A capital budgeting decision is characterized by costs and benefits that are spread out over several timeperiods. This leads to a requirement that the time value of money be considered in order to evaluatethe alternatives correctly. Although to make decisions we must consider risks as well as time value, I restrict the discussion to situations in which the costs and benefits are known with certainty. There are sufficient difficulties in just taking the time value of money into consideration. Moreover, when the cash flows are allowed to be uncertain, I would suggest the use of procedures that are based on the initial recommendations made with the certainty ...view middle of the document...
Dependent and Independent Investments
In evaluating the investment proposals presented to management, it is important to be aware of the possible interrelationships between pairs of investment proposals. An investment proposal will be said to be economically independent of a second investment if the cash flows (or equivalently the costs and benefits) expected from the first
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investment would be the same regardless of whether the second investment were accepted or rejected. If the cash flows associated with the first investment are affected by the decision to accept or reject the second investment, the first investment is said to be economically dependent on the second. In order for investment A to be economically independent of investment B, two conditions must be satisfied. First, it must be technically possible to undertake investment A whether or not investment B is accepted. Second, the net benefits to be expected from the first investment must not be affected by the acceptance or rejection of the second. The dependency relationship can be classified further. In the extreme case where the potential benefits to be derived from the first investment will completely disappear if the second investment is accepted, or where it is technically impossible to undertake the first when the second has been accepted, the two investments are said to be mutually exclusive.
It is possible for two or more investments to be economically independent but statistically dependent. Statistical dependence is said to be present if the cash flows from two or more investments would be affected by some external event or happening whose occurrence is uncertain. For example, a firm could produce high-priced yachts and expensive cars. The investment decisions affecting these two product lines are economically independent. However, the fortunes of both activities are closely associated with high business activity and a large amount of discretionary income for the “rich” people. This statistical dependence may affect the risk of investments in these product lines because the swings of profitability of a firm with these two product lines will be wider than those of a firm with two product lines having less statistical dependence.
Incremental Cash Flows
Investments should be analyzed using after-tax incremental cash flows. Although we shall assume zero taxes so that we can concentrate on the technique of analysis, it should be remembered that the only relevant cash flows of a period are after all tax effects have been taken into account. The definition of incremental cash flows is relatively straightforward: If the...