One of the interesting concepts I’ve learned in business school is the opportunity cost of capital and how it relates to investment decisions made by financial managers at public corporations.
In a nutshell, the opportunity cost of capital (expressed as a percentage) is the expected investment rate of return a company gives up for a certain amount of money invested in the financial markets when it instead decides to invest the money in the itself (development of a new product or service).
For example, let’s pretend that a pharmaceutical company has $1 billion sitting in their coffers. The company could return that money to shareholders in the form of dividends, they could invest that money in the financial markets (in stocks, bonds, treasuries, etc.), or they could reinvest that money in the company by perhaps researching, testing, and marketing a new drug.
Assuming the company decides not to pay a dividend to the shareholders (so the shareholders can reinvest the money themselves), financial managers within Pfizer must identify new projects that offer a higher rate of return than what they could get if they simply invested the money in the financial market (this being the opportunity cost of capital).
The trick with the opportunity cost of capital is making sure you compare the expected rate of return of a new investment project with the rate of return in the financial markets of an investment vehicle of similar risk (this is where a great deal of experience, guessing, and arguing comes into play among a corporation’s management, board of directors, and shareholders).
If it appears the company’s new invest project yields a higher expected return vs. investing company funds in the financial markets at a similar risk level, then it makes since to move ahead with the company’s new project.
On the other hand, if the expected rate of return on the proposed project is less than what the company could earn if it simply invested the money in the stock market, bonds, or treasuries, then it wouldn’t make sense to continue on with the proposed investment project.
How Does the Opportunity Cost of Capital Affect You and Your Personal Finances:
If you’ve been reading this blog for a while, you’re probably aware that I like to think a little differently when it comes to personal finance, investing, paying off debt, and saving. Considering the opportunity cost of capital as it relates to your everyday finances is another great example of this.
Let’s say you decide to purchase a new vehicle for $30,000. Not only is that $30,000 vehicle going to depreciate more than $15,000 in three years (most likely), you’ll also have missed out on the opportunity to have invested that money in the financial markets.
In three years, not only would you have lost $15,000 in the form of depreciation, you also would have lost out on the compounding interest you could have earned by investing that $30,000 in a highly rated bond corporate or government bond paying around 6% (as of this writing). This lost investment opportunity amounts to another $5,730 (30000 X 1.06^3 = $5,730).
Your opportunity cost of capital in this case would be the $5,730 you gave up by instead deciding to purchase the new car. I’m not saying you shouldn’t buy a new car (in fact I just bought one a few months ago), what I do think you should consider is how much that vehicle is really costing you in the long run.
I hope this gives you a little more food for thought the next time you consider making a big financial purchase.