FACC300 Final Exam

Lecture Notes 4-8

Manufacturing Costs

• Direct Raw Materials

• Direct Labour

• Manufacturing Overhead

Nonmanufacturing Costs

• Overhead

• Marketing

• Administrative Functions

Period Costs

Appear when they are charged for that period (Marketing expenses, marketing, administrative functions)

Product Costs

Appear when the product is sold (direct material costs, direct labour cost, manufacturing overhead)

Where do product costs show up?

Balance sheet:

Direct materials appear in Raw materials inventory (direct materials use in produciton in balance sheet)

Direct labor and Manufacturing overhead appear in work-in process inventory (cost of goods manufactured in balance sheet)

Where do period costs (selling and administrative) show up?

Income Statement

Examples of product costs

Raw materials, Labor, Overhead (Supplies/Utilities)

Examples of Period Costs

Taxes, Operating Expenses (Rent, Debt service)

Fixed Cost

Unaffected by production output (rent, repayment of debt, insurance, salaried employees)

Variable Costs

Costs affected by production output (costs of direct materials, direct labour, hourly employees)

Total costs

Fixed + Variable Costs

Total cost functions typical shape

“S-shaped” —> being steep at low and high production rates, and shallow at “medium” rates

Average Total Cost (average cost per unit)

Slope of a line connecting the origin to TC(x)

(Total Cost)/x

Marginal Cost (cost of one additional unit)

Derivative of TOtal cost w.r.t. x

AFC (average fixed cost)

always decreasing

AVC (average variable cost)

decreases then increases

When is average total cost minimized

when it’s derivative = 0

when ATC = MC

When is MC minimzed

when its derivative = 0

Profit

Revenue - Costs

Revenue formula

P x Q

Costs formula

FC + vc x Q

(Fixed Costs) + average variable costs x qty

Contribution margin

profit from selling one additional unit (marginal profit)

CM = P - vc

Break-even rate

Production rate where TP >= 0

Total revenue = Total Profit

Q = FC/CM

How do firms acquire funds?

Debt and Equity

Debt

Receiving loans, issuing bonds

Equity

Issuing shares, retained earnings

Cost

The effective annual interest rate that makes all cash inflows and outflows equivalent

Debt: Bonds (company’s POV)

• Company receives cash today

• Principal paid back at bond’s maturity

• Interest baid back every year

Debt: Bonds (bondholder POV)

• low risk because:

  • interest must be paid

  • if company can’t pay interest, the principal (face value) is immediately due

  • if company declares bankruptcy then bondholders are paid fire

• low ROI due to low risk

interest paid from bond

CPN rate * FV (NOT MARKET PRICE)

Equity: Preferred Stock

• Shared qualities with both common stock and bonds

• “Safe” kind of stock

• Shareholder has NO voting rights

• company received funds today: FV - issuing expenses

• investor receives fixed dividend forever

Equity: Preferred Stock (Shareholder POV)

• medium risk

• dividends must be paid, if they can’t:

  • company is forbidden from issuing common dividends

  • next year, company has to pay this year’s PLUS next year’s dividend

• Price of preferred shares tends to be very stable

• If company declares bankruptcy, shareholders are paid back FV (if they can afford it), after bondholders are paid

• medium ROI due to medium risk

Equity: Common Stock

• 1 share = 1 vote

• Company receives funding today (price - issuing expenses)

  • Investor receives dividends (not guaranteed)

Equity: Commom Stock (shareholder POV)

• high risk

• no guarantee of common dividends

• healthy companies try to have divs grow at a fixed % every year

• price of common shares tend to be very volatile

• If company declares bankruptcy, shareholders are paid back FV (if they can afford it), after bondholders and preferred shareholders are paid

• high ROI due to high risk

Equity: Retained Earnings

Net Income - Dividents paid

Company’s value grows higher with _____ retained earnings

more

Cost of capital

WACC

Weighted average of cost of all sources of capital:

• Cost of debt

• Cost of equity

Cost of long term debt (kd)

Effective annual interest rate that makes net proceeds equivalent to interest payments and face value

approximatino for cost of debt (before tax)

interest payments/face value (fully correct when no issuing expenses, annual coupon payments,and sold at par)

Impact on net income: Interest (coupon) payments

reduces taxes paid at time of payment

Impact on net income: Issuing expenses

Reduces taxes paid at time of issue

Impact on net income: Discount

Increases taxes paid at maturity

Approximatino for cost of debt (After tax)

kd = I(1-t)/F *when N>20 then F becomes NP

Cost of Capital: Preferred Equity (FV, div and Cost of PE)

Face Value (Issuing price and used to calculate preffered dividends)

Preferred dividends: (Div rate * FV)/(# div per year)

Cost of preferred equity (effective annual interest rate that makes net proceeds equivalent to preferred dividends)

net proceeds for debt after tax

FV - (FV)(iss. expense) + (t)(iss. expense)

CPN after tax

CPN*(1-t)

rough approx. for cost of preferred equity (before tax)

kp = Div/NPbt * after tax approx. is just with NPat instead

Cost of Capital: Common Shares (FV, div and Cost of PE)

Face Value: Issuing price but meaningless once shares are trading on the market

Common Dividends: typically constant and growing at g% per year, but 0$ for forseeable future

kc = effective annual interest rate that makes net proceecs equiv. to common dividends

For both Preferred Equity and Common Shares, only ____ are affected by taxes

issuing expenses

WACC formula

kd*(Cd/V) + ke*(Ce/V) where V = Cd + Ce

Dilution

issuing new shares when current shares already exist

Debt ration

Cd/V

Payback period

Amount of time to earn back initial cost

Discounted Payback Period

Payback period that factors in time value of money

when to approve a project (which NPW)

greater than 0 (if exactly zero remain neutral)

Present-value ration

NPV(entire project)/NPV(initial costs)

Profitability Index

PI = NPV(production cash flows)/NPV(initial costs) * PI>1

Benefit-Cost Ration

BCR = NPV (all benefits)/NPV (all costs) * BCR>1

Capital Cost/Capital Expenditure

• Cost of purchasing asset

• Usually one time expense

  • 
    

Salvage Value

Revenue from selling asset at end of life

Operating Costs

• Annual expenses from operating asset

• Labour, raw materials, routine maintenance

IRR

interest rate where NPV = 0

Simple cash flows

Negative cash flow(s) followed by positive cash flow(s), only one sign change!

Complex cash flow

Multiple sign changes, number of roots is less than or equal to number of sign changes

what does IRR stand for?

Internal Rate of return

Modified IRR (MIRR) aka External Rate of Return (ERR)

Future value of all cash inflows at the end of project life/Present value of all cash outflows at the beginning of project life = (1 + MIRR)^N

• provide sreasomable approximation of IRR for non-conventional cash flows

if i < IRR(B2 - B1) then…

NPV(B2 - B1) > 0 and we should pick B1!

if i > IRR(B2 - B1) then…

NPV(B2 - B1) < 0 and we should pick B2!

if i > IRR(B1)…

pick neither!!! NPV of both is negative

IRR(B2-B1)

Crossover point

Market Value: “True Value’

• Value that an asset can be sold for in an open market

Book Value

Initial cost of an asset, minus all the depreciation claimed up until now

Are Market Value and Book value always the same

Nope! They are rarely indentical

Accounting Depreciation (Book Depreciation)

• Can pick own depreciation style

  • BV at end of life = Salvage Value

Tax Depreciation

• Needed to calculate your income taxes

• Govenment tell you how to depreciate

  • Book value at end of life = 0

Straight-Line Depreciation

Depreciate the same amount every year

DC = (IC - SV)/N

BV = IC - n((IC - SV)/N)

Declining-Balance Depreciation

The depreciation charge in a given year is a constant fraction of the previous year’s book value (d = depreciation rate)

DC = IC(1-d)^(n-1) * d

BV = IC(1-d)^n

Units of production depreciation

Depreciation charge is proportional to units produced in that year

• ex: DC in year 2 = (IC - SV)*(usage in year 2/lifetime usage)

Sum of the Years Depreciation

Depreciation charge decreases linearly over time

Depreciation rate d in year n of a project with a life of N years

• dn = (N + 1 - n)/sum of k from k=1 to N

Lower taxable income = _____ taxes paid

less

Total Cash Flow (CF) = Net Income + _____

Depreciation

Are there taxes associated with purchase of fixed asset?

No!!!

When in CF to add or subtract taxes

Operating expenses: reduces taxes paid

Annual revenue: increases taxes paid

Depreciation: reduces taxes paid

Salvage value: tax savings or penalty based on difference between SV and BV

SV > IC then pay:

taxes on over-depreciation PLUS capital gain

Capital gains

pay tax on 50% of “profit” —> (SV - IC)

CCA Rate is another term for

declining balance depreciation rate

UCC

Undepreciated cost of capital: value of assets that have not yet been depreciated, or in other words the BV

Operating tax factor

useful for converting a before tax cash flow to an after cash tax flow

NPV (initial cost and tax savings from depreciation)

IC * CTF

NFV is SV * CTF

Half year rule

You can only claim hald the normal depreciation in the year of acquisition (d is halved)

If you can buy 30% as many big macs in 2026 as you could in 1995, what is happening to the purchasing power?

Decreased by 70%

Current dollar

Purchasing power of money at that moment

COnstnat dollar

Purchasing power of money with respect to a reference year

Current $ formula

Current $ = Constant $ * (Index year N/Index year 0)

Inflation adjusted rates formula

(1 + i) = (1 + i’)(1 + f) where i (Actual) is interest rate in current dollars and i’ (real) is interest rate in constant dollars