In evaluating the investment proposals presented to management, it is important to be aware of the possible interrelationships between pairs of investment proposals. A given investment proposal may be economically independent of, or dependent on, another investment proposal.An investment proposal is said to be economically independent of a second investment if the cash flows (or the costs and benefits)expected from the first investment are the same regardless of whether the second investment is accepted or rejected. If the cash flows associated with the first investment are affected by the decision to accept or reject the second investment, the first investment is said to be economically dependent on the second. It should be clear that when one investment is dependent on another, some attention must be given to the question of whether decisions about the first investment can or should be made separately from decisions about the second
Economically Independent Investments
In order for investment A to be economically independent of investment B, two conditions must be satisfied. First, it must be technically possible to undertake investment A whether or not investment B is accepted. For example, it is not possible to build a school and a shopping center on the same site; therefore, the proposal to build the one is not independent of a proposal to build the other. Second,the net benefits to be expected from the first investment must not be affected bathe acceptance or rejection of the second.
If the estimates of the cash outlays and the cash inflows for investment A are not the same when B is either accepted or rejected, the two investments are not independent. Thus, it is technically possible to build a toll bridge and operate a ferry across adjacent points on a river, but the two investments are not independent because the proceeds from one will be affected by the existence of the other.
The two investments would not be economically independent in the sense of which we are using the term, even if the traffic across the river at this point were sufficient to profitably operate both the bridge and the ferry.Sometimes two investments cannot both be accepted because the firm doesn’t have enough cash to finance both. This situation could occur if the amount of cash available for investments were strictly limited by management rather than by the capital market, or if increments of funds obtained from the capital market cost more than previous increments. In such a situation, the acceptance of one investment may cause the rejection of the other. But we will not consider the two investments to be economically dependent. To classify this type of investment as dependent would make all investments for such a firm dependent, and this is not useful definition for our purposes.
Economically Dependent Investments
The dependency relationship can be classified further. If a decision to undertake the second investment will increase the benefits expected from the first (or decrease the costs of undertaking the first without changing the benefits), the second investments said to be a complement of the first. If the decision to undertake the second investment will decrease the benefits expected from the first (or increase the costs of undertaking the first without changing the benefits), the second is said to be a substitute for the first.
In the extreme case where the potential benefits to be derived from the first investment will completely disappear if the second investment is accepted, or where it is technically impossible to undertake the first when the second has been accepted, the two investments are said to be mutually exclusive.