Capital budgeting decisions when cash flows and project lives are stochastic and dependent

The purpose of this study is twofold: (1) to develop an operational economic state and simulation capital budgeting procedure for allowing cash flows and project lives to be dependent and (2) to provide empirical evidence of the impact of stochastic project lives on mean‐variance and mean‐semivariance capital budgeting decisions. The required number of input estimates for the proposed model is small. For individual projects, incorrectly assuming deterministic project lives when project lives are stochastic often results in large overestimates of expected net present values and large underestimates of the variance of the net present value. Similar results occur for the mean‐variance and mean‐semivariance portfolio models. The primary managerial implication of this study is that the inclusion of stochastic project lives in capital budgeting decisions is critical to obtain appropriate risk‐return estimates.