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McGraw-Hill/Irwin

Supplement A

Financial Analysis

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Cost DefinitionsExpected Value

Depreciation

Activity-Based CostingInvestment Categories

Cost of Capital

Interest Rate EffectsMethods of Ranking Investments

OBJECTIVES

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Cost Definitions

Fixed costs are any expenses thatremains constant regardless of the levelof output

Variable costs are expenses that

fluctuate directly with changes in thelevel of output

Sunk costs are past expenses orinvestments that have no salvage value

and therefore should not be taken intoaccount in considering investmentalternatives

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Cost Definitions (Continued)Opportunity cost is the benefit

forgone, or advantage lost, thatresults from choosing one actionover the best alternative course of

actionAvoidable costs include any

expense that is not incurred if an

investment is made but must beincurred if the investment is notmade

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Expected ValueThis analysis is used to include risk

factors (probabilities) with payoff

values for decision making

Basic premise:

occuringoutcomeofyProbabilit

xoutcomeExpectedvalueExpected

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7Expected Value ProblemSuppose you have to choose between one of

three processes (A, B, or C) with the followingmonthly profit and respective probabilities ofthose profits being realized. Compute expectedvalues and choose a process.

occuringoutcomeofyProbabilit

xoutcomeExpectedvalueExpected

Process Payoffs Probabilities Pay x Prob. EVA $6,000 90% 6,000x0.90 = $5,400

B $8,000 75% 8,000x0.75 = $6,000

C $9,000 65% 9,000x0.65 = $5,850

Select

Process

B

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Economic Life and ObsolescenceEconomic life of a machine is the

period time over which it

provides the best method forperforming its task

Obsolescence occurs when a

machine is worn out

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DepreciationDepreciation is a method for

allocating costs of capitalinvestment, including buildings,

machinery, etcDepreciation procedures may not

reflect an assets true value

because obsolescence may at any

time cause a large differencebetween the true value and bookvalue

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Depreciation MethodsStraight-Line Method

Sum-of-the-Years-Digits (SYD)

Method

Declining-Balance Method

Double-Declining-Balance Method

Depreciation-by-Use Method

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Traditional and Activity-Based CostingTraditional Costing

End product cost

Total overhead

Labor-hourallocation

Activity-Based Costing

End product cost

Cost pools

Cost-driver

allocation

Total overhead

Pooledbased

on activities

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Choosing Among Investment Proposals:Investment Decision CategoriesPurchase of new equipment and/or

facilities

Replacement of existing equipment or

facilitiesMake-or-buy decisions

Lease-or-buy decisions

Temporary shutdowns or plant-abandonment decisions

Addition or elimination of a product orproduct line

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Cost of CapitalThe cost of capital is calculated

from a weighted average of debt

and equity security costs

Short-term debt

Long-term debt

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Interest Rate EffectsCompound value of a single amount

Compound value of an annuity

Present value of a future single payment

Present value of an annuity

Discounted cash flow

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Methods of Ranking InvestmentsNet present value

Payback period

Internal rate of return

Ranking investments with unevenlives

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End of Supplement

A