• Unit 3: Financial Management

    When a company is considering investing, the starting point is to list all the relevant costs it will incur and the benefits it expects to realize. For example, a service company that is considering the addition of an expensive piece of testing equipment might consider the cost to purchase the equipment, installation expense, perform routine maintenance, and procure replacement parts (cost), as well as the potential for new business, cost reductions, and improved operating efficiencies (benefits).

    Completing this unit should take you approximately 4 hours.

    • Upon successful completion of this unit, you will be able to:

      • calculate the value of a dollar today and at some time in the future;
      • calculate the internal rate of return (IRR) for an investment; and
      • explain how the TVM affects investment decisions faced by the firm.

    • 3.1: Financial Management and the Financial Environment

      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.
      • Capital Budgeting Decisions Book
        As you can see, any discussion on costs can quickly become complicated, but it is a critical component of a cost/benefit analysis. These sections provide a summary of how to evaluate investment decisions. Pay particular attention to the calculations on the rate of return.

    • 3.2: Time Value of Money (TVM)

      • Time Value of Money Page
        When we discuss the concept of money, both invested and received, we will necessarily have to consider the impact of time. One investment rule states that "a dollar today is worth more than a dollar received a year from today". Why?

        It's due to the earnings I will lose from the interest that I give up by not investing that dollar for a year. The principle of considering interest is critical to any investment decision. A discussion on the time value of money will involve the topics of interest, discounting, future value (FV), and present value (PV). Watch this video on the time value of money.
      • Time Value of Money Fundamentals Book
        Investments represent the expenditure of money today for an anticipated return sometime in the future. The first step in understanding how to evaluate an investment is to understand the time value of money. In this section, you will learn about the present and future value of money.

    • 3.3: Net Present Value (NPV)

      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.

      • Net Present Value Page
        Specifically, companies can be faced with several investment opportunities, and after some analysis, they identify a few projects that all represent a positive return. If funds are limited and they can only invest in one project, which one should it be? A firm will conduct a Net Present Value analysis to determine the best investment. Watch this video that explains this process.
      • Use Discounted Cash Flow Models to Make Capital Investment Decisions Book

        If you have more than one investment opportunity but can only afford one, which one will you choose? You are presented with a chance to acquire new equipment that can improve your operating efficiency and help you to increase your sales, but is it worth the cost? After reading the material in this section, you will be able to calculate the value of an investment using discounted cash flows.

    • 3.4: Evaluating Capital Investment Decisions

      Investments are an important financial activity for any business. To meet the expectations of owners or shareholders, a business invests the funds available to them to earn more funds. Capital investments usually involve acquiring large value equipment that will generate a return to the firm over time, such as new manufacturing equipment or a new plant. Companies are expected to make these investments to support their continued growth and increase the firm's value for its owners.

    • 3.5: Other Financial Measures

      We have spent some time understanding the importance of realizing a return on the investments that we make to increase the firm's value. Remember that investments require the expenditure of funds today for some expected return in the future. A simple approach to evaluating investments is to determine the break-even point, or how long it will take to recoup the initial investment. For example, a $1,000 investment that will return $500 a year has a break-even point of 2 years.
      • Calculate a Break-Even Point in Units and Dollars Book
        The calculation of the break-even point (BEP) does not account for the cost of capital, interest rates, or projections on a return on this investment. After you read, you should be able to point out how the BEP is used.
      • Rule of 72 Page
        Another calculation we can use in considering investments is the Rule of 72. Understanding this rule will allow you to determine how long it will take to double your investment given a specified interest rate.

    • Study Session

      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.

    • Unit 3 Assessment

      • Unit 3 Assessment Quiz
        Receive a grade

        Take this assessment to see how well you understood this unit.

        • This assessment does not count towards your grade. It is just for practice!
        • You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
        • You can take this assessment as many times as you want, whenever you want.