a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality.
b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline.
c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
e. Identifying an externality can never lead to an increase in the calculated NPV.
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