DEPENDENCE AND INDEPENDENCE OF

CASHFLOWS OVERTIME

INTRODUCTION
 The most crucial information for the capital

budgeting decision is a forecast of future cash flows.

 There is possibility of risk because forecasts

cannot be made with perfection or certainty since future events on which they depend are uncertain.

INTRODUCTION
 Risk is the variability of possible outcomes.  Investment proposals entail different degrees of

risk, statistical techniques are used as analytical tools for handling risky investments.

 Risk is expressed interms of the dispersion of the

probability distribution of possible NPV or IRR and is measured by S.D.

PROBABILITY
 Probability is defined as a measure of

someones opinion about the likelihood that an event will occur.

 The probability of all events lies between zero

and one

PROBABILITY
 Probability theory plays an important role in

analysing risk in capital budgeting .  The risk of an investment project can be described by calculating the expected NPV and SD.  The risk can be measured under the assumptions of serial independence of cash flows overtime and their dependence.

INDEPENDENCE OF CASHFLOWS OVERTIME

 The independence of cash flows overtime

means that the probability distributions for the future periods are not dependent on each other.

ASSUMPTION OF INDEPENDENCE
 With the independence of cash flows

overtime, the outcome in period t does not depend on what happened in period t-1  In other words, there is no causative relationship between cash flows from period to period.

EXPECTED NET PRESENT VALUE

 Once probabilities are assigned to the future

cash flows, the next step is to find out expected NPV.

 The ENPV can be found out by multiplying

the monetary values of the possible events (cash flows) by their probabilities.

EXPECTED NET PRESENT VALUE

 ENPV=Sum of P.V. of expected net cashflows

 ENPV=nENCFt/(1+k)t
t=0

 Expected NCF can be calculated as

ENCFt=NCFjt * Pjt

WHERE

NCFjt =Net cashflow for jth event in period t Pjt= Probability of net cashflow for jth event in period t

RISK-FREE RATE FOR DISCOUNTING

 It is important to note that the discount rate

should be risk-free when we use probability information for cashflow distributions.  The probability of the occurrence of a given set of cashflows will be high or low depending on whether the risk is high or low.

RISK-FREE RATE FOR DISCOUNTING

 If cost of capital is used as the discount rate,

it would result in double counting of risk. ( Cost of capital incorporates both a risk-free rate and a premium for risk)

STANDARD DEVIATION
 The S.D of net cashflows for each period can

be expressed as-




=n(NCFjt-ENCFt)2 Pjt t
t=S.D.

of net cashflows in period t  NCFjt=net cashflow

 ENCFt=Expected value of the net cashflow  Pjt =Probability associated with each cashflow

STANDARD DEVIATION
 Using S.Ds for various periods, we can

develop a measure of risk for the project under the assumption of independence of cashflows overtime. = =
2/(1+Rf)2t

 

or

2/(1+kf)2t

STANDARDIZING THE DISPERSION

 The expected value and S.D. of the

probability distribution of possible NPVs gives us a considerable amount of information by which to evaluate the risk of the investment proposal.  If the probability distribution is approximately normal (bell-shaped), we are able to calculate the probability of a proposal providing NPVs of less than or more than a specified amount.

STANDARDIZING THE DISPERSION

 The normal distribution can be used to further

analyse the risk element in capital budgeting.  The probability is found by determining the area under the curve to the left or right of a particular point of interest.
 S=X-NPV/  X= outcome in which we are interested 

=S.D