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Capital budgeting is the process of choosing investments and assets for long-term business development. A capital budget is made up of a mix of old and new projects and products. The relationship between a company’s cash flow and capital budgeting typically begins with the business’s reliance on capital budgeting to supply it with an inflow of cash. The most significant connection happens when measuring the profitability of items in a capital budget, because business financers use cash flows instead of accounting profits in the calculations.
Since so much of a company’s financial health and perceived stability is based on accounting records, especially profits, some people may wonder why capital budgeting would be based on cash flows. For one, most American accounting is done on an accrual basis, which means that some profits and expenses are not factored into the finances until the end of the company’s accounting cycle. Calculating with cash flows offers a way to evaluate a capital budget in real time.
Financial managers often use incremental after-tax cash flows to organize the funds when figuring the cash flow and capital budgeting for a new project. The incremental method of looking at cash flows distinguishes only the changes to cash flow that the new project would generate. This allows managers to see how much new projects cost and how much cash each project generates. Determining incremental cash flow amounts can be difficult because the system lacks the structure of accrual accounting.
Incremental cash flows systems are especially helpful when calculating cash flow and capital budgeting for new products that may compete with a company’s existing goods. Under a typical accrual system, the income from the new product would be counted as profit only, but the incremental system allows managers to factor both the loss of sales from the older product and the cash inflows from the new product. Added together with the cost of development and introduction, it may end up that the new product isn’t actually worth the capital investment. Moving cash inflows from one product to another isn’t enough to create growth, so companies need to increase total cash flows with each addition to the capital budget.
In cash flow and capital budgeting, the term 'working capital' refers to those funds used to develop and introduce a new project. Under the incremental cash-flow system, any initial investment of working capital remains tied up in the project for the duration of the venture. There is no return on investment, only a potential increase, or decrease, in cash flows. This concept often makes financial managers very wary of starting new projects, especially ventures with a high working capital investment.