What is the opportunity cost of capital, its calculation & why is it important?

The opportunity cost of capital is merely the opportunity cost of investing that capital.  It is the potential gain you will lose by not investing in the alternatives.  You choose the best investments by weighing the risks involved along with their capability of gaining a profit.  You will do well to consider the investment opportunities that would produce the lowest opportunity cost of capital, with the highest rate of return.  The current market determines the cost of capital. This serves to illustrate the amount of identified risk for investors.

Obviously, you do not want to take on any additional risk unless you foresee an extra return. The risk-return tradeoff relates your anticipated return on investment to its risk. High risk, or high levels of uncertainty, correlate with high expected returns. Low risk, or low levels of uncertainty, correlate with low expected returns. You must be willing to accept more risk if you want higher returns. The exact tradeoff will vary based on your personal inclination towards risk-taking.

Determining Opportunity Cost of Capital

The opportunity cost of capital is expressed as a percentage. It is the expected rate of return on your investment in financial markets your business gives up, to invest those funds into the business itself for the development of new projects. You can determine the opportunity cost of capital by comparing your return on investment, or ROI.

You can calculate the return on your investment by using this formula: ROI = market value - cost/cost.  For example, say you are considering the construction of an apartment building.  You have determined that the estimated market value of the completed apartment building will be \$800,000.  The estimated cost it would take for you to complete the apartment building is \$100,000.  By using this formula, you would take 800,000 - 100,000 (which equals 700,000) and divide it by 100,000 (which is 7).  7 x 100 = 700% ROI.  The opportunity cost of capital is the difference between the ROI of each investment.  You can not know the actual return on your investment, because these calculations are merely projections.  For this reason, it is crucial that you compare investment alternatives that have nearly the same amount of risk involved.

Why it is Important?

It is extremely important that you evaluate and properly assess the opportunity cost of capital, as this plays a vital role in how your business finances its general affairs and growth.  Debt and equity both call for a certain amount of expenditure in order to reward lenders and shareholders for the risk of their investment.  Each one comes with an opportunity cost, as well.  For example, if you choose to use funds to make payments on loans, you lose the invested income those funds could have produced through stocks or bonds.  You must determine which will produce larger profits, either the growth resulting from the leveraging power of debt, or the income gained from investments.

The opportunity cost of capital is a key component in economic thinking and sound business decision making. As a business manager, you must understand how to utilize this valuable concept to properly manage and increase the funds your business depends on for effective production and expansion.

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