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How would you differentiate Opportunity Cost of Capital from Required Rate of Return (RRR)?
In the calculation of Required Rate of Return (RRR), if the risks are comparable, then it is called the opportunity cost of capital. The equation for calculation of RRR is given by: RRR = Risk-Free Rate + Risk Premium
Here, risk-free rate refers to the time value and risk premium adjusts the risks. The individuals choosing an investment that will pay in the future there are some risks inherent in them. The managers usually invest in investment vehicles that offer more than their cost of capital.
Note − The RRR is related to the time value of money.
The cost of the capital requires the borrower to pay interest (cost) to the lender while it also costs the lender in terms of uncertainties (risk). Thus,the cost of capital is applicable to both the investors and borrowers alike.It is the RRR in most cases. Investors usually look at the volatility of an investment (beta) before zeroing on investments.
In other terms, the cost of capital is the comparable Rate of Return (RRR) that is achievable by an individual or a company by investing in a company. The cost of capital is obtained by adding the cost of debt with the cost of equities.
Note − Cost of Capital is comparable to RRR but they have dissimilarities.
RRR Vs. Opportunity Cost of Capital
Although RRR is not exactly the cost of capital,there are some similarities between the two. The cost of capital is the added sum of the cost of debt and securities. It is also the rate of return achievable from another project by an investor.
The rate of return shows the expected inflow of cash, income, and return from a project. In the case of an investment, one should choose a project where RRR is higher and the cost of capital is lower.
Cost of Capital shows the incurred costs while equity or debt capitals.Equity Capital costs may involve the cost incurred in issuing shares. The debt capital is the interest rate charged by lenders.
The rate of return shows the return that can be generated by investing in a project. Note that it is a future forecast, while the cost of capital is a present decision.
Investments should be made in projects where the cost of capital is lower because it lowers the overall expenditure of the company. However, in case of RRR, the lowest RRR should be chosen because it helps the company earn more in general.
Note − Investments that have a lower cost of capital and higher RRR are favorable.
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