1. Operating cash flows rather than accounting income are listed in your text. Why do we focus on cash flows as opposed to net income in capital budgeting?

I believe in capital budgeting, Net income is considered apparent income (forecasted), whereas Cash flow is considered true income (current). We focus on cash flow because it is more important within capital budgeting because company’s need to know what they have currently to decide if they can or cannot invest in a proposed project.

2. What is the difference between cash flow and accounting income?

The difference between the two is that Cash Flow is more critical because it lets a company know how much cash they have on-hand to pay for their expenses (creditors, employees, etc…) on time and to decide whether or not they should reinvest.

3. Explain why sunk costs should not be included in a capital budgeting analysis, but opportunity costs and externalities should be included? Give an example of each.

Sunk Cost is defined as a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. It is cost that has been spent and does not give any support within the capital budgeting analysis. However, opportunity cost depicts what cash flows are needed to support the project and externalities display the side effects of cash flows a firm inherits by taking on a project (pg 403). Firms sunk cost gives no relevancy within the capital budgeting analysis, whereas opportunity cost and externalities do.

4. Why are interest charges not deducted when a project’s cash flows for use in a capital budgeting analysis are calculated?

The interest charges will give false information because it is calculate in the weighted average cost of capital, and within the capital budgeting analysis.

5. Most firms generate cash inflows