Opportunity cost of capital

The opportunity cost of capital is the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security. Thus, if the projected return on the internal project is less than the expected rate of return on a marketable security, one would not invest in the internal project, assuming that this is the only basis for the decision. The opportunity cost of capital is the difference between the returns on the two projects.

For example, the senior management of a business expects to earn 8% on a long-term $10,000,000 investment in a new manufacturing facility, or it can invest the cash in stocks for which the expected long-term return is 12%. Barring any other considerations, the better use of the cash is to invest $10,000,000 in stocks. The opportunity cost of capital of investing in the manufacturing facility is 2%, which is the difference in return on the two investment opportunities.

This concept is not as simple as it may first appear. The person making the decision must estimate the variability of returns on the alternative investments through the period during which the cash is expected to be used. To return to the example, senior management may be certain that the company can generate an 8% return on the new manufacturing facility, whereas there may be considerable uncertainty regarding the variability of returns from an investment in stocks (which could even be negative during the cash usage period). Thus, the variability of returns should also be considered when arriving at the opportunity cost of capital. This uncertainty can be quantified by assigning a probability of occurrence to different return on investment outcomes, and using the weighted average as the most likely return. No matter how the issue is addressed, the main point is that there is uncertainty surrounding the derivation of the opportunity cost of capital, so that a decision is rarely based on completely reliable investment information.

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