368 Part 4 Investing in Long-Term Assets: Capital Budgeting
One of the best examples of a company fouling up as a result of not dealing
correctly with a cannibalization situation was IBM’s response when transistors
made personal computers possible in the 1970s. IBM’s mainframe computers were
the biggest game in town, and they generated huge pro" ts. But IBM had the tech-
nology, got into PCs, and for a time was the leading PC company. However, top
management decided to rein back the PC division because managers were afraid
it would hurt the more pro" table mainframe business. That decision opened the
door for Microsoft, Intel, Dell, Hewlett-Packard and others; and IBM went from
being the most pro" table " rm in the world to one whose very survival was threat-
ened. This experience highlights the fact that while it is essential to understand the
theory of " nance, it is equally important to understand the business environment,
including how competitors are likely to react to a " rm’s actions. A great deal of
judgment goes into making good " nancial decisions.Positive Within-Firm Externalities
Cannibalization occurs when new products compete with old ones. However, a new
project also can be complementary to an old one, in which case cash! ows in the old
operation will be increased when the new one is introduced. For example, Apple’s
iPod was a pro" table product; but when Apple made an investment in another proj-
ect, its music store, that investment boosted sales of the iPod. So if an analysis of the
proposed music store indicated a negative NPV, the analysis would not be complete
unless the incremental cash! ows that would occur in the iPod division were cred-
ited to the music store. That might well change an NPV from negative to positive.Environmental Externalities
The most common type of negative externality has to do with the environment.
Government rules and regulations constrain what companies can do, but " rms have
some! exibility in dealing with the environment. For example, suppose a manufac-
turer is studying a proposed new plant. The company could meet the environmental
regulations at a cost of $1 million, but the plant would still emit fumes that might
cause ill feelings in its neighborhood. Those ill feelings would not show up in the
cash! ow analysis, but they still should be considered. Perhaps a relatively small
additional expenditure would reduce the emissions substantially, make the plant
look good relative to other plants in the area, and provide goodwill that would help
the " rm’s sales and negotiations with governmental agencies in the future.
Of course, everyone’s pro" ts depend on the earth remaining healthy, so com-
panies have an incentive to do things to protect the environment even though
those actions are not required. However, if one " rm decides to take actions that are
good for the environment but costly, its products must re! ect the higher costs. If its
competitors decide to get by with less costly but less environmentally friendly
processes, they can price their products lower and make more money. Of course,
the more environmentally friendly companies can advertise their environmental
efforts, and this might—or might not—offset the higher costs. All of this illustrates
why government regulations are necessary, both nationally and internationally.
Finance, politics, and the environment are all interconnected.SELF^ TEST Why should companies use a project’s cash! ows rather than accounting in-
come when " nding a project’s NPV?
Explain the following terms: incremental cash! ow, sunk cost, opportunity
cost, externality, and cannibalization.
Give an example of a “good” externality, that is, one that increases a project’s
true NPV.