Why do capital budgeting decisions rely on cash flow rather than accounting profitability?

• A. Because cash flow reflects the actual timing of cash inflows and outflows, which affects liquidity and NPV.
• B. Because accounting profitability always guarantees positive cash flow.
• C. Because cash flow ignores taxes.
• D. Because cash flow is irrelevant to NPV.

Answer: (A)

Cash flow is the driver of capital budgeting because a project's true value comes from the actual money it generates over time, which you bring back to present value through discounting. The timing of cash inflows and outflows matters for several reasons: it determines liquidity—whether the firm has cash available to fund the project or meet other obligations—and it dictates the present value of those cash flows in the NPV calculation. Accounting profitability, by contrast, is based on accruals and can include non-cash items like depreciation or revenue recognized before cash is received. A project can show a profit on the income statement while still consuming cash, due to large upfront investments, working-capital needs, or slower collections. After-tax cash flows capture the actual cash that remains to reinvest or distribute, and they reflect how taxes, capital expenditures, and changes in working capital affect the money the project generates. Because of this, cash flow provides the correct basis for evaluating economic viability and funding implications, whereas accounting profits can mislead due to timing and non-cash adjustments.