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Capital budgeting decisions should be based on cash flows that are adjusted for the time value of money. The time value of money recognizes that a dollar received or spent in the future is less valuable than a dollar received or spent in the present. Calculations such as the internal rate of return, net present value, and excess present value include adjustments for the time value of money. In these calculations present value factors, financial calculators, or computer software are used to discount the cash flows to their present values.Under accrual accounting, revenues and expenses are reported based on accounting principles. This means that revenues are reported when they are earned, and expenses are matched to the periods of the revenue. In other words, revenues and expenses are not reported on the income statement when the money is received or spent. Further, the revenue and expense amounts are not adjusted for the time value of money because of the monetary unit assumption.
Capital budgeting decisions are best made by using cashflows as a capital project is a major nonrecurring expenditure that's required to purchase or construct a facility or equipment, which inevitably leads to a loss of liquidity.
Such decisions are taken on the basis of cash flows as the use of cash flows to evaluate investment projects provides a verifiable measure with which to delineate the costs and benefits of each capital project, which can then be used to prioritize and select projects on the basis of the greater expected returns.
Capital budgeting should be based on cash flow.
