Opportunity Cost is a term widely used in Finance and Economics. It is not found in Accounting because it is not an explicit cost paid out of the pocket. Rather, it is an implicit cost which is why Accounting does not include it. Opportunity cost is related to investment decisions. In Finance, it is often used when alternate use of money is required.
The opportunity cost of capital usually represents the alternate uses of money.
For example, let's suppose an investor has INR 100,000 in his hand and he wants to invest the money in the stock market. He can choose between stocks and property. When he chooses the property, he cannot choose the stock options for the money invested in the property. Therefore, the money invested in property is foregone.
Opportunity cost is the money that is foregone in making investment decisions. In the above example, the money that could have been invested in the stock market is the opportunity cost. The opportunity cost represents the second-best option of investment.
The opportunity costs of capital should be compared across similar projects. To avoid ending up choosing the wrong projects, it must be noted that comparisons should be made with projects of similar risk profiles.
For example, if we compare investments between a stock market and government bonds, stock markets will offer more return compared to government bonds. So, government bonds will always look good as the opportunity cost. However, investments in the stock markets and government bonds have very different risk profiles. While one guarantees a fixed rate of return, there are no guarantees in the other. So, using one as the opportunity cost of capital for another will provide a biased picture and the riskier alternative will always be chosen. Hence, projects that have similar risks must be used for the opportunity cost of capital comparison.
Opportunity cost helps in choosing the right project when faced with a variety of alternatives. Here is how the decision is affected −
Higher Opportunity Cost Lowers NPV − A bigger discount rate is represented by a higher opportunity cost. The bigger discount rate shows that the future values of investment are worth considerably less today. This creates a situation where the net present value or NPV is lowered. The higher opportunity cost of capital also ups the bar for all other projects.
Only the Best Investment Has Positive NPV − It is implied that in the case of 2-3 investment proposals, only the best proposal has a positive NPV. This is so because the best proposal will always be the opportunity cost of capital for the other projects. As the opportunity cost of capital would be higher than the cash flows the project has to offer, the NPV of such projects will be negative.