When it comes to allocating capital, most investors have limited resources and, therefore, must choose among competing alternatives. Investors make these choices with reference to their opportunity cost.
An investor’s opportunity cost represents the return on the investor’s next best alternative. In other words, the opportunity cost is the return which the investor foregoes by pursuing the chosen investment.
The concept of opportunity cost is central to most business and investment decisions. For example, a real estate investor will be unwilling to sell a building for $2 million if she knows that there is a standing offer for $2.5 million. The latter amount is the investor’s opportunity cost because it represents the next best alternative offer for the building.
Opportunity cost is the most economically appropriate way to calculate gains and losses. In the above example, suppose the real estate investor’s cost basis on the building is $1 million. Thus, it may seem like the investor would make a $1 million gain by selling the building for $2 million. However, because the investor’s next best alternative is to sell the building for $2.5 million, the investor will lose $500 thousand on an opportunity cost basis.
Opportunity cost has a special application in the cost of equity capital. Unlike debt, whose cost is observable (many sources publish current interest rates charged by banks and other lenders), investors and financial managers must estimate equity costs based on expected returns in various asset classes. The investor or financial manager can then establish the minimal “hurdle rate” necessary to calculate the investment’s financial feasibility.
By understanding the opportunity cost of capital, investors and financial managers can better compare investment alternatives and make more intelligent capital allocation decisions.
