Final answer:
Depreciation is not included as a cash flow in capital budgeting because it is not a cash outflow. Capital budgeting focuses on actual inflows and outflows of cash and involves comparing the cost of investment to the present discounted value of future cash flows. Depreciation merely helps in reducing tax liabilities and is an accounting method rather than a cash-based metric.
Step-by-step explanation:
Depreciation is not included as a cash flow in capital budgeting decisions for the purpose of recovering the original cost of an asset. Instead, it is a non-cash accounting charge that allocates the cost of an asset over its useful life for tax and accounting purposes. In capital budgeting, the focus is on cash flows, which represent the actual inflows and outflows of cash. Including depreciation would not accurately reflect these cash movements.
When evaluating capital investments, firms compare the present costs of investment to the present discounted value of future benefits, such as the cash flows that an investment generates. This is done through an analysis that discounts future cash flows back to their present value, allowing for a comparison of the investment's cost against the benefits it will bring over time.
It's important to distinguish between cash flow and accounting measures like depreciation. Depreciation affects taxable income and thereby indirectly benefits cash flow by reducing the amount of tax paid. However, the actual cash outflows used to pay for the asset occur at the time of purchase, not as depreciation is recorded over time.
Furthermore, reinvesting profits into the company can drive growth, and as long as the reinvested cash is larger than the depreciation on the equipment, the company can continue to grow its operations. In essence, capital budgeting and most other financial decisions should be based on cash flows rather than accounting concepts like depreciation.