What is Opportunity Cost?

Dec 20, 2023 By Triston Martin

Opportunity cost is the amount of money lost when one option is chosen over another. It serves as a reminder of every possible option before making a final decision. For example, let's say you own $1,000,000 and decide to put it into the product line, which will yield a profit of 5 percent. If you could have invested the money in an alternative investment, that could have earned a 7 percent return. The 22% difference between the two choices is the chance cost of this choice. The term "opportunity cost" doesn't necessarily include the amount of money. It could also be a reference to different ways to use time. For instance, do you invest 20 hours studying a new skill or reading the latest book?


Explanation


The opportunity cost assessment plays an important aspect in determining the company's capital structure. A company has to pay for the cost when it issues equity and debt capital to compensate shareholders and lenders for the risk associated with an investment; however, each comes with the risk of an investment. The funds used to pay on loans, such as cannot be invested in bonds or stocks, but they do provide the possibility of earning investment income. The business must determine whether the expansion facilitated by the leverage potential of debt will yield greater profits than what it can earn by investing. The firm must weigh the advantages and costs of issuance of stock and debt and financial and nonmonetary factors and arrive at an optimal balance that reduces chance costs. Since the opportunity expense is considered a forecasting aspect and the value of the return (RoR) for both options is not known at present, this assessment is difficult to implement in real life.


In the above scenario, suppose that the company in the previous example does not purchase new equipment instead of investing in the market for stocks. If the chosen securities decline in price, the business might lose funds instead of gaining the expected return of 12. For simplicity's sake, consider that the investment earns an interest rate of 0%, and the company takes exactly what it invested. The potential cost of selecting this option is 10 percent to zero and 10 percent. It is equally likely that, had the business selected new equipment, there would be no impact on production efficiency as profits would remain steady. The cost of pursuing this choice is 12 percent instead of the anticipated 2 percent.


It is essential to look at the investment options that carry the same risk. Comparing an investment in a Treasury bill that is almost risk-free with an investment in a highly volatile company could result in a faulty calculation. Both could offer yields of 5 percent; however, it is the U.S. government backs the RoR of T-bills, but there isn't an assurance of this for the market for stocks. The opportunity cost of both options is zero, and the T-bill is the more secure option when you consider the risk-to-reward ratio of every investment.



Example of Opportunity Cost


The consumer can buy an item like a croissant while driving to work. They might choose this option over eating breakfast at home or eating in a cafe for an entire breakfast. A croissant is more affordable than a meal at a restaurant but is more costly than breakfast at home. However, consumers don't spend time thinking about this for days or hours. These decisions are made in a matter of minutes or seconds.


If a consumer purchases a Croissant, the price is $2 or whatever it is. The cost that could be saved is what could be purchased instead of a Croissant. It could be a glass of Cola or perhaps a Pretzel or even some French Fries. When evaluating the cost of the opportunity, it is crucial to think about "utility," which is the amount of pleasure or enjoyment that a person gets. While the Croissant is a great way to save the time and effort required, it will cost more than breakfast at home and offers less satisfaction than a full breakfast.


Estimation of Opportunity Cost



It is not possible to be quantified in full before the decision is taken. The person who makes the decision will only be able to roughly assess the results of various options, which means that a lack of information can result in opportunity costs that may only be apparent in the future. This is particularly true in cases of high variance in return. In the first instance, the investment of 7% could be highly variable in return, which means that it may not earn all 7% of the return over the fund's duration.

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