Opportunity cost of capital is the difference between the rate of return on a new project and investment stocks. Business managers use it to compare alternatives and evaluate costs and benefits. It is important to consider the risks associated with an investment.
The opportunity cost of capital is the money that is risked by a company when it chooses to invest its funds in a new project or venture rather than investment stocks. This cost is calculated by projecting the rate of return for both the project and the investment. If the rate of return on the investment is higher than that on the business project, the opportunity cost would be the amount of that difference. Business managers use this tool to compare alternatives and evaluate the costs and benefits of different business initiatives.
Earning profits is the goal of every business, but knowing what to do with those profits can be the difference between a business being successful over a long period of time and one that comes on after a short period of success. It is imperative that managers consider all of their alternatives when deciding what to do with their excess funds. One concept that can help them is the opportunity cost of capital, which shows the difference between rates of return on new projects and investment opportunities.
As an example of how this works, someone could imagine that a company received $100,000 United States Dollars (USD) in a specific year and has to decide what to do with it. Consider expanding into a new market, projecting a return on investment of $10,000 USD on the original amount over a year, which is a 10% increase. The other alternative is investing in blue-chip stocks, which is expected to increase by 15% in a year. The gain is made by taking 15% of $100,000 USD, which is $15,000 USD – $5,000 more than the $10,000 USD gain that would be raised by the expansion project. This $5,000 USD is the opportunity cost of capital in this example.
Of course, the hard thing to measure is that projections are never 100% certain. In the example above, the company that issued the stock could conceivably suffer some sort of trading loss that would significantly alter the value of its stock. Such a calamity would in turn alter the opportunity cost of the investment.
Since such uncertain outcomes are always a possibility, companies should ensure that they also consider the risks of an investment. If a project has a certain risk associated with its success, the firm should compare it to an investment with a similar degree of risk. This can help reveal which of the two alternatives is the better choice for a business to make.
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