Opportunity Cost of Capital

8 Key excerpts on "Opportunity Cost of Capital"

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  eBook - ePub

  Economics for Policy Makers

  A Guide for Non-Economists

  • Gustavo Rinaldi(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  Economics as a discipline is about how people make choices under conditions of scarcity. Scarcity compels individuals to take into account trade-offs between different alternatives. When we consider the capital or the time available to a person, we should consider the alternative uses which that person could make with those resources.

  Even if a resource, my work or my capital does not cost me anything, I should take into account the opportunities that I miss through using that resource to pursue a specific project instead of other projects.

  The working hours of an entrepreneur could be sold to a different firm where they could go to work as an employee and earn a monthly wage.

  Entrepreneur’s opportunity cost2 = Best possible net salary as an employee3

  The capital of the entrepreneur could be invested with minimal risk in some safe bond and it could give a safe return. Otherwise this capital could be invested in a different project with the same risk as in this project, but with a higher return.

  If the firm uses capital which belongs to the entrepreneur, to partners or to shareholders, that capital may not appear as a cost in the income statement of the firm because the firm uses this production factor at zero cost. It will receive some remuneration in the eventual presence of profits. In some cases, the entrepreneur, their family or some shareholders lend money to the firm at a rate below the market rate. In both cases the Opportunity Cost of Capital must be considered.

  Opportunity Cost of Capital = Potential remuneration in the next best alternative project4

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  The first recommended text is Indian. It is an interesting way to analyze our choices about such things as buying a mobile phone, having holidays or buying a car. Too often we choose something without taking into account what we have to give up in order to follow that path. The consideration of the alternative choices may help us to decide better.

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  Managing Finance

  • D. Crowther(Author)
  • 2007(Publication Date)
  • Routledge

    (Publisher)

  From the above example we can see how a company can reduce its overall cost of capital by mixing the amount of equity capital and debt capital in its capital structure. The WACC is relatively easy to calculate and is therefore widely used by businesses. However, it has come in for some criticisms from academics. There are two main reasons why a firm should not use its historical cost of capital as shown in the balance sheet when evaluating the desired return from a new investment. Firstly, the cost of capital may have risen if investors require higher, returns than previously for financing such investments. This is why the firm’s cost of capital as shown in the balance sheet should not be used to calculate the firm’s cost of capital for investment purposes. Secondly, the new project may expose the business to a different level of risk than its existing projects and, if this is the case investors will demand a higher rate of return to compensate them for the extra risk. Finally, management must remember that an investment will only increase shareholder wealth if it can earn the return which investors expect from financing this type of investment.

  Opportunity Cost

  The opportunity cost rate may be defined as the rate of return on the next best alternative investment of equal risk. A firm can use its opportunity cost rate as the basis for discounting future cash flows to obtain their present values (PVs) (see below). Every business investment decision has an opportunity cost attached to it and this is really the true cost of any investment decision. In order that the WACC reflects opportunity cost, the components of the capital structure should be valued at market values wherever this is practicable before calculating the cost of servicing each separate component and aggregating them, i.e. we want to obtain an estimate of the opportunity WACC.

  Capital Budgeting

  All businesses need to incur capital expenditure at some time, whether it is a small plumber buying a new van, a manufacturer purchasing new equipment, or a retailer building a new hypermarket. Capital investment in a business is essential both to replace existing assets as they become worn out (and fully depreciated) and to provide additional assets in order to improve the performance of the business. This improved performance can be in terms of reduced costs of production, increased quality, increased output or changes in the product mix. It is important therefore that capital expenditure proposals are considered in the context of the objectives of the organisation and its long-term plan in order to ensure that any proposed expenditure helps the business to achieve its objectives.

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  Economic Dimensions in Education

  • Martin O'Donoghue(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  A potential investment project, for example, may call for the expenditure of £100 now and in return it is expected to yield £105 one year from now, the rate of return on cost being then 5 per cent per annum. The expected returns exceed the costs, but before deciding that the project is worthwhile, the opportunity cost calculation will be made by comparing this return with some appropriate interest rate. If this interest rate is, say, 3 per cent the project will be worthwhile since the expected return of 5 per cent is greater than this. Similarly, if the relevant interest rate were 10 per cent the project would be rejected because of its inadequate rate of return The actual rate of interest (or, possibly more correctly, rates) which a business will apply for these calculations, is that which they can earn on funds by lending them, or which they must pay for borrowed funds. This market rate of interest, the price at which money may be borrowed or lent, measures the opportunity cost of a project because it reflects both the alternative investment and the alternative consumption uses of the required resources. It reflects alternative investment uses because the demand for funds will be based on the estimated profitability of all potential investment opportunities. Equally, it reflects alternative consumption uses because the supply of funds will be based on comparisons by lenders between the utility to them of spending now or of saving (which will permit higher future spending). Demand for funds is, then, a function of what is termed the productivity of investment, while supply is a function of what is termed time-preference between present and future goods. The conventional method of illustrating this process of interest determination is that given in Figure 3.1

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  Islamic Capital Markets

  Theory and Practice

  • Noureddine Krichene(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  market refers to the universe of investors who are reasonable candidates to provide funds for a particular investment. Capital or funds are usually provided in the form of cash, although in some instances capital may be provided in form of other assets. The cost of capital usually is expressed in percentage terms—that is, the annual amount of dollars that investors require or expect to realize, expressed as a percentage of the dollar amount invested. It applies to a company, security, or project in which we are interested.

  Since the cost of anything can be defined as the price one must pay to get it, the cost of capital is the return a company must promise in order to get capital from the market, either debt or equity. A company does not set its own cost of capital; it must go to the market to discover it. Yet meeting this cost is the financial market’s one basic yardstick for determining whether a company’s performance is adequate. The cost of capital is always an expected or forward-looking return. The Opportunity Cost of Capital is equal to the return that could have been earned on alternative investments at a specific level of risk. In other words, it is the competitive return available in the market on a comparable investment, with risk being the most important component of comparability.

  The cost of capital depends on the components of a company’s capital structure. The primary components of a capital structure include:

  • Debt capital
  • Preferred equity
  • Common equity

  Each component of an entity’s capital structure has its unique cost, depending primarily on its respective risk. The cost of capital can be viewed from three different perspectives. On the asset side of a firm’s balance sheet, it is the rate that should be used to discount to a present value the future expected cash flows. On the liability side, it is the economic cost to the firm of attracting and retaining capital in a competitive environment, in which investors (capital providers) carefully analyze and compare all return-generating opportunities. On the investor’s side, it is the return one expects and requires from an investment in a firm’s debt or equity. While each of these perspectives might view the cost of capital differently, they are all dealing with the same number.

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  Speaking Truth to Power

  Art and Craft of Policy Analysis

  • Aaron Wildavsky(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  23 In doing so, he emphasized that the notion of opportunity cost is the only objective one, measured in units of alternate or displaced product, and further that it is not to be confused with “pain” or other undesirable attributes of production experienced by individuals. As the bulk of theoretical economics moved on to other matters, this basic understanding of cost remained intact. From Smith's capitalist interests through Marx's theories of socialism and the Austrians' socialist drift, the idea of opportunity cost had claimed for itself a validity independent of political distinctions.

  TEXTS IN THE PRIVATE SECTOR

  How do modern texts treat opportunity cost? Outside of cost-benefit analysis, which will be discussed below, the treatment of opportunity cost in the private sector texts is (at first) surprisingly small.24 In Paul Samuelson's introduction to Economics, perhaps the most widely used text, he first discusses opportunity cost on page 443, in a chapter (23) amazingly entitled “Implicit- and Opportunity-Cost Elements: A Digression”!25 His brief discussion is fairly representative of textbooks, correctly conveying the notion that cost of doing one thing is really sacrifice of doing some other thing. Most of these definitions are presented as part of the discussion of the theory of the firm, which is an attempt to explain and predict production and pricing decisions, and therefore to distinguish cost as opportunity cost from “expenses” or the accountant's notion of cost as outlays. Texts then customarily proceed to (or, as in Samuelson's, are preceded by) analysis of such issues as fixed versus variable costs, short-run versus long-run costs, sunk and marginal costs, and others, most often using exactly what the accountant would name “expenses” or “outlays” to represent cost (in resources acquired or price paid). Buchanan has also mentioned this trend in texts: “Opportunity cost tends to be defined acceptably, but the logic of the concept is not normally allowed to enter into and inform the subsequent analytical applications.”26

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  The Economic Theory of Costs

  Foundations and New Directions

  • Matthew McCaffrey(Author)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  1 Mises (1998) provides a complete exposition of the central place of human action in economic theory. See “The Procedure of Economics” (pp. 64–69) for a summary.

  2 Mises (1998): “Costs are equal to the value attached to the satisfaction which one must forego in order to attain the end aimed at” (p. 97). Rothbard (2009): “‘Cost’ is simply the utility of the next best alternative that must be forgone in any action, and it is therefore part and parcel of utility on the individual’s value scale” (p. 136).

  3 This conclusion is surprisingly uncontroversial. Consider, for example, Krugman and Wells (2009): “The concept of opportunity cost is crucial to understanding individual choice because, in the end, all costs are opportunity costs” (p. 7).

  4 As Mises (1998) explains: “Acting man is eager to substitute a more satisfactory state of affairs for a less satisfactory” (p. 13). This insight is particularly useful in solving apparent conundrums in the logic of action. For example, McCaffrey (2015) uses it to address a separate criticism of causal-realist theory regarding love and gifts: “in the universal, praxeological sense, it is not material goods that are exchanged, but rather states of the world, as subjectively interpreted by the actor” (p. 213).

  5 Rothbard’s (1956) “Toward a Reconstruction of Utility and Welfare Economics” is a seminal work in this literature.

  6 See Boyes (2014) for an example of how opportunity costs may be applied in a critique of the Keynesian multiplier.

  7 For other examples, see Acemoglu, Laibson, and List (2015, pp. 9, 12, 173), Chiang (2017, pp. 9, 36), Coppock and Mateer (2017, pp. 13, 35), Cowen and Tabarrok (2015, pp. 4, 17), Hubbard and O’Brien (2015, pp. 8, 39), Parkin (2015, pp. 9, 33), and Taylor (2007, pp. 5, 12).

  8 Consider, for example, the two definitions offered in Chiang (2017): “Opportunity cost measures the value of the next best alternative use of your time and money, or what you give up when you make an economic decision” (p. 9, emphasis mine); and “Opportunity cost – The cost paid for one product in terms of the output (or consumption) of another product

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  The Financial System and the Economy

  Principles of Money and Banking

  • Maureen Burton, Bruce Brown(Authors)
  • 2014(Publication Date)
  • Routledge

    (Publisher)

  opportunity cost of holding or spending money is the return that one could have earned by using it in the next best alternative or opportunity. Whether the firm borrows or uses accumulated profits, the cost of funds is the prevailing interest rate. A final point should be noted: the interest rate that matters for investment decisions is the real interest rate, which is approximately the nominal interest rate minus the expected inflation rate. This is so because the real interest rate has been adjusted for expected inflation and represents the true opportunity cost of using funds. Another reason that the real interest rate is the relevant rate for investment decisions is that debts are denominated in dollars. If inflation is expected, a firm would be able to pay a higher nominal interest rate because the real value of its debt would be expected to fall. For example, if 5 percent inflation is expected, the firm would be willing to pay a 5 percent higher rate because the value of its outstanding debt would be falling by 5 percent in real terms. Also, if inflation does materialize, revenues coming into the firm would most likely increase.

  Opportunity Cost

  The return one could have earned by using funds in the next best alternative; for investment spending, the real interest rate.

  As already discussed, whether a firm is willing to invest depends on a comparison of the cost of funds with the returns expected on the new capital goods. In general, the business outlook and the government’s tax policy are important factors in the firm’s assessment of the expected return on any particular investment project. The expected return is the present value of the future stream of returns likely to be associated with a particular project. The value of that stream is determined by the profits the project is expected to generate. Profits are a function of the productivity of the capital good, the price of the firm’s output, the costs associated with operating and maintaining the capital good, and federal, state, and local taxes. If the business outlook is good, firms will expect demand for output to continue to grow, prices to rise, and, therefore, revenues to increase. On the other hand, if firms expect a long-lasting recession to begin shortly, the situation and outlook will not be conducive to investment: lower expected future sales will mean lower future profits; similarly, the future value of profits will also be lowered if the government is expected to raise corporate taxes.

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  Corporate Finance

  A Practical Approach

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Cost of capital estimation is a challenging task. As we have already implied, the cost of capital is not observable but, rather, must be estimated. Arriving at a cost of capital estimate requires a host of assumptions and estimates. Another challenge is that the cost of capital that is appropriately applied to a specific investment depends on the characteristics of that investment: The riskier the investment’s cash flows, the greater its cost of capital. In reality, a company must estimate project-specific costs of capital. What is often done, however, is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project.

  This chapter is organized as follows: In the next section, we introduce the cost of capital and its basic computation. Section 3 presents a selection of methods for estimating the costs of the various sources of capital, and Section 4 discusses issues an analyst faces in using the cost of capital. Section 5 summarizes the chapter.

  2. COST OF CAPITAL

  The cost of capital is the rate of return that the suppliers of capital—bondholders and owners—require as compensation for their contribution of capital. Another way of looking at the cost of capital is that it is the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk.

  A company typically has several alternatives for raising capital, including issuing equity, debt, and instruments that share characteristics of debt and equity. Each source selected becomes a component of the company’s funding and has a cost (required rate of return) that may be called a component cost of capital. Because we are using the cost of capital in the evaluation of investment opportunities, we are dealing with a marginal

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