DEPENDENCE OF CASHFLOWS

OVER TIME

DEPENDENCE OF CASHFLOWSINTRODUCTION
 Independence of cash flows are less risky

than dependent cash flows.  In many projects, the cash flow in one future period depends in part on the cash flows in previous periods.  Therefore, it is realistic to assume that in case of investment projects that cash flows are dependent overtime.

DEPENDENCE OF CASHFLOWS
 The favorable or unfavorable outcome in

earlier periods is generally accompanied by the favorable or unfavorable outcome in the later periods in the life of an investment project.

DEPENDENCE OF CASHFLOWS
 When cash flows are dependent overtime,

the S.D. will be larger than what would be under the assumption of independence of cash flows.  The greater will be the degree of correlation between cash flows, the larger will be the S.D.

DEPENDENCE OF CASHFLOWS
 However, the expected value of NPV remains

unchanged irrespective of the independence and dependence of cash flows.

PERFECT CORRELATION
 Cash flows are perfectly correlated overtime if

they deviate in exactly the same relative manner.

 Cash flow in any period is a linear function of

the cash flows in all other periods.

PERFECT CORRELATION
 The formula for the S.D. of the cash flows in

case of perfect correlation is =n t /(1+kf)

MODERATE CORRELATION
 In certain cases, the cash flows are neither

independent nor perfectly correlated overtime. They are rather moderately correlated.  One method of dealing with the problem of moderate correlation is with the series of conditional probability distribution and decision trees.

MODERATE CORRELATION
 The use of conditional probability distributions

enable us to take account of the correlation of cash flows overtime.  Formula for determining S.D. is =(NPVj ENPV)2 p

SIMULATION
 For complex situations, the mathematical

calculation of S.D. is unfeasible.  For these situations, we can approximate the S.D. by means of simulation.  With this method, we use random sampling to select cash flow series for evaluation and calculation of NPV or IRR for each selected series.