Understanding Opportunity Cost of Capital
OPORTUNITY COST OF CAPITAL (OCC) – Opportunity Cost of Capital is the lost benefit because the capital is used for other projects/programs. OCC is concerned with the expected return by financing a project rather than investing the capital in stocks, the unofficial language is that capital can be turned into a business/project and why it is more profitable to invest in stock investments.
Opportunity Cost of Capital (OCC) concept in corporate investment
The concept of OCC is closely related to “capital budgeting” in a company and capital budgeting itself is a tool used by the investment manager of a company to assess the company’s main profit opportunities and how he decides to invest in capital to make it more profitable for the company. The company uses capital budgeting to measure long-term profits which includes the concept of Opportunity Cost of Capital (OCC).
An economist or investment manager must be able to use the OCC concept as well as possible, based on OCC, an investment manager must be able to determine which investment project will have the opportunity to generate the greatest value and must also be able to find the optimal composition of funding sources for the company. Therefore, the concept of Opportunity Cost of Capital (OCC) is quite important in the economy and a concept that is often used in modern finance.
The use of this capital must take into account the level of return and the level of risk that is comparable to what investors can get when they invest their capital in a company. This concept also underlies a businessman or stock investor in running his business.
The Concept of Opportunity Cost of Capital (OCC) in Country Investment
In State Investment, the approach to determining OCC is to use data on interest rates prevailing in the market. The OCC method of investing in this country is often called the “Harberger”. This method uses an estimate of the Discount rate as a weighted average and capital income before tax and net income (after tax).
The numbers that are often used in the Harberger method usually range between 10-15% even though there is no supporting data for this value. An example is the government’s income from the oil and gas sector which is an important savings then used for state investment through low interest rates which will then be channeled to the private sector through liquidity credits and the rest is channeled to state projects.
Example of Using Opportunity Cost of Capital (OCC)
Case in point X . Company
– Investment in a project:
Return earned on Project = ($220,000-$200,000) / 200,000 = 10%
– Investment in a Share:
X’s share price today is $17.85 and the expected stock price at the end of the year is $20
Expected stock return = (20-17.85) / 17.85 = 12%
The conclusion is that the return on stock investment is 12% and if the stock return is chosen as an OCC (Opportunity Cost of Capital) project, then there is no need to invest in the project, but otherwise there will be an Opportunity Cost of Capital of 12% -10% = 2% ( Opportunity cost of capital / benefits lost from the project).
The definition of Opportunity Cost of Capital is a cost arising from the difference between the rate of return of two investments, namely the chosen investment and the unselected investment. Simply put, the Opportunity Cost of Capital calculates the potential loss caused by not getting the best return from the right investment choices.
By definition it does compare between 2 investment options, but in practice it can be more than 2 or 3 to 10. Because there are various options available. It should be underlined that the Opportunity Cost of Capital is not a COST or COST as the terminology used because there is no loss created or must be paid. This is in order to calculate the level of effectiveness of an investment compared to other investments.
The term Opportunity of Cost is used in financial instruments in general, but is also often used in various other transactions such as buying and selling property, antiques, general trading and so on.
The financial instruments are:
– Share
– mutual funds
– Bond
– Participation Unit (Unit Link)
– Invest in Investment Manager
– Leveraged Trading Products such as Forex, CFDs, Commodities, Energy, Indexes, Futures, and so on
In the world of Budgeting and Financing, not all investments can be made because there are limited capital. That’s why some investors use the Opportunity Cost of Capital before making investment decisions. The goal is always to find the investment with the lower cost of capital and the one that provides the highest return on investment.
The expected ideal condition is that there is no opportunity cost of capital, but in reality we are often faced with choices. As a simple example, a child who has just graduated from high school, can choose whether to go straight to work with an income of 3 million a month, or choose to go to college for 5 years with a total cost of 100 million but with the possibility that after graduating from college he can get a job with a salary of 6 million a month. If he chooses to work, the child can get a total income for the next 15 years of 540 million. But if you choose college, even though you have to sacrifice 100 million in the first 5 years, and only work in the 6th year, 10 years later or 15 years after graduating from high school, the child can earn 720 million. When choosing to go to college, the opportunity cost is 540 million. But if you choose to work, the opportunity cost is 720 million. This is an overview without considering other factors. Economically, choosing to go to college is the best choice.
So the opportunity cost of capital is important to know, especially by a capital owner or investor to get the most optimal results from his investment. For example, an investor wants to invest their funds in forex trading, there are trader A and trader B. Trader A can make a profit of 10% a month, while trader B makes a profit of 12% a month. If the investor chooses to invest in trader A, then there is an opportunity cost of capital of 2%. But if you choose to invest in trader B, there is no opportunity cost capital and this is the most ideal choice.
But other factors can be taken into consideration, for example, even though trader A only promises a profit of 10% a month, trader A promises that 50% of the investor’s capital will not be lost and is guaranteed by the trader. So even though choosing trader A is subject to an opportunity cost of capital of 2%, this could be a better choice if you look at the security and guarantee of capital.