- The present value of cash flows determines a firm's value.
- Incremental cash flows are the difference between accepting and rejecting a project.
- The rental car company's purchase of new cars is a replacement project.
- Sunk costs are not considered in capital budgeting analysis.
- The introduction of a zero-calorie cola drink creates an externality.
The present value of cash flows can indeed be used to determine the basis of a firm's value. By discounting future cash flows to their present value, we can assess the financial worth of a firm and make informed decisions.
Regarding the description of incremental cash flows, the correct answer is:
They are the difference between the cash flows the firm will have if it accepts the project versus the cash flows it will have if it rejects the project. Incremental cash flows represent the additional cash flows generated by accepting a project compared to the cash flows that would occur without the project.
In the case of the rental car company buying a new fleet of midsize cars and selling off its old cars, this would be considered a replacement project. The company is replacing its old cars with new ones, aiming to maintain or improve its operational efficiency and customer satisfaction.
Sunk costs are costs that have already been incurred and cannot be recovered. In capital budgeting analysis, sunk costs are not considered because they are irrelevant to the decision-making process. These costs are already spent and cannot be changed, so they should not influence future investment decisions.
In the scenario of the large soft-drink company introducing a new zero-calorie drink that tastes like regular cola, this project is likely to produce an externality. The introduction of a new product that combines the taste of regular cola with zero calories can impact the sales and market perception of both the regular cola and diet cola. It creates an externality by affecting related products within the company's portfolio.