What is Opportunity Cost?

Opportunity cost is the cost of any activity measured in terms of the value of the other alternative that is not chosen (that is foregone). Put another way, it is the benefit you could have received by taking an alternative action; the difference in return between a chosen investment and one that is not taken. Say you invest in a stock and it returns 6% over a year. In placing your money in the stock, you gave up the opportunity of another investment - say, a fixed deposit yielding 8%. In this situation, your opportunity costs are 2% (8% - 6%). Check the time value of money here.

But do you expect only fixed deposit returns from stocks? Certainly not. You expect to earn more than the return from fixed deposit when you invest in stocks. Otherwise you are better off with fixed deposits. The reason you expect higher returns from stocks is because the stocks are much riskier as compared to fixed deposits. This extra risk that you assume when you invest in stocks calls for additional return that you assume over other risk-free (or near risk-free) return.

The discount rate of cost of capital to be used in case of discounting future cash flows to come up with their present value is termed as Weighted Average Cost of Capital (WACC).

Where
D = Debt portion of the Total Capital Employed by the firm
TC = Total Capital Employed by the frim (D+E+P)
Kd = Cost of Debt of the Company.
t = Effective tax rate of the firm
E = Equity portion of the Total Capital employed by the firm
P = Preferred Equity portion of the Total Capital employed by the firm Kp = Cost of Preferred Equity of the firm

The Cost of equity of the firm, Ke (or any other risky asset) is given by the Capital Asset Pricing Model (CAPM)

Where
Rf = Risk-free rate
β = Beta, the factor signifying risk of the firm
Rm = Implied required rate of return for the market



Subscribe for daily stock market newsletter and make money online trading.