Concept of Opportunity Cost
Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them.
The term “opportunity cost” comes up often in finance and economics when trying to choose one investment, either financial or capital, over another. It serves as a measure of an economic choice as compared to the next best one. For example, there is an opportunity cost of choosing to finance a company with debt over issuing stock.
Opportunity cost cannot always be fully quantified at the time when a decision is made. Instead, the person making the decision can only roughly estimate the outcomes of various alternatives, which means imperfect knowledge can lead to an opportunity cost that will only become obvious in retrospect. This is a particular concern when there is a high variability of return. To return to the first example, the foregone investment at 7% might have a high variability of return, and so might not generate the full 7% return over the life of the investment.
The concept of opportunity cost does not always work, since it can be too difficult to make a quantitative comparison of two alternatives. It works best when there is a common unit of measure, such as money spent or time used.
Opportunity cost is not an accounting concept, and so does not appear in the financial records of an entity. It is strictly a financial analysis concept.
How is Opportunity Cost Calculated?
In financial analysis, the opportunity cost is factored into the present when calculating Net Present Value formula.
NPV: Net Present Value
FCF: Free cash flow
r: Discount rate
n: Number of periods
When presented with mutually exclusive options, the decision-making rule is to choose the project with the highest NPV. However, if the alternative project gives a single and immediate benefit, the opportunity costs can be added to the total costs incurred in C0. As a result, the decision rule then changes from choosing the project with the highest NPV into undertaking the project if NPV is greater than zero.
Financial analysts use financial modeling to evaluate the opportunity cost of alternative investments
Application of Opportunity Cost
For example, assume a firm discovered oil in one of its lands. A land surveyor determines that the land can be sold at a price of $40 billion. A consultant determines that extracting the oil will generate an operating revenue of $80 billion in present value terms if the firm is willing to invest $30 billion today. The accounting profit would be to invest the $30 billion to receive $80 billion, hence leading to an accounting profit of $50 billion. However, the economic profit for choosing to extract will be $10 billion because the opportunity cost of not selling the land will be $40 billion.