Let’s look at two investment opportunities.
Opportunity A is a deposit in your local bank. You put the money in and forget it for a year. It’s relatively safe and offers an annual return of 7%. This means that if you put in 100 dollars on January 1 of this year, one year later your account will have 107 dollars. The first 100 dollars will be your original investment, or the principal amount and the next 7 dollars will be your return.
Opportunity B is your friend’s company that is in dire need of cash. They have a large contract that requires them to make a significant investment for one year. But they have no money. In desperation, he has called you to ask if you would be interested in investing a large amount for one year in his business. Any profits or losses from the contract will be split equally between you and him. Your friend expects that if the contract is executed to the client’s satisfaction, you will get a return of 20 cents on every dollar invested. This means that if you invest 100 dollars today, at the end of one year your investment would be worth 120 dollars. Once again, the first 100 dollars will be your original investment (principal) and the next 20 dollars will be your return.
What would you do? Friendship aside, should you put the money in the bank or in your friend’s company? How can you evaluate which is a better investment? Can you actually arrive at an objective value for both investments?
We will look at a number of scenarios and will try to answer the above questions.
Scenario 1 – Understanding Opportunity Cost
For a minute, let’s assume that you have the money and are not concerned about the risk in opportunity A or B. (A rich uncle just left you his entire portfolio of Internet stocks and you don’t have any immediate financial concerns). For all practical purposes, you have enough available to you to invest in any opportunity that you feel like.
What is your opportunity cost? Well, if you declined your friend’s invitation, you can always get the 7% guaranteed from your local bank. Your opportunity cost is what you can get from an alternative guaranteed investment, which in this case is the guaranteed 7% return if you put your money in the bank.
In this scenario, the alternative investment offers a return of 20%. It’s 13% more than your opportunity cost. Therefore, since you are not bothered by the risk, you should invest in your friend’s company.
Scenario 2 – Understanding Cost of Capital
Once again, let’s assume that your rich uncle left you his portfolio of Internet stocks. However, in this scenario, the lawyers won’t let you sell anything because of some arcane reason you just can’t understand. Undeterred by legal jargon you go to your local bank and ask for a loan against your portfolio of Internet stocks. The bank is more than happy to lend you the required amount as long as you pay them 15% annual interest. This means that you borrow a hundred dollars today and pay back 115 dollars one year later.
The sole objective of this loan is to invest in your friend’s venture. Since you are not concerned with the risk, your expected return is 20% and your cost of capital is 15% (the interest rate you have to pay to the bank). As above, you are still 5 % ahead on the difference between what you pay and what you are paid and you should invest in your friend’s company.
Cost of capital is what it costs you to put your money to work. In order to grow rich and famous as well as retire young, it’s important that your expected return is greater than your cost of capital. You will run into trouble if it’s not.
Opportunity cost is what you can get in alternative investments with similar risk and reward profiles. In simpler terms, opportunity cost refers to the cost of choosing one alternative and forgoing the other.
The two terms, Cost of Capital and Opportunity Cost, are sometimes used interchangeably but that is not correct as the explanations earlier will show that they are two entirely different concepts.