- Earnings versus Cash Flows
There are significant differences between accounting earnings and cash flows. The reasons can be traced to two fundamental accounting principles:
a. Accrual Accounting, where revenues and expenses are related to activity in the current period, and not to whether cash is received or paid.
b. Capital versus Operating Expenditures: Operating expenses are treated as expenses for computing income, but capital expeditures are not. Instead, they are depreciated or amortized over time, creating a non-cash expense in future periods.
- Reinvestment Rate Assumption in Investment Decision Rules
The net present value rule implicitly assumes that intermediate cash flows from a project are invested at the hurdle rate. The internal rate of return rule assumes that intermediate cash flows are invested at the internal rate of return. Note that this makes little difference when analyzing independent projects. An independent project with an IRR greater than the hurdle rate will continue to have an IRR>Hurdle rate, as long as the intermediate cash flows earn a market rate of return.
- Real versus Nominal Investment Analysis
Investment analyses can be done in terms of real or nominal cash flows. The discount rates have to be defined consistently - real for real cash flows and nominal for nominal cash flows. If done consistently, each analysis should yield the same net present value.
The choice between nominal and real cash flows therefore boils down to one of convenience. When inflation rates are low, it is better to do the analysis in nominal terms since taxes are based upon nominal income. When inflation rates are high and volatile, it is easier to do the analysis in real terms.
Given a choice, I would rather do the analysis in nominal terms, since taxes and financial statements are usually based upon nominal results.