Some liabilities have low interest rates and some have no interest associated with them. For example, some of a company’s accounts payable may allow payment in 30 days. With those payables it is better to have the liability and to keep your cash in the bank until they become due.

In our personal lives, our first house was probably purchased with a downpayment and mortgage loan. That mortgage loan was a big liability, but it allowed us to upgrade our living space. I viewed my mortgage loan liability as a good thing because it allowed me to own a nice home in beautiful neighborhood.

So some liabilities are good—especially the ones that have a very low interest rate. Too many liabilities could cause financial hardships.

Learn more about the Balance Sheet.

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation’s common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.

If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.

The internal rate of return or IRR is the rate that will discount all cash inflows and outflows to a net present value of $0. In other words, the IRR model provides you with the true, effective interest rate being earned on a project after taking into consideration the time periods when the various cash amounts are flowing in or out. If you use present value tables to calculate the internal rate of return, it will require some trial and error or iterations to determine the exact rate the project is earning. Software or some financial calculators will provide a quicker and more accurate answer.

The net present value (NPV) discounts all of the cash inflows and outflows by a specified interest rate. The net amount of all of the discounted amounts is the net present value. If the net present value is $0, the project is expected to earn exactly the specified rate. If the net present value is a positive amount, the project will be earning more than the specified interest rate. A negative net present value means the project is expected to earn less than the specified interest rate.

Learn more about the internal rate of return and the net present value at Evaluating Business Investments.

On the other hand, the fixed cost per unit will change as the level of volume or activity changes. Using the amounts above, the fixed cost per unit is $2 when the volume is 3,000 units ($6,000 divided by 3,000 units). When the volume is 4,000 units, the fixed cost per unit is $1.50 ($6,000 divided by 4,000 units).

AccountingCoach.com has free explanations, drills, Q&A, and puzzles on 27 accounting topics.

Here’s an illustration. A company manufactures products in its 100,000 square foot plant. The company’s depreciation on the plant is $1,000,000 per year. The capacity of the plant is 500,000 units of output and its normal output is 400,000 units per year. When the company is manufacturing between 300,000 and 500,000 units, it needs salaried managers earning $400,000 per year. Below 300,000 units of output, some of the salaried manager positions would be eliminated. Above 500,000 units, the company will need to add plant space and managers.

For this example, the relevant range is between 300,000 units and 500,000 units of output per year. In that range the total of the two fixed costs is $1,400,000 per year. Below 300,000 units, the fixed costs will drop to less than $1,400,000 because some salaries will be eliminated and some of the space might be rented. When the volume exceeds 500,000 units per year, the company will need to add fixed costs because of the additional space and the additional managers.  Perhaps the total fixed costs will be $2,000,000 for output between 500,000 units and 700,000 units.

Here’s how it works. If you invest an amount for 8 years at 9% annual interest it will double (because 8 years X 9% = 72). If you invest an amount for 9 years at 8% it will also double (since 9 years X 8% = 72). If your investment earns 6%, it will take 12 years for it to double (since 12 years X 6% = 72; or 72 divided by 6 = 12).

If you invest $1,000 at 12% compounded annually, it will grow to approximately $2,000 in 6 years (6 X 12 = 72; or 72/12 = 6). If the $2,000 continues to earn 12% each year, six years later the investment will be worth $4,000. If the investment continues to earn 12% per year, then in six more years it will have a value of $8,000.

If successful investors were able to earn 18% each year, the value of their portfolios would have doubled every four years (72 divided by 18 = 4). If the investors live a long life and continue to earn 18% compounded annually they will become very wealthy.

Net present value is the present value of the cash inflows minus the present value of the cash outflows. For example, let’s assume that an investment of $5,000 today will result in one cash receipt of $10,000 at the end of 5 years. If the investor requires a 10% annual return compounded annually, the net present value of the investment is $1,620. This is the result of the present value of the cash inflow $6,210 (from above) minus the present value of the $5,000 cash outflow. (Since the $5,000 cash outflow occurred at the present time, its present value is $5,000.)

Present value calculations can be seen at Present Value of a Single Amount and Present Value of an Ordinary Annuity Net present value calculations can be seen at Evaluating Business Investments.

A stakeholder is anyone that has an interest or is affected by a corporation. In other words, the stockholder isn’t the only party having a stake in the corporation. Other stakeholders in a corporation include the employees, the employees’ families, suppliers, customers, community, and others.

Some organizations do not have stockholders, but have stakeholders. For example, the state university doesn’t have stockholders, but it has many stakeholders: students, the students’ families, professors, administrators, employers, state taxpayers, the local community, the state community, society in general, custodians, suppliers, etc.

Learn more about Stockholders’ Equity.

The payback method simply computes the number of years it will take for an investment to return cash equal to the amount invested. For example, if an investment of $100,000 is made in January 2007 and it generates cash of $50,000 for two years followed by $10,000 per year for four additional years, its payback is two years ($50,000 + $50,000). If another investment of $100,000 generates cash of $20,000 per year for two years and then provides cash of $40,000 per year for six additional years, its payback is approximately 3.5 years ($20,000 + $20,000 + $40,000 + 0.5 times $40,000).

As you can see in the examples, payback only answers one question: How long before the cash invested is returned? Payback does not address which investment is more profitable. Payback not only ignored the time value of money, it ignored all of the cash received after the payback period.

The accounting rate of return or return on investment (ROI) are two more examples of methods used in capital budgeting that does not involve discounting future cash amounts.

To overcome the shortcomings of payback, accounting rate of return, and return on investment, capital budgeting should include techniques that consider the time value of money. Two of these methods include (1) the net present value method, and (2) the internal rate of return calculation. Under these techniques, the future cash flows are discounted. This means that each dollar in the distant future will be less valuable than each dollar in the near future, and both of these will have less value than each dollar invested in the present.

We can demonstrate relevant costs with the following situation. A company is deciding whether or not to eliminate a product line. The product line accounts for approximately 4% of the companies activities. If the product line is eliminated, the officers of the corporation will continue to receive the same salaries and the central office expenses will not change. The product line managers and other employees working directly on the product line will be terminated. Hence, their salaries will be eliminated.

The salaries of the product line managers and other employees whose salaries will be eliminated are relevant to the decision. If these salaries are $700,000 with the product line and $0 without the product line, the $700,000 of savings is relevant. Those cost savings and other possible cost savings will be considered along with the loss of sales revenues.

On the other hand, the officers’ salaries are not relevant in the decision. In other words, it doesn’t matter if the officers’ salaries are $500,000 or $5,000,000. The officers’ salaries will be the same with or without the product line. Similarly, the decision maker does not need to know the amount of its central office expenses, since they will be the same with or without the product line. Expenses from previous years are also irrelevant.

To recap, relevant costs are the future costs that will differ among alternatives. You might use the past costs to help you predict those future costs, but the past costs are otherwise irrelevant to the decision. Accountants refer to the past costs as sunk costs.

Obviously, the further into the future you look, the more uncertain are the cash flows. This problem will be offset when the future cash flows are discounted to the present. The further into the future, the bigger the discounting. This means that the present value for distant amounts will be relatively minor in amount.

Even if it is difficult to predict the near future, you could do several calculations. Each calculation would contain different assumptions. You might find that the answer will be the same under each calculation or set of assumptions.

Of course deciding to buy a new machine or to use an old one might be so obvious that the present value calculations are not necessary. For example, if your old machine is becoming unsafe, or is becoming too noisy for residents, there’s little point to calculate the net present value.

You can learn more decisions on buying a new machine by reading Evaluating Business Investments (under the Topics Expained tab) on www.AccountingCoach.com.

Payback. This calculates the number of years it will take to recoup the cash spent on a project. A criticism of payback is that the time value of money is not considered and the cash flows over the entire life of the project are not considered.

Accounting Rate of Return or Return on Investment. This approach looks at the increase in accounting profit compared to the increased investment. This approach also ignores the time value of money.

Internal rate of return. This method does consider the time value of money and looks at the cash flows over the entire life of the project. The technique computes the rate that will discount the future cash flows to be equal to the cash outlay for the project.

Net present value. This method discounts the project’s future cash flows by a predetermined rate, such as the targeted or needed rate. If the cash flows discounted by the targeted rate exceed the cash investment, the project is accepted. That is, the project provides the targeted return or more.

Learn more about Evaluating Business Investments.