Opportunity Cost of Capital

Opportunity cost of a capital is a term unique to economics and finance. It is unique in the sense that you will not find mention of opportunity cost of capital in the accounting books. It is not an explicit cost which is paid out of the pocket. Hence, there is no mention of this cost in the accounting records. Rather, it is an implicit cost which results out of our investment decisions. This article will explain about opportunity cost of capital and how it must be used while making financial decisions:

Alternate Uses of Money

Opportunity cost of capital represents alternate uses of money.

    Let’s say, if I have a $1000 to invest and I decide to invest the money in the stock market, I am committing my resources. By investing $1000 in the stock market, I will now not be able to use the same $1000 for any other purposes now. I must therefore ensure that I am committing my resources to the best possible project.

    Let’s say, I have a choice between real estate and stock market investment, when I choose the stock market investment, I make it my best possible choice. Opportunity cost of capital tells us what we are foregoing to choose that best possible alternative. Opportunity cost of capital is therefore the value of the second best alternative.

Alternate Projects Must Share Similar Risk Profile

However, we must ensure that we compare opportunity costs of capital across similar projects. This will ensure that we do not see a biased picture and end up choosing the wrong projects.

Consider a comparison between a stock market investment and government bonds. Usually, stock markets will offer more return compared to government bonds. So, using government bonds as the opportunity cost will always make them look good. But stock market investments and government bond investments have very different risk profiles. One guarantees a fixed rate of return whereas there are no guarantees in the other. Hence, using one as the opportunity cost of capital for another will provide a skewed picture and the risky alternative will always be chosen. Hence, only projects with similar risk must be used for opportunity cost of capital calculation. This makes these calculations very subjective and open to debate.

Alternate Uses Represent Implicit Costs

The investment decision is all about prioritizing. It is about choosing the best possible alternative. So, if we have 2 alternatives, one which offers a $100 return potential whereas another which offers an $80 return potential, then by choosing one alternative we are alternatively foregoing the other one. So, if we choose to get a $100 return, we are foregoing the $80 return. Corporate finance captures this implicit tradeoff in the expected rate of return number.

How Opportunity Cost Helps in Decision Making ?

Opportunity cost helps in choosing the right project when faced with a variety of alternatives. Here is how the decision is affected:

  • Higher Opportunity Cost Lowers NPV: A higher opportunity cost implies a bigger discount rate. A bigger discount rate means that the future values are worth considerably less today. This creates a situation where the NPV is lowered. A high opportunity cost of capital raises the bar for all other projects as well.

  • Only the Best Investment Has Positive NPV: Also, we need to understand that in a given set of 2-3 investment proposals, only the best proposal will have a positive NPV. This is because the best proposal will be the opportunity cost of capital for the other projects. Since the opportunity cost of capital will be higher than the cash flows that the project has to offer, the NPV of such a project will be negative. One just needs to be careful about the risk profile of different projects to ensure an “apples to apples” comparison.

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Corporate Finance