Finance - Cost Concepts

Question 1

Cost vs Expense

Answer 1

Expense is portion of cost that relate to portion of a good or service that has been used up; Cost is amount paid for an asset

Cost and expense can occur at different times and in different amounts - “Cost of machinery = resource; Expense depreciation of the asset)

Can occur simultaneously and in same amount; Cost -> Expense (wages)

Question 2

Sunk Cost

Answer 2

Costs of past and cannot be changed by current or future decisions (not relevant in decision making process)

EX - Purchase price of old equipment and related depreciation

Question 3

Opportunity Cost

Answer 3

Discounted dollar value of benefits lost from an opportunity not taken due to another opportunity chosen

Question 4

Differential/Incremental Cost

Answer 4

Costs that are different between 2 or more alternatives; costs that are the same are not relevant

Question 5

Cost of Capital

Answer 5

Cost of long-term funds - debt/equity

1) Long-term debt
2) Preferred stock
3) Common stock

Debt - Rate of return that must be paid to investors to attract and retain funds

Preferred stock - Rate of return that must be paid to shareholders to attract and retain funds

• Like debt - dividends expected and paid before common stick
• Like equity - possible claim to additional dividends

Required rate of return (cost) greater than debt but less than co,,on stock

Common stock - Rate of return that must be paid to attract and retain common shareholders’ investment

-more risky than debt or preferred stock; required rate of return is greater

Question 6

Underlying concept of Cost of Capital

Answer 6

Rate of return required by each source is determined by opportunity cost each source has in the market for a comparable risk

Must pay rate of return at least equal to next best alternative rate in market with comparable risk

Cost of each source can be consolidated into weighted average cost of capital

Question 7

WACC

Answer 7

Rate of return of each source of capital weighted by its share of the total capital

Calculation

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

Tax savings only apply to bond no C/S or P/S