Answer to Question #6362 in Economics of Enterprise for lamarcus streeter

Question

1. Which of the following statements is CORRECT?

a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality.
b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline.
c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
e. Identifying an externality can never lead to an increase in the calculated NPV.

Answer 1

An example of an externality is a situation where a bank opens a new office, and
that new office causes deposits in the bank’s other offices to decline is
CORRECT statement. An externality is the side effect on an individual or entity
due to the actions of another individual or entity. The external effects
generated by a project may be easy to identify, but are often difficult to
quantify. Both NPV and IRR methods are primarily used in capital budgeting, the
process by which companies determine whether a new investment or expansion
opportunity is worthwhile. Given an investment opportunity, a firm needs to
decide whether undertaking the investment will generate net economic profits or
losses for the company.