Understanding Costs and Financial Instruments: A Comprehensive Guide

Posted on May 4, 2024 in Economy

Classifications of Costs

First Cost

The initial expense to start an activity, typically non-recurring.

Operational and Maintenance Costs

Ongoing expenses for operating and maintaining a firm, including labor, energy, materials, overhead, and repairs.

Fixed and Variable Costs

Fixed costs remain constant, while variable costs fluctuate with operational activity.

Incremental and Marginal Costs

Incremental costs represent an increase in costs, while marginal costs refer to the cost of producing one additional unit.

Sunk Costs

Past costs that cannot be changed by future actions.

Life Cycle Cost

All recurring and non-recurring costs over a product or system’s life cycle.

Life Cycle of a System/Product

Acquisition Phase

  1. Conceptual Preliminary Design
  2. Detail Design Development
  3. Production or Construction

Utilization Phase

  1. System/Product Use
  2. Phase Out/Disposal

Interest

The cost of borrowing money or the return on investment.

Interest Rate

The rate of return on an investment.

Lender Viewpoint

Lenders consider options like exchanging money for goods, storing money, or lending money with or without interest, depending on inflation rates.

Factors for Lending

  1. Risk of Loss (Borrower Default)
  2. Administrative Expenses
  3. Investment Opportunities Forgone
  4. Changes in Interest Rates and Inflation

Earning Power of Money

The potential profit from using borrowed funds for productive purposes.

Time Value of Money

The concept that money received in the future is worth less than the same amount today due to inflation and potential earnings.

Purchasing Power of Money

The amount of goods or services that can be purchased with a unit of currency, affected by inflation.

Simple Interest

Interest calculated only on the principal amount.

Compound Interest

Interest calculated on the principal and accumulated interest.

Principles of Equivalence

  1. Equivalent cash flows have the same economic value at the same point in time.
  2. Cash flows equivalent at one point are equivalent at any point in time.
  3. If A is equivalent to B and C is equivalent to B, then A is equivalent to C.
  4. Conversion of cash flows must reflect the interest rates in effect.
  5. The actual interest rate equates equivalent receipts and disbursements.
  6. A cash flow can be partitioned, and the equivalents of receipts and disbursements for each partition will always be equal with opposite signs.

Bonds

Financial instruments for borrowing money under specific conditions, involving interest payments and repayment of the face value at maturity.

  1. Face Value: The amount to be repaid at maturity.
  2. Market Value: The current price of the bond.
  3. Maturity Life: The time until the face value is repaid.
  4. Yield to Maturity: The effective interest rate considering the purchase price and anticipated receipts.
  5. Interest Rate: The rate of interest paid on the face value.
  6. Current Yield: The annual interest earned as a percentage of the bond’s current price.

Note: Yield to maturity and current yield are equal only when a bond is purchased at its face value.

Loans

Agreements between borrowers and lenders outlining the terms of borrowing and repayment.

Working Capital

Funds needed to finance day-to-day operations, including cash, accounts receivable, inventory, and finished goods.