In evaluating the investment proposals presented to management, it is important to know the possible interrelationships between pairs of investment proposals.
A given investment proposal may be economically independent of, or dependent on, another investment proposal.
Economically Dependent Investments
An investment proposal is 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. Suppose the cash flows associated with the first investment are affected by the decision to accept or reject the second investment. In that case, 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
Two conditions must be satisfied for investment A to be economically independent of investment B. First, it must be technically possible to undertake investment A whether or not investment B is accepted. For example, it is impossible to build a school and a shopping centre on the same site; therefore, the proposal to build one is not independent of a proposal to build the other. Second, the net benefits expected from the first investment must not be affected by bathe acceptance or rejection of the second.
If the estimates of the cash outlay and the cash inflows for investment A are not the same when B is 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. Still, 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, which we are using, even if the traffic across the river at this point were sufficient to operate both the bridge and the ferry profitably. Sometimes two investments cannot 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 in increments of funds obtained from the capital market cost more than previous increments.
In such a situation, accepting one investment may cause the rejection of the other. But we will not consider the two investments to be economically dependent. Classifying this type of investment as a dependent would make all investments for such a firm dependent, which is not a useful definition for our purposes.
The dependency relationship can be further classified. Suppose 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). In that case, the second investment is said to complement the first. Suppose 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). In that case, the second is a substitute for the first.
In the extreme case where the potential benefits 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 beneficial exclusive.