Cost Concepts

Question 1

What is the difference between a cost and expense?

Answer 1

Cost is the amount paid in cause or other resources for a good or service

Expense is the PORTION OF COST that relates to the PORTION of a good or service that has BEEN USED up

Question 2

T/F: Cost and expense can occur at different times or at the same time?

Answer 2

TRUE

Cost may become a resource (asset) and then depreciation as an expense

or it may be expensed immediately

Question 3

What is a sunk cost?

Answer 3

Cost of resources that have been incurred in the past and cannot be changed by current or future decisions.

• Not relevant in making current decisions

Example: In making a decision about equipment replacement, the original or carrying value of the current equipment is a sunk cost

Question 4

What is opportunity cost?

Answer 4

Discounted dollar value of benefits lost from an opportunity not taken as a result of choosing another opportunity

Example: Revenue lost from an alternative not selected is opportunity cost associated with the alternative that is elected

Opportunity cost do not involve actual cash flows

Relevant to current decisions

Question 5

What is differential cost/incremental cost?

Answer 5

Costs that are different between the two or more alternatives

Question 6

What is the cost of capital?

Answer 6

Cost of long-term funds - debt/equity- used to finance an operations

• Long-term debt
• Preferred stock
• Common stock

Each source of capital funding has a cost associated with it- the “cost of capital”

Question 7

What is the cost of debt?

Answer 7

Cost of debt = rate of return that must be paid to attract and retain lenders funds

Rate of return is determined by:

• Level of interest rate in general market
• Perceived default risk
• Perceived interest rate risk
• Perceived inflationary rate
• Longevity risk- length of debt

Generally DEBT is considered LESS RISKY than EQUITY

Required rate of return on debt is less than on preferred or common stock

Question 8

What is the cost of preferred stock?

Answer 8

Rate of return that must be paid to attract and retain PREFERRED stockholders investment

Preferred stock has characteristics of both debt and equity

• Like debt- Dividends expected and paid before common
• Like equity- possible claim to additional dividends and has a priority claim on assets

Generally considered more risky than debt, but less risky than common stock

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

Question 9

What is the cost of common stock?

Answer 9

Rate of return that must be paid to attract and retain common shareholders investment

Rate of return is required is determined by

• perceived risk of stock
• expected dividends
• expected price appreciation

More risky than debt/preferred stock
- Rate of return is higher than both mentioned above

Question 10

What is the weighted average cost of capital?

Answer 10

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

Calculation:

• Percentage of total capital for each source of capital
• Percentage is multiplied by cost of capital for that source
• Resulting weighted costs of capital are summed to get the weighted average cost of capital