1. A “random variable” is defined as the outcome of one or more
chance processes. Imagine that you’re
forecasting the cash flows associated with a new business venture. List some of the things that come together to
produce cash flows in future periods.
Describe how they might be considered to be outcomes of chance processes
and therefore random variables. Cash
flow forecasts for a project are used in Equations 10.1 and 10.2 to calculate
the project’s NPV and IRR. That makes
NPV and IRR random variables as well. Is
their variability likely to be greater or less than the variability of the
individual cash flows making them up?
2. One of the problems of using simulations to
incorporate risk in capital budgeting is related to the idea that the
probability distributions of successive cash flows usually are not
independent. If the first period’s cash
flow is at the high end of its range, for example, flows in subsequent periods
are more likely to be high than low. Why
do you think this is generally the case?
Describe an approach through which the computer might adjust for this
phenomenon to portray risk better.