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.
The CORRECT statement is B.An externality is an effect of a purchase or use decision by one set of parties on others who did not have a choice and whose interests were not taken into account. 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 negative externality. Externalities can cause market failure if the price mechanism does not take into account the full social costs and social benefits of production and consumption. 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.