Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows

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Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows

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Most firms generate cash inflows every day, not just once at the end of the year. In capital budgeting, should we recognize this fact by estimating daily project cash flows and then using them in the analysis? If we do not, will this bias our results? If it does, would the NPV be biased up or down? Explain.

Explanation & AnswerSolution by a verified expert

Explanation

Generally, cash flows occur on a daily basis, but arriving at daily accurate cash flows could be a daunting task and may not be free from errors. Also, such cash flows need to be discounted, and a project tenure usually ranges from one to 10 years. For longer-duration projects, calculating the present value of cash flow daily could prove to be practically impossible. Apart from the timing of cash flows, monetary amounts of daily cash flows would be equal to the end-of-year cash flows, and capital budgeting assumes end-of-year cash flows for simplicity.
 
 
The results might be biased when end-of-year payments are assumed, as the timing of cash flows is not recorded in the most accurate fashion.

Sample Response

For simplicity and user friendliness of the capital budgeting statements, it is best to assume that the cash flows occur at the end of the year. Although cash flows do occur on a daily basis, estimating such costs accurately would be a difficult task. Moreover, even if the daily cash flows are identified, calculating the present value would be impractical. When the cash outflows and inflows are distributed significantly apart, the results are biased by using year-end assumption of cash flow occurrence, as it ignores accurate cash flow timing.

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