What Is the Opportunity Cost of Capital?
The opportunity cost of capital is any money that is risked by a business when it chooses to invest its funds in a new project or initiative rather than in investment securities. This cost is calculated by projecting the rate of return for both the project and the investments. If the rate of return on the investments is higher than it is on the business project, the opportunity cost would be the amount of that difference. Business managers use this tool when comparing alternatives and weighing the costs and benefits of different business initiatives.
Earning profit is the goal of every business, but knowing what to do with those profits can be the difference between a business that succeeds for a long period of time and one that flames out after a brief period of success. It is imperative that managers consider all of their alternatives when deciding what to do with their excess funds. One concept that can help them out is the opportunity cost of capital, which shows the difference between rates of return on new projects and investment opportunities.
As an example of how this works, someone can imagine that a company has received $100,000 US Dollars (USD) in a specific year and has to decide what to do with it. It considers expanding into a new market, forecasting a return of investment of $10,000 USD on the original amount in a year's time, which is a 10% increase. The other alternative is investment in a blue-chip stock, which is projected to rise by 15% in a year. The gain is found by taking 15% of $100,000 USD, which is $15,000 USD — $5,000 more than the $10,000 USD gain that would be reaped by the expansion project. This $5,000 USD is the opportunity cost of capital in this example.
Of course, the hard thing about measuring this is the fact that projections are never 100% sure to come true. In the example above, the company issuing the stock could conceivably suffer some sort of business loss that would significantly alter the value of its stock. Such a calamity would alter the opportunity cost of the investment in turn.
Since such uncertain outcomes are always a possibility, businesses should make sure to consider the risks of an investment as well. If a project has a certain amount of risk attached to its success, the business should compare it to an investment with a similar degree of risk. This can help reveal which of the two alternatives is the best choice for a business to make.
This points out why we see businesses going to primarily "safe" investments such as bonds during economic downturns, doesn't it? Then the risk outweighs the potential rewards, companies will move their money where it is safer.
That behavior is expected, but it can lead to worsening problems in a down economy as businesses that could expand and provide jobs find it more difficult to get the cash they need.
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