BUS601: Financial Management

Investment represents a decision to spend money now (cost of the investment), for a return at some point in the future. Not to complicate matters too much, but let's just take a minute to review the types of costs that might be involved.

• Relevant Costs - For a cost to be relevant, it must only be incurred as a result of the investment. For example, if you are looking to invest in a new machine for your manufacturing operation: Relevant – Costs for the equipment, shipping, installation, maintenance, and training. Non-relevant – rent for the facility (unless you need a new place for the machine), business overhead, and marketing expenses.
  
  
• Cost from Cannibalization - A more complex cost to consider involves the determination of whether the investment will have any impact on existing sales.
  
  For example, if your investment will produce a new product/service that will eliminate any of the sales of your existing offering, cannibalization is occurring. A relevant cost would be to account for the lost revenue.
  
  You have been selling one equipment model, A, in your business, and you forecast sales for the next 12 months of $100,000. Based on feedback from your customers, and changes in your market, you have decided to add an additional model, B, to your product offering. You forecast that you can sell $100,000 of model B next year. However, you also realize that some of the customers who would have purchased model A will probably switch to model B. In other words, the new product will cannibalize some of model A's sales.
  
  

  Products	Current Sales	Projected Sales
  Model A	$100,000.	$60,000.
  Model B	$0.	$100,000.
  Total Sales	$100,000.	$160,000.

  
  
  A relevant cost in considering the cost/benefit analysis of expanding the product line is the loss of $40,000 from model A revenue. The good news is that you are making more money.
  
  
• Opportunity Cost - One of the more challenging costs to identify and quantify may be opportunity cost or the loss of revenue for pursuing one opportunity over another. You may remember this term from your first economics course.
  
  What if you have two investment opportunities, both of which can produce a positive ROI, but you can only pick one? The opportunity cost represents the loss of revenue from the investment that we did not pick. Opportunity costs help us to understand the trade-offs that are involved when we have to decide between two investment opportunities.
  
  For example, you purchase a new service vehicle for your business. You have the option of fitting it for residential or commercial work. For the purpose of our example, assume that it has to be one or the other. Once you make your decision to use this vehicle for commercial customers, the opportunity cost is the revenue that you will not get from the residential market.
  
  
• Sunk Cost - A simple way to think about sunk costs, is that once you have spent money on something if you can't recover that money, it is a sunk cost. Sunk costs will not be considered in any investment decisions going forward. Remember, we are looking at cost through a financial analysis set of lenses. Some examples may help. You have spent $5,000 training your technicians on a new product, and the manufacturer has decided not to launch it. You won't keep spending money on training, just because you've already spent $5,000. It is a sunk cost. You paid a bonus to one of your employees last year based on his/her performance. This year, this employee has turned out to be a disaster. You won't let the fact that you paid a big cash bonus last year affect your decision on whether or not to keep this employee. It's a sunk cost.

Now that we've covered the concept of the time value of money, including present and future values, we can turn our attention to how we can use this information to improve our decisions regarding major purchases or investments for the business. This will require some discussion on how to use net present value (NPV) in your analysis of investment opportunities. We will also review some "investment rules" used with the NPV analysis.

As you work to grow your business, you will be making decisions that require investments. You may have to buy new service vehicles, expand your facilities, or invest in new technology. In financial planning, this process is called capital budgeting. You identify major projects with substantial investments that will affect the business long-term. These investment decisions are part of your company's strategic plan for growth.

This study session is an excellent way to review what you've learned so far and is presented by the professor who created the course. Watch this as you work through the unit and prepare for the final exam.