Question 4.RQ.4: Why are cash flows rather than profit flows used in the IRR,...
Why are cash flows rather than profit flows used in the IRR, NPV and PP methods of investment appraisal?
Cash flows are preferred to profit flows because cash is the ultimate measure of economic wealth. Cash is used to acquire resources and for distribution to shareholders. When cash is invested in an investment project an opportunity cost is incurred, as the cash cannot be used in other investment projects. Similarly, when positive cash flows are generated by the project, the cash can be used to reinvest in other investment projects.
Profit, meanwhile, is relevant to reporting the productive effort for a period. This measure of effort may have only a tenuous relationship to cash flows for a period. The conventions of accounting may lead to the recognition of gains and losses in one period and the relevant cash inflows and outflows occurring in another period.