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Flashcards in Financial Management: Concepts and Tools Deck (11):

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. 
  • 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. 

  • 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.

  • 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.

  • 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. 

  • 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."