Probability Distribution Approach
In the earlier part of this chapter dealing with basic risk concepts, we had introduced the use of the concept of probability for incorporating risk in evaluating capital budgeting proposals. As already observed, the probability distribution of cash flows over time provides valuable information about the expected value of return and the dispersion of the probability distribution of possible returns. On the basis of this information an accept-reject decision can be taken. We discuss the application of probability theory to capital budgeting in this section.
The application of this theory in analyzing risk in capital budgeting depends upon the behavior of the cash flows, from the point of view of behavioral cash flows being (i) independent, or (ii) dependent. The assumption that cash flows arc independent over time Signifies that future cash flows are not affected by the cash flows in the preceding or following years. Thus, cash flows in year 3 are not dependent on cash flows in year 2 and so on. When cash flows in one period depend upon the cash flows in previous periods, they are referred to as dependent cash flows.