Listening to Scott Hanselman\'s interview with the Stack Overflow team (part 1 and 2), he was adamant that the SQL server and application server should be on separate machin
Tom is correct on this. Some other reasons are that it isn't cost effective and that there are additional security risks.
Webservers have different hardware requirements than database servers. Database servers fare better with a lot of memory and a really fast disk array while web servers only require enough memory to cache files and frequent DB requests (depending on your setup). Regarding cost effectiveness, the two servers won't necessarily be less expensive, however performance/cost ratio should be higher since you don't have to different applications competing for resources. For this reason, you're probably going to have to spend a lot more for one server which caters to both and offers equivalent performance to 2 specialized ones.
The security concern is that if the single machine is compromised, both webserver and database are vulnerable. With two servers, you have some breathing room as the 2nd server will still be secure (for a while at least).
Also, there are some scalability benefits since you may only have to maintain a few database servers that are used by a bunch of different web applications. This way you have less work to do applying upgrades or patches and doing performance tuning. I believe that there are server management tools for making these tasks easier though (in the single machine case).