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#analyst-notes #cfa-level-1 #corporate-finance #reading-35-capital-budgeting #study-session-10
Assumptions of capital budgeting are:

  • Capital budgeting decisions must be based on cash flows, not accounting income.

    Accounting profits only measure the return on the invested capital. Accounting income calculations reflect non-cash items and ignore the time value of money. They are important for some purposes, but for capital budgeting, cash flows are what are relevant.

    Economic income is an investment's after-tax cash flow plus the change in the market value. Financing costs are ignored in computing economic income.

  • Cash flow timing is critical because money is worth more the sooner you get it. Also, firms must have adequate cash flow to meet maturing obligations.

  • The opportunity cost should be charged against a project. Remember that just because something is on hand does not mean it's free. See below for the definition of opportunity cost.

  • Expected future cash flows must be measured on an after-tax basis. The firm's wealth depends on its usable after-tax funds.

  • Ignore how the project is financed. Interest payments should not be included in the estimated cash flows since the effects of debt financing are reflected in the cost of capital used to discount the cash flows. The existence of a project depends on business factors, not financing.
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Subject 2. Basic Principles of Capital Budgeting
Capital budgeting decisions are based on incremental after-tax cash flows discounted at the opportunity cost of capital. Assumptions of capital budgeting are: Capital budgeting decisions must be based on cash flows, not accounting income. Accounting profits only measure the return on the invested capital. Accounting income calculations reflect non-cash items and ignore the time value of money. They are important for some purposes, but for capital budgeting, cash flows are what are relevant. Economic income is an investment's after-tax cash flow plus the change in the market value. Financing costs are ignored in computing economic income. Cash flow timing is critical because money is worth more the sooner you get it. Also, firms must have adequate cash flow to meet maturing obligations. The opportunity cost should be charged against a project. Remember that just because something is on hand does not mean it's free. See below for the definition of opportunity cost. Expected future cash flows must be measured on an after-tax basis. The firm's wealth depends on its usable after-tax funds. Ignore how the project is financed. Interest payments should not be included in the estimated cash flows since the effects of debt financing are reflected in the cost of capital used to discount the cash flows. The existence of a project depends on business factors, not financing. Important capital budgeting concepts: A sunk cost is a cash outlay that has already been incurred and which


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