Question

Which of the following statements is/are correct?

1. Since depreciation is not a cash expense, it has no effect on FCF thus no effect on capital budgeting. (this is not the answer, I got marked off).

2. Externality can be either negative or positive factor when estimating FCF.

3. If sunk costs are considered and reflected in a project’s cash flows, then the project’s NPV will be higher thus sunk cost should be included.

4. The inclusion of an externality can never be lead to an increase in a project’s NPV.

5. The sale of the equipment when the project is completed. The tax is calculated by multiplying tax rate with the sale price of the equipment.

Answer 1

The correct answer is Option Second(Externality can be either negative or positive factor when estimating FCF)

Externality affects the cash flows which are not associated with project. They can be positive or negative.

Option First is incorrect since although depreciation is a non cash expense but it is added back to get the Free Cash Flows and thus it has effect on capital budgeting.

Option Third is Incorrect since If sunk costs are considered, it will increase the cash outflows which will in turn reduce the NPV.

Option Fourth is incorrect since Externality can also lead to savings in cost. It can be both positive or negative but it is not associated with the project directly.

Option Fifth is incorrect since when the equipment is sold at a higher price, the tax is calculated by multiplying the tax rate with the gain (difference between sale price and book value).