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The Opportunity Cost of Capital Definition
The opportunity cost of capital definition is the return on investment a company or an individual loses because they choose to invest their funds in another project rather than invest it in a security that provides a return. The opportunity cost of capital is a cost that typically occurs when a company or a firm does not make the best use of its resources.
Opportunity cost is the benefit that an individual or an investor misses out on when they choose one alternative over the other.
For example, the opportunity cost of going to the cinema and spending time with your friends is equal to the money you miss when choosing to go to the cinema instead of using the time to work. This is illustrated in Figure 1 below.
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The opportunity cost of capital, in a similar manner, represents the opportunity that a company or individual misses out on for not investing the money in a security that generates a return or a savings account but instead choosing to invest it in another project.
The opportunity cost of capital is the opportunity cost of the financial capital that has been invested in the business rather than used for alternative investments.
Imagine you have a company that has an asset it is considering selling, leasing, or employing elsewhere in the business. If the asset is utilized in the new project, then any potential income from other uses of the asset will be lost. These missed opportunities to make money are, in a real sense, expenses.
They are referred to as opportunity costs of capital because when a company undertakes a project, it does so at the expense of other potential use for its assets.
How do companies make use of the opportunity cost of capital to choose between projects? From the example mentioned above, there would always be a cost associated with choosing one alternative over the other.
Suppose the company has to choose between using its cash to expand or investing it in a security. In that case, the company will choose to use its money to expand only if expanding provides a higher return than the return of the security.
In such a case, the opportunity cost of capital is the difference between the return the company gets from expanding and the return the company receives from investing the money in a marketable security.
Opportunity Cost of Capital Example
Let's go over an example of the opportunity cost of capital.
Consider Mike, who has $100,000 dollars and wants to open a business using these $100,000 dollars he has managed to save over the years. After careful consideration, Mike decides to open the business and spends the entire $100,000.
What if Mike instead spent the $100,000 on something else? Were there other alternatives that Mike could have invested his money into? Well, yes, there are other alternatives that Mike could have invested his money into, such as stocks, bonds, or savings accounts.
Is there any cost associated with starting a business besides the explicit cost of $100,000? Yes, there is the opportunity cost of capital. In other words, the missed opportunity that Mike experienced by opening his business instead of investing the money into another alternative investment.
Imagine that a local bank where Mike lived offered a 4% interest rate on a savings account. If Mike had instead placed his money in a savings account with an interest rate of 4%, he would have received $4,000 in interest each year. Mike has, as a result, sacrificed an interest income of $4,000 per year so that he would have his own business.
One of the hidden expenses associated with running Mike's business is the cost of losing out on $4,000 a year. The $4,000 is the opportunity cost of capital that Mike experiences.
Economic Cost vs. Accounting Cost
The opportunity cost of capital is what differentiates economists from accountants. Economists and accountants look at costs from very different perspectives, and this is notably evident in how each profession evaluates the price of capital.
An implied cost of Mike's business, in the eyes of an economist, is the annual loss of interest revenue amounting to $4,000 that he endures.
However, Mike's accountant will not display this $4,000 as a cost since there is no money flowing out of the firm to pay for it; hence, it is not a cost from the point of view of accounting.
To learn more about the difference between economic cost and accounting cost, check out our article: Economic profit vs accounting profit.
All companies experience the opportunity cost of capital. Companies must account for the opportunity cost of the financial capital that has been put into the company when choosing to invest in different projects.
Opportunity Cost of Capital Formula
The opportunity cost of capital formula is simple. The opportunity cost of capital refers to the difference between the course of action that a company chooses to value and the value that the company would have received from the alternative that the company did not pursue.
The opportunity cost of capital is expressed in terms of investment; hence, we use the rate of return when calculating the opportunity cost of capital formula.
The opportunity cost of capital formula measures whether pursuing a course of action is more beneficial than the alternative a company could choose from.
The opportunity cost of capital is therefore expressed as follows.
\(\hbox{The opportunity cost of capital}=\)
\(= \hbox{Rate of Return on Most Profitable Investment} -\)
\(- \hbox{Rate of Return on Investment Chosen to Pursue} \)
Calculate Opportunity Cost of Capital
Let's calculate the opportunity cost of capital for a company.
Assume that a company can invest $100,000 in building a new factory, which is projected to generate a return of 10%, or invest the $100,000 in stocks with a projected return of 8%. What is the opportunity cost of capital for investing in stocks?
| Project | Return on the Project |
| Build a new factory | 10% |
| Invest in stocks | 8% |
| Table 1 - Rate of return on the two possible investments example | |
Table 1 represents the rate of return on building a new factory vs. investing in stocks.
\(\hbox{The opportunity cost of capital}=\)
\(= \hbox{Rate of Return on Most Profitable Investment} -\)
\(- \hbox{Rate of Return on Investment Chosen to Pursue} \)
\(\hbox{The opportunity cost of capital}= 10\% - 8\% \)
\(\hbox{The opportunity cost of capital}= 2\% \)
The opportunity cost of capital when investing in stocks is 2%. This means that if the company chooses to invest in stocks rather than build a new factory, it will lose a 2% return or: \( 0.02\times\$100,000=\$2,000\).
The Opportunity Cost of Capital Finance
The opportunity cost of capital in finance is used when a company decides to invest in different projects. An investor compares different rates of return that are associated with various projects. The opportunity cost of capital in finance is represented by the rate of return on the project that the investor does not choose to pursue.
An investor like the one in Figure 2 will choose to invest in a project only if the rate of return is greater than the investor's opportunity cost of capital.
Let's say an investor has $10,000 to invest and decides to put that money in the stock market. This means that the investor is committing his resources to the stock market and can't invest in any other project. Therefore, the investor should ensure that he invests in the best possible asset.
Let's assume that the investor has an option between investing in bonds or the stock market; if he does decide to invest in the stock market, he will ensure that he is making the most informed decision possible.
The opportunity cost of capital shows what the investor is giving up to choose the option that offers the greatest benefit. The opportunity cost of capital is consequently equal to the value of the option considered second best.
If bonds offered a 5% return while the stock market offered a 4% return, the investor should never invest his $10,000 in the stock market. He should invest in the stock market only if the opportunity cost of capital is below the projected return of the stock market.
Opportunity Cost of Capital - Key takeaways
- Opportunity cost is the benefit that an individual or an investor misses out on when they choose one alternative over the other.
- The opportunity cost of capital is the opportunity cost of the financial capital that has been invested in the business rather than used for alternative investments.
- \(\hbox{The opportunity cost of capital}=\)\(= \hbox{Rate of Return on Most Profitable Investment} -\)\(- \hbox{Rate of Return on Investment Chosen to Pursue} \)
- The opportunity cost of capital in finance is used when a company decides to invest in different projects.
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Frequently Asked Questions about Opportunity Cost of Capital
What is opportunity cost of capital example?
An example of opportunity cost of capital is you using $10,000 to open up a business instead of investing it in the stock market.
How do you calculate opportunity cost of capital?
Using the formula:
The opportunity cost of capital = Rate of Return on Most Profitable Investment - Rate of Return on Investment Chosen to Pursue
What is an opportunity cost, give an example?
For example, the opportunity cost of going to the cinema and spending time with your friends is equal to the money you miss when choosing to go to the cinema instead of using the time to work.
Why the cost of capital is called an opportunity cost?
Because the investor misses out on another alternative that they could undertake with financial capital.
Is opportunity cost of capital the same as discount rate?
Opportunity cost of capital is the same as discount rate.
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