Question

Opportunity cost of capital. Explain why we refer to the opportunity cost of capital, instead of just “cost of capital” or discount rate”. While you’re at it, also explain the following statement: “The opportunity cost of capital depends on the proposed use of cash, not the source of financing”.

Answer 1

Opportunity Cost of capital is the additional income that could have been generated if the amount of capital deployed for a particular purpose was utilized for another one. In other words, it is the incremental benefit forgone by using the capital for a particular project, instead of another one.

Cost of capital is the actual cost incurred for raising that particular amount of capital. In the case of debt capital, it is nothing but the interest paid or to be paid either in absolute amount or in percentage terms (rate). However, in the case of equity capital, the cost is measured in terms of investor’s expectation of capital. In both the cases, it is in real terms, as opposed to opportunity cost in which case it is hypothetical.

Discount rate is the notional rate applied to assess the present value of a cash flow stream. This rate is the assumed cost of capital or expected rate of yield of the purpose for which it was utilized. Opportunity cost, on the other hand, is in comparison with an alternate purpose for which it could have been utilized.

Now referring to the later part of the question. As discussed above, opportunity cost of capital is all about the use of capital. This compares the revenues from the actual use and an alternate use, whether in existence or proposed. This is irrespective of the source of cash raised and utilized.