Consider the following statement: A firm that earns negative net income will quickly find itself in financial distress.
I. This statement is false because it is possible for a firm to have negative profits but still have positive cash flows.
II. This statement is false because accounting profits do not generally equal cash flow and it is a lack of cash, not profits, that causes financial distress.
III. This statement is true because negative profits mean negative cash flows.
Correct Answer: I and II
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Open it ties create costs for other parts of the firm. For example, if the bookstore is considering opening a branch two blocks away, some customers who buy books at the old store will switch to the new branch. The customers lost by the old store are <span>a negative externality. The primary type of negative externality is cannibalization, which occurs when the introduction of a new product causes sales of existing products to decline.
Original toplevel document
Subject 2. Basic Principles of Capital Budgeting d in the estimated cash flows since the effects of debt financing are reflected in the cost of capital used to discount the cash flows. The existence of a project depends on business factors, not financing.
<span>Important capital budgeting concepts:
A sunk cost is a cash outlay that has already been incurred and which cannot be recovered regardless of whether a project is accepted or rejected. Since sunk costs are not increment costs, they should not be included in the capital budgeting analysis.
For example, a small bookstore is considering opening a coffee shop within its store, which will generate an annual net cash outflow of $10,000 from selling coffee. That is, the coffee shop will always be losing money. In the previous year, the bookstore spent $5,000 to hire a consultant to perform an analysis. This $5,000 consulting fee is a sunk cost; whether the coffee shop is opened or not, the $5,000 is spent.
Incremental cash flow is the net cash flow attributable to an investment project. It represents the change in the firm's total cash flow that occurs as a direct result of accepting the project.
Forget sunk costs. Subtract opportunity costs. Consider side effects on other parts of the firm: externalities and cannibalization. Recognize the investment and recovery of net working capital.
Opportunity cost is the return on the best alternative use of an asset or the highest return that will not be earned if funds are invested in a particular project. For example, to continue with the bookstore example, the space to be occupied by the coffee shop is an opportunity cost - it could be used to sell books and generate a $5,000 annual net cash inflow.
Externalities are the effects of a project on cash flows in other parts of a firm. Although they are difficult to quantify, they should be considered. Externalities can be either positive or negative:
Positive externalities create benefits for other parts of the firm. For example, the coffee shop may generate some additional customers for the bookstore (who otherwise may not buy books there). Future cash flows generated by positive externalities occur with the project and do not occur without the project, so they are incremental.
Negative externalities create costs for other parts of the firm. For example, if the bookstore is considering opening a branch two blocks away, some customers who buy books at the old store will switch to the new branch. The customers lost by the old store are a negative externality. The primary type of negative externality is cannibalization, which occurs when the introduction of a new product causes sales of existing products to decline.
Future cash flows represented by negative externalities occur regardless of the project, so they are non-incremental. Such cash flows represent a transfer from existing projects to new projects, and thus should be subtracted from the new projects' cash flows.
Conventional versus non-conventional cash flows.
A conventional cash flow pattern is one with an initial outflow followed by a series of inflows.
In a non-conventional cash flow pattern, the initial outflow can be followed by inflows and/or outflows.
Some project interactions:
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