The cost of capital is the cost of investing in a project or asset. In the world of capital budgeting, not all projects can be approved so financiers must come up with a reason to reject or accept a project. The opportunity cost is the percentage return lost for rejecting one project and accepting another. The goal is always to accept the project with the lower cost of capital, which delivers the highest return on investment. The best way to calculate the opportunity cost of capital is to compare the return on investment on two different projects.
Review the calculation for ROI (return on investment), which is ROI = (Current Price of the Investment - Cost of the Investment) / Cost of the Investment.
Determine the costs of two projects or investments.The cost is the price paid. For an investment, this includes broker and any other transaction fees. For a project, this includes all direct labour, inventory (goods used) and other operating expenses.
In the example used in the following steps, you are deciding between a project to build a toll bridge and a project to buy a boat. The toll bridge will cost £13,000. The boat will cost £48,750.
Determine the current market value or the selling price for the asset or project. This is the amount you can reasonably expect to be paid from the market. Hire a broker or appraiser if the asset isn't traded on a national exchange like the stock market. You can also look at the sales for comparable investments.
For example, the appraiser estimates that the value of the bridge after completion will be £97,500. The boat will go down in value to £19,500; however, the value of the brand name associated with the taxi boat business has a market value of £78,000.
Determine the ROI for the first project or investment. For example, for the bridge: ROI = ($150,000 - 20,000) / £13,000 = £84,500 / £13,000 = 6.5 x 100 = 650% ROI.
Determine the ROI for the second project or investment. For example, for the boat: ROI = ($150,000 - £48,750) / £48,750 = £48,750 / £48,750 = 1 x 100 = 100% ROI.
Determine the opportunity cost of accepting one project over the other. The opportunity cost is the difference between the ROI for the first project and ROI for the second project. For instance, the opportunity cost of buying the boat over building the bridge is 650% - 100% or 550%. The bridge is the better investment opportunity.
Things you need
- Calculator or spreadsheet