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What is opportunity cost of equity capital?
"Opportunity cost" is a term that is used extensively in economics and finance. The uniqueness of the term lies in the fact that there is no mention of the opportunity cost of capital in the accounting books. It is not an "explicit cost"; so, there is no mention of this cost in the accounting records. Rather, it is an "implicit cost" that results out of the investment decisions.
Alternate Uses of Money
The opportunity cost of capital represents various alternate uses of money. For example, if an investor has INR 1,00,000 to invest and he/she decides to invest it in the stock market, he/she is committing the resources. By investing INR 1,00,000 in the stock market, he/she will now not be able to use the same INR 1,00,000 for any other purposes.
Therefore, the investor must ensure that he/she is committing their resources to the best possible project. For example, the investor has a choice between real estate and stock market investment. If the investor chooses the stock market investment, he/she makes the best possible choice. The opportunity cost of capital represents what the investors are foregoing to choose the best possible alternative. The opportunity cost of capital is hence the value of the second-best alternative.
Alternate Projects Must Share Similar Risk Profile
Investors must ensure that they compare opportunity costs of capital across similar projects. This will help avoid a biased picture and end up in choosing the wrong projects.
For example, if an investor looks for investment in a stock and government bonds, he is taking two different projects that may result in a completely biased outcome because the comparison will let the investor choose the wrong project for the sake of higher profits, while he/she could save enough money investing in bonds.
Alternate Uses Represent Implicit Costs
The investment decision in equities is almost all about prioritizing. It is about selecting the best possible alternative. Suppose an investor has two alternatives, one which offers an INR 100 return potential whereas another which offers an INR 75 return potential. In such a case, by selecting one alternative, the investor is foregoing the other one. So, if one chooses the INR 100 return, he/she is foregoing the INR 75 return. Corporate finance takes this into account as an implicit tradeoff resulting in the expected rate of the return number.
How does Opportunity Cost help in Decision Making?
Opportunity cost lets one choose the best alternative among many options.
- Higher Opportunity Cost Lowers NPV − A higher opportunity cost means a bigger discount rate which means that the future values are worth considerably less in the present. This results in a situation where the NPV is lowered. A greater opportunity cost of capital also raises the bar for all other projects as well.
- Only the Best Investment Has Positive NPV − In a given set of two-to-three investment proposals, only the best proposal will have a positive NPV. This is so because only the best proposal will be the opportunity cost of capital for the other projects. As the opportunity cost of capital has higher cash flows than the other project has to offer, the NPV of such a project will be negative. However, the only requirement is to compare similar projects as mentioned earlier.
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