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    Sunk Costs, preferred stock, business risk

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    1. Sunk Cost A cost that has already occurred and is not affected by the capital project decision. Sunk costs are not relevant to capital budgeting decisions.


    I own Jai's Ice Cream Shop and noticed that it is not worth it to continue the business in the winter because people do not want to buy ice cream in cold weather. I may decide to shut down the business for the winter season and reopen in the summer. Jai's fixed cost, which is the rent expense for the building can be considered a sunk cost because I signed a lease to continue on paying rent for the whole year. Sunk costs are ignored and are irrelevant to the businessperson when making decisions regarding his/her business.

    2. Preferred Stock A hybrid-it is similar to bonds in some respects and to common stock in other respects. Preferred stock represents ownership in the issuing corporation and has prior claim on dividends. In the case of bankruptcy, preferred stock has a claim on assets ahead of common stockholders. Preferred stock is junior to the issuing entity's debt obligations but senior to common stock in the payment of dividends and the liquidation of assets. The dividend can be fixed or floating and is usually stated as a percentage of par value. Preferred stock usually has no voting rights and frequently has a mandatory or optional redemption provision. The expected dividend is part of the issue's description.

    Example: Payment-in-kind (PIK) - Doesn't pay cash dividends, but rather pays in additional shares of preferred stock, used primarily in takeovers, and are not a major corporate financing tool.

    3. Business Risk The risk inherent in the operations of the firm, prior to the financing decision. Thus, business risk is the uncertainty inherent in a total risk sense, future operating income, or earnings before interest and taxes. Business risk is caused by many factors. Two of the most important are sales variability and operating leverage.

    Example: Business risk can be found in a few broad categories: (price (market); currency (FX, IR, inflation); credit (default); liquidity (cash, opportunity); operational (systems, production); systemic (payments intermediary); reputation (Andersen-Enron); legal and regulatory; and political (al-Qaeda).

    4. Trend Analysis A set of techniques for determining the extent of a company's progress, or lack of it, by comparison of past and present financial statements. Attention is focused on the year-to-year changes in significant figures and ratios.


    If Jai's Ice Cream Shop's inventory turnover rate has shown a noticeable increase in the period between the first and second year reporting dates (First year: $55,000/$25,000 = 2.2 and Second year: $85,000/$23,000 = 3.69); this shows a rising turnover rate shows that either improved sales, improved purchasing or improved stock control. Because sales have increased and inventories have decreased, it is possible that improvements have been made in all three areas.

    5. Target Capital Structure The relative amount of debt, preferred stock, and common equity that the firm desires. The weighted average cost of capital should be based on these target weights.


    Jai's Ice Cream Shop's target capital structure is 30 percent debt, 10 percent preferred stock, and 60 percent

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    Solution Preview

    1) Sunk costs
    The above mentioned example is correct. However, you can use the following example also:
    When we pre order a movie ticket, it becomes a sunk cost in the sense that even if we do not go for the moview later on, money cannot be recovered.

    Airline example:(source: http://www.definethat.com/hitting.asp?ID=337 )
    Another example of a sunk cost is the cost of a seat on an airplane to the airline. The Cost of an airline seat is primarily fixed and sunk (as long as one assumes the flight was going to take place regardless of ...

    Solution Summary

    Sunk Costs, preferred stock, business risk examples