The main contents of this chapter include all of the following: Cost definitions, expected value, depreciation, activity-based costing, investment categories, cost of capital, interest rate effects, methods of ranking investments. | Supplement A Financial Analysis Cost Definitions Expected Value Depreciation Activity-Based Costing Investment Categories Cost of Capital Interest Rate Effects Methods of Ranking Investments OBJECTIVES 2 Cost Definitions Fixed costs are any expenses that remains constant regardless of the level of output Variable costs are expenses that fluctuate directly with changes in the level of output Sunk costs are past expenses or investments that have no salvage value and therefore should not be taken into account in considering investment alternatives 3 Cost Definitions (Continued) Opportunity cost is the benefit forgone, or advantage lost, that results from choosing one action over the best alternative course of action Avoidable costs include any expense that is not incurred if an investment is made but must be incurred if the investment is not made 3 Expected Value This analysis is used to include risk factors (probabilities) with payoff values for decision making Basic premise: 4 Expected | Supplement A Financial Analysis Cost Definitions Expected Value Depreciation Activity-Based Costing Investment Categories Cost of Capital Interest Rate Effects Methods of Ranking Investments OBJECTIVES 2 Cost Definitions Fixed costs are any expenses that remains constant regardless of the level of output Variable costs are expenses that fluctuate directly with changes in the level of output Sunk costs are past expenses or investments that have no salvage value and therefore should not be taken into account in considering investment alternatives 3 Cost Definitions (Continued) Opportunity cost is the benefit forgone, or advantage lost, that results from choosing one action over the best alternative course of action Avoidable costs include any expense that is not incurred if an investment is made but must be incurred if the investment is not made 3 Expected Value This analysis is used to include risk factors (probabilities) with payoff values for decision making Basic premise: 4 Expected Value Problem Suppose you have to choose between one of three processes (A, B, or C) with the following monthly profit and respective probabilities of those profits being realized. Compute expected values and choose a process. Process Payoffs Probabilities Pay x Prob. EV A $6,000 90% 6, = $5,400 B $8,000 75% 8, = $6,000 C $9,000 65% 9, = $5,850 Select Process B 4 Economic Life and Obsolescence Economic life of a machine is the period time over which it provides the best method for performing its task Obsolescence occurs when a machine is worn out 4 Depreciation Depreciation is a method for allocating costs of capital investment, including buildings, machinery, etc Depreciation procedures may not reflect an asset’s true value because obsolescence may at any time cause a large difference between the true value and book value 3 Depreciation Methods Straight-Line Method Sum-of-the-Years’-Digits (SYD) Method Declining-Balance Method Double-Declining-Balance Method .
