Skip to main content
Pearson+ LogoPearson+ Logo
Start typing, then use the up and down arrows to select an option from the list.

Introduction to Cost Method Investments

Brian Krogol
Was this helpful?
Alright now let's discuss some of the investments a company can make to earn investment income, and how we classify those investments. Alright, let's do an introduction now. So a company may choose to invest for one of two main reasons. The first one would be if they have excess cash, right? They've been generating a lot of cash through their business and they have more cash than they can invest back into their business. Maybe they can't specifically grow their business. So they might buy some investments to earn a little extra money. So they're gonna earn some income off of these investments that they make. Or they can do it to uh to exercise influence over another company. If you buy enough stock in another company, you can say that you influence the company. Imagine if you owned all the stock in a company, well then you would be able to control that company, Right? So buying enough stock in another company allows you to affect its decision making. Okay? You can have you can have influence over the decision making. And we say that when you generally when you have more than 20% of the company, you're able to influence the company. Okay. So at this point we're gonna focus on less than 20% investment. So small investments that you make, maybe you buy 10 shares of Apple stock or some like that. Well, you're not gonna be able to control the company with just a few shares of the stock, but you might be able to make some income. So we're kind of focused more on this idea where you're just trying to make a little extra income off excess cash. Okay. We'll talk about influence in later videos. Um, but for now, let's discuss some of these securities that you might buy. So security. We use this word security for basically any kind of investment that you make. If you buy stock, if you buy bonds, right, any kind of financial instrument that holds monetary value, right? That's a security. Okay. So it's kind of a generic term and it could represent an ownership in the company or a creditor relationship. So creditor is like where they owe you money, right? So we have two types of securities. We, we talk about equity securities, which is an ownership interest, right? This is where you have an ownership interest in the company. So that's like buying common stock of the company or you might buy a special type of stock called preferred stock. Okay. It's similar to common stock, but it has special rules. Not, not too much to talk about it now, but it's basically just buying ownership interest in the company. Okay. So the way that you earn money off of an equity security is through the dividends that it pays. So we've talked about dividends before, but now we're on the receiving end, right? The company's gonna pay dividends and we're gonna receive a dividend that's income to us and through capital gains capital gains. Well, capital gains is when there's an increase in the value of the security. So you buy it at one price and the price goes up and you sell it at a higher price, right? Buy low, sell high. Those are capital gains there. So let's do a quick example about equity securities and uh income. So what do we got here? You purchased 10 shares of banana stock for $400. The company paid a dividend of $1 per share. You sell the banana stock when the price has increased to $55 per share. How much income did you earn on your investment? Okay, so there's two sources of income here, right? You earn income from the dividends you receive and you earn income from the capital gains. So let's check each of them separately 1st. Let's do the dividends. So the dividends, it says they paid $1 per share and you bought 10 shares, right? So if you bought 10 shares and you got $1 per share in dividends, 10 times $1 Well that's $10 in dividends that you received. Right? Not too nothing too crazy there. Let's think about the capital gains. Now You earned some money on the change in the price between when you bought it and you sold it. So let's see what you bought it for. You bought it, you bought 10 shares for $400, right? So there's two ways you can go about this, let's go about it. Two different ways you can think about the investment as a whole and think about how much you earned on the total investment. So if you if you bought 10 shares for 400, how much did you sell those shares for? $55 per share? And there were 10 shares. Right? So the selling price was $550 uh for the 10 shares, right? And you bought them for $400. So your earnings were $150 in capital gains, right? So you can think of it in total or you can do it on a per share basis But you're gonna get to the same answer right? So what you could do is you can find out, you sold each one for $55 per share. Let's find out how much you bought each one. So sorry, so you bought each one for $55 per share. How much did you purchase them for? Well you bought four, you spent 400 on 10 shares, so you paid $40 per share, right? So that means you earned 55 -40, you earned $15 per share was your earnings. And you you bought 10 shares, so you got 100 and $50 right. Either way you got 100 and $50 in capital gains and $10 from dividends. So how much income did you earn? Well you earned 160 right, you earned the sum of the 21 50 plus the 10 equals 1 60 total earnings. Right? The total of the two earnings would be your total investment income. So with equity securities, you can earn from two different places from dividends and from capital gains. Now, what about debt securities? These are the other type of security. We're gonna either have an equity security where we buy equity in a company, or debt security where we loan money to another company money. So in a debt security, it's money that is borrowed and it must be repaid with interest. So in this case, we're the ones lending out the money, right? So we're lending money to somebody and they're gonna pay us back with interest eventually. So this is usually bonds that we're gonna see as the investment will see. We will buy bonds in another company. Okay, So in that in that case we'll be dealing with how much interest that we earned, uh, nothing too crazy there. So let's go ahead and pause here and then we'll talk about the different classifications of securities, how we classify them on our books