Financial Management: Concepts and Tools Flashcards
Cost Concepts: What’s the difference between “Cost” and “Expense”?
Cost: the amount paid or obligation incurred in for a good or service; may be unexpired or expired.
- An unexpired cost is an asset;
- An expired cost is an expense.
Expense: the portion of cost that relates to the portion of a good or service that has been used up.
- Cost and Expense are not the same concepts
- Cost and Expense can occur at the same time or at different times.
Example: Cost and Expense occurring at different time and different amounts:
- Cost=$10,000
- Resource (asset)=$10,000
- Expense (e.g. depreciation)=$2,000
Example: Cost and Expense occurring simultaneously and in same amount:
- Cost=$10,000
- Expense (e.g. wages)=$10,000
Cost Concepts: What are “Sunk Costs”?
Sunk Costs: Costs incurred in the past that cannot be changed by current or future decisions and, therefore, are irrelevant to current decisions.
Sunk Cost Example:
In making a decision about equipment replacement, the original cost or carrying value of the current equipment is a sunk cost.
- Sunk cost is not relevant to making replacement decision.
Cost Concepts: What’s an “Opportunity Cost”?
Opportunity Cost: Benefit lost from an opportunity as a result of choosing another opportunity. It is measured as the discounted dollar value or other benefit foregone and is relevant in making current decisions.
Example of Opportunity Cost:
- The revenue lost from an alternative not selected is an opportunity cost associated with the alternative that is selected.
- Opportunity cost do not involve actual cash flows, but potentia benefit of selecting one opportunity over another is sacrificed.
Cost Concepts: What are “Differential (or Incremental) Costs”?
Differential (or Incremental) Costs: Costs which are different between two or more alternatives.
- Differential costs are relevant in making decisions between the alternatives - thus relevant to current and future economic decisions.
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For example:
- In deciding whether or not to accept a special order for a product, only the new costs that would be incurred in accepting the order would be relevant.
- Fixed costs that would not change whether or not the order is accepted would not be relevant.
Cost Concepts: What constitutes “Cost of Capital”?
Cost of Capital: Cost of long-term funds–debt/equity–used to finance an operation.
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Major long-term sources of capital funding include:
- Long-term debt
- Preferred Stock
- Common Stock
- Each source of capital funding has a cost associated with it – the “cost of capital”.
Cost Concepts: How is a firm’s Cost of Capital determined?
Determination of Cost of Capital:
- It is the rate of return that must be earned by prospective investors in order for a firm to attract and retain their investments.
- Investors’ expected rate of return is determined primarily by the rate of return that could be earned on other opportunities with comparable risk.
Cost Concepts: Cost of Capital – Cost of Debt:
Cost of Debt: Rate of return that must be paid to attract and retain lenders’ funds.
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Rate of return required is determined by:
- Level of interest rate in general maket;
- Perceived defauld risk of the firm;
- Perceived interest rate risk;
- Perceived inflationary risk;
- Longetivity risk – Length of debt;
- Perhaps others
- Generally debt is considered less risky than equity.
- Required rate of return on debt (cost of debt) is less than on preferred or common stock.
Cost Concepts: Cost of Capital – Cost of Preferred Stock:
Cost of Preferred Stock: Rate of return that must be paid to attract and retain preferred shareholders’ investment.
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Preferred stock has characteristics of both debt and equity:
- Like Debt – Dividends expected and paid before common dividends
- Like Equity – Possible claim to additional dividents and priority claim to assets upon liquidation.
- Generally considered more risky than debt, but less risky than C/S.
- Required rate of return (cost) greater than debt, but less than C/S.
Cost Concepts: Cost of Capital – The Underlying Concept:
Underlying Concept: Rate of return required by each source is determined by the opportunity cost each source has in the market for comparable risk.
- Attracting and retaining each source of capital requires paying a rate of return at least equal to the next best available alternative rate in the market with comparable risk.
- Costo of each source can be consolidated into a weighted average cost of capital for all elements used by an entity.
Cost Concepts: Cost of Capital – Weighted Average Cost of Capital (WACC):
Weighted Average Cost of Capital (WACC): Rate of return of each source of capital weighted by its share of the total capital. Company’s objective is to minimize it.
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Calculation of WACC:
- 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.
- The use of a company-wide cost of capital to evaluate new capital investments will result in high-risk divisions over-investing in new projects and low-risk divisions under-investing in new projects.
- Because the company has multiple operating divisions, each having unique risk attributes and related capital costs, the use of a company-wide cost of capital to evaluate new capital investments applies a common, average hurdle rate to all projects, regardless of the risk or cost of capital of the particular division for which the capital investment is being considered. Thus, for example, a high-risk division will use the company-wide average cost of capital that will be less than the cost of capital appropriate for its risk and separate cost of capital. Similarly, a low-risk division will use a cost of capital that is greater than the cost of capital appropriate for its risk and separate cost of capital.
Cost Concepts: What’s a “Product Cost”?
Product cost: is the cost assigned to goods that were either purchased or manufactured for resale. Product cost also is often referred to as “inventoriable cost.”
