Opportunity cost

(noun)

The cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the most valuable forgone alternative.

Related Terms

Examples of Opportunity cost in the following topics:

  • Opportunity Costs

    • Opportunity cost refers to the value lost when a choice is made between two mutually exclusive options.
    • Opportunity cost is the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).
    • Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility are also considered implicit. or opportunity, costs.
    • In a restaurant situation, the opportunity cost of eating steak could be trying the salmon.
    • The opportunity cost of having happier children could therefore be a remodeled bathroom.

  • Understanding the Cost of Money

    • The cost of money is the opportunity cost of holding money instead of investing it, depending on the rate of interest.
    • Furthermore, the time value of money is related to the concept of opportunity cost.
    • The cost of any decision includes the cost of the most forgone alternative.
    • The cost of money is the opportunity cost of holding money in hands instead of investing it.
    • The cost of money is the opportunity cost of holding money in hands instead of investing it.

  • Disadvantages of the NPV method

    • NPV is hard to estimate accurately, does not fully account for opportunity cost, and does not give a complete picture of an investment's gain or loss.
    • For example, when developing a new product, such as a new medicine, the NPV is based on estimates of costs and revenues .
    • The cost of developing the drug is unknown and the revenues from the sale of the drug can be hard to estimate, especially many years in the future.
    • Furthermore, the NPV is only useful for comparing projects at the same time; it does not fully build in opportunity cost.
    • NPV does not build in the opportunity cost of not having the capital to spend on future investment options.

  • Relationship Between Financial Policy and the Cost of Capital

    • Financial policy, not cost of capital, must be utilized to determine which investments to pursue, given that resources are limited.
    • As opposed to strictly using cost of capital, decisions must be made using opportunity cost of capital.
    • Opportunity cost of capital is the amount of money foregone by investing in one asset compared to another.
    • For example, an idle piece of land could be used for a new factory; however, the opportunity cost of what else it could have been used for must be taken into consideration during analysis.
    • Explain the relationship between a company's financial policy and its cost of capital

  • Factors External to the Firm

    • When it comes to projecting the cost of capital, it's useful to assess some of the external factors that may influence the overall cost.
    • Profit beyond the cost of expenses and capital will be taxed as well, which impacts the overall weighted average cost of capital.
    • The cost of capital is largely a simple trade off between the time value of money, risk, return, and opportunity cost.
    • Any external factors in the form of opportunity costs or unexpected risks can impact the overall cost of capital.
    • Recognize the various external factors that may impact the weighted average cost of capital

  • Defining the Cost of Capital

    • The reason that capital incurs interest revolves around the simple fact that time has an impact on the valuation of capital, presenting opportunity costs and risk.
    • From the investor's point of view, every investment has a required rate of return for (generally) two reasons: the opportunity cost of foregone investments and the risk of the borrower defaulting on payments.
    • For example, if an investor can get 10% return on an investment with exactly the same risk as an option with 12% return, the investor would incur an opportunity cost of 2% by investing in the 10% return option.
    • The cost of this capital is calculated as:
    • With the above options in mind, the weighted average cost of capital (WACC) normalizes the cost of capital by combining the interest rates being incurred from both debt and equity.

  • The Cost of Retained Earnings

    • Due to the relationship between retained earnings and dividends, the cost of retained earnings as a source of capital is relative to the overall cost of equity.
    • No capital comes without costs, however, and the cost of this capital must be taken into account when calculating the weighted average cost of capital (WACC).
    • Retained earnings are included in the WACC equation as equity, as dividends are a component of the return on capital to equity stakeholders, and thus will have a correspondingly weighted influence on the cost of equity.
    • The relationship between dividends and retained earnings is quite clear when it comes to recognizing the opportunity cost and thus the overall cost of this capital source.
    • Retained earnings is listed under equity, and is thus relative to the cost of equity.

  • The Cost of New Common Stock

    • In order to understand the weighted average cost of capital (WACC) of all of these inputs, the cost of each source of debt and/or equity must be determined.
    • Increased accounting costs (if initial IPO) for management of a publicly traded firm
    • Indirect costs include:
    • As the issuance of publicly traded common stock is essentially the sale of the public auction of organizational equity, any and all considerations pertaining to control, ownership and legal implications should be considered as opportunity costs compared to other forms of funding.
    • Weigh the direct and indirect costs of issuing new common stock as a form of capital

  • Window of Opportunity

    • In corporate finance, a "window of opportunity" is the time when an asset or product which is unattainable will become available.
    • In corporate finance, a "window of opportunity" basically is the idea of a time when an asset or product that is unattainable will become available.
    • Therefore, the IPO presents a window of opportunity to the potential investor to get in on the new equity while it is still affordable and a greater return on investment is attainable.
    • From the firm side, the opportunity to purchase a new plant or real estate at a cheap cost or lower lending rates also presents an opportunity to attain a greater investment on assets used in production.
    • Management of a firm must take this into account in order to keep costs low and returns high, in order to make the firm look like the best possible investment for creditors of all types.

  • Weighted Average Cost of Capital

    • From debt options such as taking out loans or offering long-term corporate bonds to equity such as preferred and common stock, larger organizations tend to find a balance between these options that is optimized for the best possible weighted average cost of capital (WACC) to operate at the scale that creates the best revenue opportunity.
    • For example, if it will cost 8% in capital costs to fund a project that creates 10% in profit, the organization can confidently borrow capital to fund this project.
    • Calculating the cost of capital is actually quite a simple equation.
    • As a result, the cost of debt is usually both certain and predictable.
    • By calculating the estimated cost of equity, and applying that to the WACC equation with the cost of debt and capital structure, organizations can determine the cost of capital (and thus the required return on projects/assets).