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.