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

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  • Fuller, Russell J.
  • Kim, Sang-Hoon

Abstract

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.

Suggested Citation

  • Fuller, Russell J. & Kim, Sang-Hoon, 1980. "Inter-Temporal Correlation of Cash Flows and the Risk of Multi-Period Investment Projects," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(5), pages 1149-1162, December.
    • Handle: RePEc:cup:jfinqa:v:15:y:1980:i:05:p:1149-1162_01
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    Cited by:

    1. Jean-Paul Paquin & Alain Charbonneau & David Tessier, 2015. "The derivation of the NPV variance of a risky capital investment project with first-order autoregressive cash flows and autoregressive conditional heteroscedastic variances," Applied Economics, Taylor & Francis Journals, vol. 47(12), pages 1170-1186, March.
    2. Rapisarda, Grazia & Echeverry, David, 2010. "A Non-parametric Approach to Incorporating Incomplete Workouts Into Loss Given Default Estimates," MPRA Paper 26797, University Library of Munich, Germany, revised 16 Nov 2010.

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