Opportunity Cost of Capital

7 Key excerpts on "Opportunity Cost of Capital"

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  The Cost of Capital

  Theory and Estimation

  • Cleveland S. Patterson(Author)
  • 1995(Publication Date)
  • Praeger

    (Publisher)

  .-1 The Concept and Uses of the Cost of Capital This chapter introduces the concept of the Opportunity Cost of Capital and re- views its use for corporate and public policy decisions. It also briefly discusses some of the difficulties involved in the estimation of its magnitude for an indi- vidual asset or firm. I. THE CONCEPT OF THE COST OF CAPITAL Most productive enterprises require a mixture of inputs to make them viable. Some of these inputs, such as labor, have clearly identifiable out-of-pocket annual costs associated with them in the form of wages, salaries, benefits, or directly assignable overheads. Others, however, take the form of capital inputs or investments. Essentially investments represent decisions to defer present consumption until a later date, and their "cost" is largely an opportunity cost rather than an out-of-pocket cash cost. We define the opportunity cost of a particular investment, A, as the expected return on the best comparable alternative, B, which is foregone as a result of the decision to commit capital to A. Although costs are normally thought of as dollars paid out, dollars not received have exactly the same effect on the ability to purchase goods. For example, assume that a firm decides to invest $100,000 in a productive asset, which promises, with certainty, to yield a payoff in constant dollars of 2 The Cost of Capital $120,000 at the end of one year. Investors usually require an inducement to defer consumption and the specific rate of return that they require for a riskless one-year investment is established by supply and demand conditions in capital markets. Let us say that it is possible to obtain a guaranteed annual return of 10% by investing in traded market securities such as one-year discount govern- ment bonds. Then the opportunity cost of investing in the project is 10%. If there are no transactions costs or taxes, this is also the project's cost of capital.

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  The Cost of Capital

  • E. Porras(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Making up her mind would also require giving up all the options other than the one selected. There is therefore an ‘opportunity cost’ involved. The opportunity cost is the cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. In her case, if she spends the money on a trip, she will have to give up the hypothetical work of art she could have bought and the pleasure derived from looking at it. Going back to our saver’s dilemma, her age, health and family status are data to be considered. If she had no family, and did not expect to live for more than 8 The Cost of Capital a year, it would probably make no sense to think of any investment whose returns would extend beyond that point in time. On the other hand, if our investor were young and adventurous, had no fear of losing her job, and had never been outside her city of birth, a trip might sound like a very attractive opportunity. Therefore, in the light of the circumstances outlined above, she would have to think in terms of ‘utility’ (the pleasure derived from the choice) rather than just dollar-quantifiable returns. The first objective of this chapter is to clarify that should our investor decide to invest the money rather than expend it, the return she receives is paid by someone else; hence it is a cost for this second party. The second point to highlight is that many variables enter into the decision-making process. Investment options is one of them, the others are related to personal traits and circumstances. A third relevant consideration is that users of money, such as governments and corporations, need to offer attractive deals so that house- holds decide to reduce their consumption and lend them their savings for some period of time. Lastly, a fourth issue to consider is that the economy is financed by these savers.

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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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  Macroeconomics

  A Contemporary Introduction

  • William A. McEachern(Author)
  • 2016(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  2-1a Opportunity Cost What do we mean when we talk about the cost of something? Isn’t it what we must give up—must forgo—to get that thing? The opportunity cost of the chosen item or activity is the value of the best alternative that is forgone. You can think of opportunity cost as the opportunity lost. Sometimes opportunity cost can be measured in terms of money, although, as we shall see, money is usually only part of opportunity cost. How many times have you heard people say they did something because they “had nothing better to do”? They actually mean they had nothing else going on. Yet, accord- ing to the idea of opportunity cost, people always do what they do because they have nothing better to do. The choice selected seems, at the time, preferable to any other possible alternative. You are reading this chapter right now because you have nothing better to do. In fact, you are attending college for the same reason: College appears more attractive than your best alternative, as discussed in the following case study. opportunity cost The value of the best alternative forgone when an item or activity is chosen • Opportunity cost • Comparative advantage • Specialization • Division of labor • Production possibilities frontier • Economic systems • Three economic questions • Capitalism, command systems, and in between C hapter 1 introduced the idea that scarcity forces us to make choices, but the chapter said little about how to make economic choices. This chapter develops a framework for evaluating economic alternatives. First, we con- sider the cost involved in selecting one alternative over others. Next, we develop tools to explore the choices available to individuals and to the economy as a whole. Finally, we examine the questions that different economies must answer—questions about what goods and services to produce, how to produce them, and for whom to produce them. Topics discussed in this chapter include: Copyright 2017 Cengage Learning.

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  Social and Business Enterprises (RLE: Organizations)

  An Introduction to Organisational Economics

  • Jonathan Boswell(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  Chapter 5 Opportunity Cost In some ways the idea of opportunity cost is complementary to that of marginalism. Whereas marginalist reasoning in its useful modified form concentrates on keen adjustments and flexible improvements, opportunity cost reasoning is part of the very act of choice. Practical marginalism is essentially tactical but opportunity cost tends to be more strategically oriented, more critical and, in a sense, more radical. Of the two ideas it is also the more important. If marginalism in the pure sense is unattainable – and in the modified sense a matter of optional effort – opportunity cost is inescapable and perpetually pressing in on us, whether we like it or not. It is inherent in the whole human condition, fraught with triumph and tragedy. The critical question is whether we recognise it properly and apply its rationale with lucidity. DEFINITION AND TYPES OF OPPORTUNITY COST Opportunity cost is the value of the opportunity sacrificed, or the benefit forgone, as a result of not employing something in its best alternative use as seen by decision makers and/or society. James Buchanan expresses the contrast between historical and opportunity costs succinctly as a contrast between ‘choice influenced’ and ‘choice influencing’ costs. 1 In thinking about opportunity cost the key terms are ‘alternatives’, ‘relinquishment’, ‘sacrifice’ and ‘displacement’. Relating these to individual experience, we may say that the opportunity cost of saving money is the benefit from the spending abstained from or postponed as a result. The opportunity cost of depositing money in a building society is measured by the return anticipated from investing in, say, government stock or perhaps equities

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  Economics

  • William Boyes, Michael Melvin(Authors)
  • 2015(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Whether they are wealthy or poor, what they have is never enough. Since people do not have everything they want, they must use their limited time and income to select those things they want most and forgo the rest. The choices they make and the manner in which the choices are made explain much about why the real world is what it is. 2-1a Opportunity Cost Opportunity cost is the highest-valued alternative that must be forgone when a choice is made. If you have $25, you could purchase many things. Suppose you select a video game. The cost of the video game is $25, but more accurately, it is anything else that you could have purchased with $25. We say the opportunity cost of the video game is the benefit you do not enjoy from purchasing something else. Opportunity cost includes not just the dollars you give up but all costs involved with your purchase. For instance, buying used books saves money but could increase frustration and affect your grades. The book might be missing pages, unreadable in spots, or out of date. The full or opportunity cost of the used book is the price you paid for the used copy plus the frustration of having an incomplete book. An attorney in Scottsdale, Arizona, is paid $325 an hour to write contracts. The attorney loves Ralph Lauren dress shirts and can get them for $100 at Nordstrom in Scottsdale or, when they are available, for $50 at the outlet mall in Casa Grande. He likes to purchase just one or two shirts at a time and usually buys them at Nordstrom, taking 15 minutes out of his lunch time to go to the store. Is this smart? Well, he figures he could spend two hours driving to Casa Grande and back and save $50 per shirt. But this also means he is not writing con-tracts and charging $325 per hour during those two hours. The real cost of the $50 saved on a single shirt in Casa Grande is the amount that the attorney would give up in income, $325 per hour less the $50 savings on each shirt, plus the cost of the additional gas used.

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  The Economist's View of the World

  And the Quest for Well-Being

  • Steven E. Rhoads(Author)
  • 2021(Publication Date)
  • Cambridge University Press

    (Publisher)

  Added costs leave us with fewer resources available to pursue values in other policy areas. In other words, whenever the costs of one program increase, the expend- itures on and benefits obtained from some other program or from private expenditures decrease. This is the idea of opportunity cost: the understanding that spending and regulatory decisions that use scarce resources or require their use incur costs in terms of forgone alternatives elsewhere. This idea seems so obvious that one can wonder why it is worth discussing. Anyone who has purchased less expensive food at the grocery store in order to pay the rent on time certainly knows something about oppor- tunity cost in the family context. As I write the revisions to this chapter, in August 2020, a major opportunity cost situation confronts all parts of the country with regard to Covid-19. Take the issue of in-person versus virtual school learning. Children don’t learn as much when they are not in the classroom, and their socialization also suffers. But, if they are in the classroom, they will be more likely to be infected with Covid-19. Moreover, with in-person instruction, infections are more likely to spread to other children and teachers, parents and any grandparents living at home. How many infections could be prevented by changes in schools’ classrooms and routines? How great would be the loss of income in single- and two-working-parent families if someone had to be home with children who were learning online? A variety of partial solutions exist for every Covid-19 complication, and opportunity cost defines the costs incurred, or what we sacrifice, in forgoing alternative options. With Covid-19, most citizens’ well-being will be affected by any deci- sion that is reached. It is rare for a public policy decision to affect so many people in such a clear and major way.

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