Question

Describe negative within-firm externalities as they pertain to cash flow versus accounting income.

Answer 1

Net income is not equal to the cash flow available for distribution to investors, For capital budgeting purposes, it is the project’s net cash flow, not its accounting income, that is relevant. Therefore, when analyzing a proposed capital budgeting project, disregard the project’s net income and focus exclusively on its net cash flow. For Cash flow estimation along with other factors, externalities are also required to consider.

Externalities are the effects of a project on other parts of the firm or on the environment. There are three types of externalities: negative within-firm externalities, positive within-firm externalities, and environmental externalities. These externalities exam the impact of the new business on the existing business.

"Negative within-firm externalities" are cannibalisation where New project competes with Old projects, so reduces Cash Flow of Old project. Loss of Cash flow from Old project should charged against Cash flow of new project to properly evaluate new project Cash flows.

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