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CFA Level I · CFA Level I Exam · Capital Investments and Capital Allocation

A firm that is considering a new product expects that it will reduce sales of an existing product, lowering that product's after-tax cash flows by a known amount. In the analysis of the new product, this lost cash flow is most appropriately treated as:

The lost cash flow is best treated as an externality (cannibalization) that reduces the new product's incremental cash flows. It occurs only if the project is accepted, so it is not sunk, and it is an operating effect rather than a financing cost captured in the discount rate.

  1. Aa sunk cost that is ignored
  2. Ban externality that reduces the project's incremental cash flowsCorrect
  3. Ca financing cost reflected in the discount rate

Explanation

Cannibalization is a negative externality: the project changes the firm's other cash flows, so it is an incremental effect deducted from the project's cash flows. It is not sunk because it arises only if the project is accepted, and it is unrelated to financing.

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