Negative Within-Firm Externalities

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(or incremental) $17 million to build and supply the center, on top of the $2 million already spent on the site study. Suppose the present value of future cash �lows is $18 million. Should the project be accepted? If the sunk costs are mistakenly included, the NPV is  , and the project would be rejected. However, that would be a bad decision. The real issue is whether the incremental $17 million would result in enough incremental cash �low to produce a positive NPV. If the $2 million sunk cost were disregarded, as it should be, then the NPV on an incremental basis would be a positive $1 million. 11-1e. Opportunity Costs Associated with Assets the Firm Already Owns Another conceptual issue relates to opportunity costs related to assets the �irm already owns. Continuing our example, suppose FedEx already owns land with a current market value of $2 million that can be used for a new distribution center. If FedEx goes forward with the project, only another $15 million will be required, not the full $17 million, because it will not need to buy the required land. Does this mean that FedEx should use the $15 million incremental cost as the cost of the new center? The answer is de�initely “No.” If the new store is not built, then FedEx could sell the land and receive a cash �low of $2 million. This $2 million is an opportunity cost—it is cash that FedEx would not receive if the land is used for the new center. Therefore, the $2 million must be charged to the new project, and failing to do so would cause the new project’s calculated NPV to be too high.
 
11-1f. Externalities Another conceptual issue relates to externalities, which are the effects of a project on other parts of the �irm or on the environment. As explained in what follows, there are three types of externalities: negative within‐�irm externalities, positive within‐�irm externalities, and environmental externalities.
 
Negative Within-Firm Externalities
 
If a retailer like Gap opens a new store that is close to its existing stores, then the new store might attract customers who would otherwise buy from the existing stores, reducing the old stores’ cash �lows. Therefore, the new store’s incremental cash �low must be reduced by the amount of the cash �low lost by its other units. This type of externality is called cannibalization, because the new business eats into the company’s existing business. Many businesses are subject to cannibalization. For example, each new iPad model cannibalizes sales from MacBook Air laptops. Those lost cash �lows should be considered, and that means charging them as a cost when analyzing new products.
 
Dealing properly with negative externalities requires careful thinking. If Apple decided not to come out with a new model of iPad because of cannibalization, another company might come out with a similar new model, causing Apple to lose sales on existing models. Apple must examine the total situation, and this is de�initely more than a simple, mechanical analysis. Experience and knowledge of the industry are required to make good decisions in most cases.
 
One of the best examples of a company getting into trouble as a result of not dealing correctly with cannibalization was IBM’s response to the development of the �irst personal computers in the 1970s. IBM’s mainframes dominated the computer industry, and they generated huge pro�its. IBM used its technology to enter the PC market, and initially it was the leading PC company. However, its top managers decided to deemphasize the PC
 
−$2 million (−$17 million) $18 million = −$1 million
 
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