Chapter 12 Cash Flow Estimation and Risk Analysis 367additional $17 million, on top of the $2 million site study, to open the store. Suppose
it then used as the required investment $19 million and found a projected NPV of
!$1 million. This would indicate that HD should reject the new store. However, that
would be a bad decision. The real issue is whether the incremental $17 million would
result in incremental cash in! ows suf" cient to produce a positive NPV. If the $2 million
sunk cost is disregarded, as it should be, the true NPV will be a positive $1 million.
Therefore, the failure to deal properly with the sunk cost would lead to turning
down a project that would add $1 million to stockholders’ value.
12-1f Opportunity Costs Associated with Assets
the Firm Owns
Another issue relates to opportunity costs associated with assets the " rm already
owns. For example, suppose Home Depot owns land with a market value of
$2 million and that land will be used for the new store if HD decides to build it. If
HD decides to go forward with the project, only another $15 million will be
required, not the typical $17 million because HD would not need to buy the
required land. Does this mean that HD should use $15 million as the cost of the
new store? The answer is no. If the new store is not built, HD could sell the land
and get a cash! ow of $2 million. This $2 million is an opportunity cost—something
that HD would not receive if the land was used for the new store. Therefore, the $2
million must be charged to the new project, and a failure to do so would arti" cially
and incorrectly increase the new project’s NPV.
If this is not clear, consider the following example. Assume that a " rm owns a
building and equipment with a market (resale) value of $10 million. The property
is not being used, and the " rm is considering using it for a new project. The only
required additional investment would be $100,000 for working capital, and the
new project would produce a cash in! ow of $50,000 forever. If the " rm has a WACC
of 10% and evaluates the project using only the $100,000 of working capital as the
required investment, it would " nd an NPV of $50,000/0.10 " $500,000. Does this
mean that the project is a good one? The answer is no. The " rm can sell the prop-
erty for $10 million, which is much better than $500,000.
12-1g Externalities
Another potential problem involves externalities, which are de" ned as the effects
of a project on other parts of the " rm or the environment. The three types of exter-
nalities are explained next.
Negative Within-Firm Externalities
As noted earlier, retailers such as Home Depot opening new stores that are too close
to their existing stores takes customers away from their existing stores. In this case,
even though the new store has positive cash! ows, its existence reduces some of the
" rm’s current cash! ows. This type of externality is called cannibalization because
the new business eats into the company’s existing business. Manufacturers also can
experience cannibalization effects. Thus, if Cengage Learning, the publisher of this
book, decides to publish another introductory " nance text, that new book will pre-
sumably reduce sales of this one. Those lost cash! ows should be taken into account,
and that means charging them as a cost when analyzing the proposed new book.
Dealing properly with negative externalities can be tricky. If Cengage decided
not to publish the new book because of its cannibalization effect, might another
publisher publish it, causing our book to lose sales regardless of what Cengage
does? Logically, Cengage must look at the total situation, which is more than a
simple mechanical analysis. Experience and knowledge of the industry is required
to make good decisions.
Opportunity Cost
The best return that can be
earned on assets the firm
already owns if those
assets are not used for the
new project.Opportunity Cost
The best return that can be
earned on assets the firm
already owns if those
assets are not used for the
new project.Externality
An effect on the firm or the
environment that is not
reflected in the project’s
cash flows.Externality
An effect on the firm or the
environment that is not
reflected in the project’s
cash flows.Cannibalization
The situation when a new
project reduces cash flows
that the firm would
otherwise have had.Cannibalization
The situation when a new
project reduces cash flows
that the firm would
otherwise have had.