1. Concepts and Tools Flashcards
Cost concepts: What is cost?
The amount paid in cash or other resources for a good or service.
Cost concepts: What is expense?
The portion of cost that relates to the portion of a good or service that has been used up.
Cost concepts: Do cost and expense occur at the same time or different time?
Both.
Cost concepts: What is sunk cost? How is it relevant?
Costs of resources that have been incurred in the past and can’t be changed by current or future decisions.
Not relevant for decision making.
Cost concepts: What is opportunity cost?
Discounted dollar value of benefits lost from an opportunity not taken as a result of choosing another opportunity.
Cost concepts: what is the relationship between opportunity cost and actual cash flow?
Opportunity cost does not involve actual cash flows, but relevant to current decisions.
Cost concepts: what is differential costs? When the cost is the same between 2 alternative, how relevant is it for decision making?
Costs that are different between 2 or more alternatives.
Not relevant.
Cost concepts: what is cost of capital?
Cost of LT funds - debt/equity - used to finance an operation.
Cost concepts: What are major LT sources of capital funding?
LT debt, preferred stock, common stock.
Cost associated with them is the cost of capital.
Cost concepts: what is cost of debt?
Rate of return that must be paid to attract and retain lenders’ funds.
Cost concepts: How is rate of return required determined?
- Level of interest rate in general market
- Perceived default risk of the firm
- Perceived interest rate risk
- Perceived inflationary risk
- Longevity risk - length of debt etc
Cost concepts: Which one is considered more risky; debt or equity? How does this impact the required rate of return?
Equity.
Required rate of return on debt (cost of debt) is less than on preferred or common stock.
Cost concepts: What is cost of preferred stock?
Rate of return that must be paid to attract and retain preferred shareholders’ investment.
Cost concepts: what kind of characteristics does preferred stock have?
Characteristics of both debt and equity.
Cost concepts: How is pref. stock like debt?
Dividends expected and paid before common dividends
Cost concepts: How is pref. stock like equity?
Possible claim to additional dividends and priority claim to assets upon liquidation.
Cost concepts: Which one is more risky; pref. stock, com. stock, debt? How does it impact required rate of return?
Debt < Pref. stock < Com. stock
The required rate of return for pref. stock is more than debt, but less than com. stock.
Cost concepts: what is cost of common stock?
Rate of return that must be paid to attract and retain common shareholders’ investment.
Cost concepts: How is the rate of return for common stock determined?
- Perceived risk of stock
- Expected dividends
- Expected price appreciation
Cost concepts: How is the rate of return required by each source determined?
By the opportunity cost each source has in the market for comparable risk.
Cost concepts: what does it involved to attract and retain each source of capital?
Require paying a rate of return at least equal to the next best available alternative rate in the market with comparable risk.
Cost concepts: what is a weighted average cost of capital?
WACC: Rate of return of each source of capital weighted by its share of the total capital.
Cost of each source consolidated for all element used by an entity.
Cost concepts: how is WACC computed?
- Percent of total capital is determined for each source
- Percent of each is multiplied by the cost of capital for that source of capital
- Resulting weighted costs of capital are summed to get the weighted average cost of capital
