” (Keown 4)

Depreciation affects free cash flows. Depreciation affects cash flow indirectly. Depreciation expense is a non-cash transaction, it indirectly affect cash flow through the income tax effect. Having higher depreciation expense can lower your taxable income, thereby reducing your income tax expense, which will change your cash outflow for taxes. Depreciation lowers profits and in turn lowers the taxes that are paid.  

Cash flows that have been incurred and cannot be recovered are referred to as “sunk costs.” Sunk costs affect the...