What Is the Opportunity Cost of Capital?
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Summary:
Opportunity costs are the returns a company foregoes when it decides to invest in a different option. This may be a decision to reinvest that money in the company itself or simply hold the money. By calculating opportunity costs, a business owner can make an informed decision on where to invest company funds.
Business owners have to make a lot of decisions when it comes to investing their capital. Is it best to put that money back into the company and improve current production? Or will you make higher returns by investing that money in the stock market?
While there’s always some risk involved in investing, companies can use a specific formula to try and get the highest returns possible. This is the formula for opportunity cost, which analyzes the missed returns of a foregone investment. In this article, we’ll discuss what opportunity costs are, what they can tell a company, and how they differ from sunk costs.
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What does “opportunity cost” mean?
Opportunity cost refers to the potential gains from an investment or project that an individual investor or a business misses out on when another option is chosen. In simple terms, this is the “what could have been” scenario of investing, evaluated based on the perceived benefits of other opportunities that weren’t taken.
If fact, you can examine the opportunity cost of capital as well as the opportunity cost of holding money when considering your investment decisions. Both of these comparisons will give you a better idea of where your money can work the most for you.
The opportunity cost of capital
While it may sound counterproductive for a business to focus on “what could have been,” opportunity cost acts as more than just a regretful reminder. Specifically, the opportunity cost of capital shows businesses the incremental return of an investment they could have made if they invested that money rather than using it for internal or other projects.
You can calculate the opportunity cost of capital using the following formula, where FO refers to the returns on the forgone option, while CO refers to the returns on the chosen option.
Opportunity cost of capital example
Let’s say your company must choose where to spend $1,000,000. You can either spend that million dollars improving a manufacturing facility or invest it in the stock market. Investing that money in your own company will provide a return on investment (ROI) of about 8%. But putting that same money into the stock market may produce an ROI of 10%.
You ultimately decide to improve your current factory, which means your opportunity cost was 2% (10% – 8%). This means that reinvesting those funds into your own company and foregoing the opportunity to invest in the stock market would result in a lower return.
Opportunity cost of capital vs. opportunity cost of holding money
Though the two phrases examine money similarly, the opportunity cost of holding money differs from the opportunity cost of capital. In this case, the opportunity cost of holding money looks at the returns one could have made if the money was invested instead of held. When money is invested instead of held onto, it’s able to grow based on what it earns through the interest rate.
To analyze the opportunity costs associated with holding money, start by pinpointing the investment vehicle for your potential investment — bond, stocks, mutual fund, retirement plan, etc. Next, consider the interest rate associated with this investment. After accounting for inflation, you can then figure out the opportunity cost of holding money based on how much stands to be gained from the investment.
The benefit of holding onto money
While holding money doesn’t produce any returns, there is a notable benefit to this strategy. By choosing not to invest money, and thus forgo the risks associated with investing, you can keep cash handy for immediate purchases.
This is a particularly useful strategy for businesses that need the economic freedom of liquid funds — in other words, the guarantee of having cash on hand. However, if your company is still getting off the ground needs additional liquid funds, you may want to consider a small business loan from one of the lenders below.
How to use opportunity cost to make decisions
Opportunity cost plays a vital role in helping a company construct its capital structure. This is made up of a company’s debts (both short- and long-term) as well as its preferred and common stocks. These values, in addition to a company’s assets and other values found on a balance sheet, provide a business’s debt-to-equity (D/E) ratio, which indicates how risky a business’s borrowing practices are.
All of this together, the company’s D/E ratio and opportunity costs, helps to inform business owners of where to put company funds and produce the highest returns. Is it best to invest in stocks, in the company, or not spend the money at all?
Pro Tip
Opportunity costs are the potential lost returns on one investment over another, but this doesn’t only refer to potential investments in the stock market. Compare the options of buying a house versus renting a house. If you choose to purchase a house, what would you be giving up by not renting? Are those losses worth more or less than the benefits you would gain from homeownership?
How risk relates to opportunity cost
In the world of economics, risk refers to the comparison between the projected investment performance and the actual performance of the same investment.
An example of this would be building risk profiles through research to assess the performance of different stocks. How did Apple perform over the last five years compared to how the stock is expected to perform over the ensuing five to ten years? Based on that analysis, you would then be able to determine whether stock in Apple is a worthwhile investment or if your money would be better spent on another company with less potential risk.
If you struggle with determining the appropriate level of investment risk, you may want to reach out to a brokerage for help.
Opportunity cost vs. sunk cost
A sunk cost refers to an expense already paid for, the funds of which cannot be regained. This is money the business spent in the past, and therefore can’t be considered when calculating opportunity costs.
For instance, let’s return to that example above. If you spent $1,000,000 on 100 shares of a stock, then that is a sunk cost of $1,000,000. Opportunity cost, on the other hand, discusses where that million dollars could’ve been used to produce higher returns.
The difference between implicit and explicit costs
An explicit cost is an expected expense, while an implicit cost is a loosely defined or assumed cost. For example, the costs of running a business or paying employees’ yearly salaries are explicit costs.
Implicit costs, however, usually involve some sort of risk due to the potential value change of future expenses, income, or investments. Generally, an implicit cost is an opportunity cost.
FAQs
If an opportunity cost isn’t a real cost, why does it matter?
While the opportunity cost of capital doesn’t show up on bank statements, it can certainly be felt and seen. Companies and individual investors will often know when an alternative to their initial investment would have been a better option based on a mixture of the gains or losses from their chosen investment (i.e., the value it added) and the comparative performance of the option not taken (based on factors outside of one’s control).
What is the opportunity cost of capital in NPV?
The opportunity cost of capital in net present value (NPV) is assessed by weighing current fees and payments with potential increases, upgrades, and fees.
Is the cost of capital the same as the opportunity cost?
The cost of capital is the expected return for a company on a given project. In other words, it refers to the gains a company needs to achieve in order to justify an investment. The opportunity cost of capital, on the other hand, refers to the potential gains a company forgoes on one alternative in order to pursue another.
Is the opportunity cost of holding money zero?
No, the opportunity cost of holding money is lost potential earnings. When you hold money, you are not achieving gains as you would by investing that money instead.
Does inflation increase the opportunity cost of holding money?
Inflation decreases the value of a dollar over time. Therefore, by not investing money and allowing it to grow, holding money can actually harm your savings.
It’s important to note that inflation doesn’t affect the amount of money in your bank account, but rather how much you can buy with that money. Depending on how long you hold your money, what was worth $900 when you started saving may be worth $1,500 when you’re ready to buy it.
Key Takeaways
- Opportunity cost refers to the returns a company missed out on by making a different decision.
- The opportunity cost of capital refers specifically to the returns missed by investing funds back into a company.
- On the other hand, the opportunity cost of holding money calculates the capital missed by holding money rather than investing it in some way.
- To effectively choose the right investment vehicle, be sure to evaluate the opportunity costs associated with each option.
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