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Inter-Temporal Correlation of Cash Flows and the Risk of Multi-Period Investment Projects

Published online by Cambridge University Press:  06 April 2009

Russell J. Fuller  and
Sang-Hoon Kim
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Extract

In capital budgeting when the net present value method (NPV) is used and future cash flows are uncertain, the measurement of the standard deviation of the project's net present value (σNPV) is unusually difficult. Typically the investment life of the project is more than one year, and the cash flows of each period are correlated with each other. The difficulty in determining the exact inter-temporal correlation (ρt, t+l) of cash flows creates special problems in estimating the overall variance of the investment project. For example, see [5, pp. 125–131]. This paper attempts to isolate the possible impact of the inter-temporal correlation of cash flows upon the total risk of the project under the assumption that the standard deviations of cash flows for each time period of the project are known. It also provides upper and lower bounds of σNPV for a multi-period investment project where the degree of the inter-temporal correlation is not exactly known.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 15 , Issue 5 , December 1980 , pp. 1149 - 1162
Copyright
Copyright © School of Business Administration, University of Washington 1980

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References

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