Opportunity cost of capital

Capital investment decisions are best made within the context of a life-cycle cost analysis. Life-cycle cost analysis focuses on the costs incurred over the life of the investment, assuming only candidate investments are considered that meet minimally acceptable performance standards in terms of the non-inonetary impacts of the investment. Using life-cycle analysis, the capital investment decision takes into account not just the initial acquisition or purchase cost, but maintenance, energy use, the expected life of the investment, and the opportunity cost of capital. When revenue considerations are prominent, an alternative method of analysis such as net benefit or net present value may be preferred. 

A dollar that will be received a year from today has a present value of I divided by (1+r), where r is the discount rate, which is equal to the opportunity cost of capital and a dollar that will be received two years from today has a present value of 1 divided by (1+r)(1+r) or (1+r)f A payment that is to be received t years from today must be divided by (1 +r). If the opportunity cost of capital is fairly high, savings that will be realized many years from today will be heavily discounted. For example, if r is 10 percent, the present value of a dollar that will he received seven years from today is about 51 cents. If a dollar will be received twenty-five years from today, its present value is not even a dime. The total value of the tunnel that saves 1 million per year indefinitely is only 1 million divided by r. If the opportunity cost of capital is 10 percent, the tunnel is worth only 10 million. The economy will not prosper if it sinks 1 billion in building a tunnel that will generate only 10 million of benefits. 

The definition of net cash flow (NCF) for capital budgeting purposes is after tax cash flows from operations discounted at the present value of the cost of capital.26 In net present value analysis the cost of capital is a pre determined value based on the opportunity cost of capital. The cost of capital is defined as a weighted average cost of capital (WACC) and takes into account the firm s capital structure, the cost of equity and debt capital, and tax rates. The formula for the weighted average cost of capital (WACC) is... 

Net Present Value of the land is simply its going market price. Net present value is determined in part by the opportunity cost of labor, that is, the value of the labor necessary for economic income the cost of defending property rights to that land the opportunity cost of capital, that is, the value of the capital necessary to produce an economic income and the equilibrium price of the land, that is, what bidders in the market place will pay after consideration of other factors. 

The capital market in the United States is distorted by the corporate income tax which increases the before tax return to corporate capital and reduces the before tax return to capital in the remainder of the economy from the level which would prevail in the absence of the taoc. V/hile the private rates of return on capital are used to estimate the expected present value of private cost saving, the social opportunity cost of capital is used to evaluate the expected present value of the social cost savings. 

Figure 4 presents the social costs of each technology and the formula for discounting and summing the social cost savings. The asterisk indicates that the prices and the discount factor reflect the social value of inputs and the social opportunity cost of capital. The total social benefits are obtained for 65 locations and for all yeairs in the forty year planning period. 

The private price projections used are those implied by the National Energy Plan of 1977 as expressed in various DOE reports. The social prices were derived from the private prices by correcting for taxes and subsidies and by adding pollution and foreign dependence costs where appropriate. The homeowner s real opportunity cost of capital was 1% and the real social opportunity of capital was 8%, Table I shows the public benefits of the solar technology with and without the storage R D activity for each time period. The present value of the total benefits of the storage R D activity under these circumstances is S. 7 billion. 

The interest rate required to induce the investor to permit his or her money to be used is referred to as the opportunity cost of capital. The value today (e.g., 95.23) of money promised for delivery sometime in the future (e.g., 100), evaluated at the opportunity cost of capital (e.g.,... 

Risk is the third component of the R D investment. Riskier investments require higher dollar returns otherwise investors would put their money in safe investments like U.S. Treasury bills. Thus, the opportunity cost of capital for R D investments must be higher than the cost of capital for risk-free investments. And, the present value of 100 that is expected next year but with a great deal of uncertainty is even lower than the present value of a risk-free investment. How much higher the opportunity cost of capital for an R D investment is, and how much lower the present value of future expected returns is, depends on the riskiness of the R D investment. 

The risk that is accounted for in the opportunity cost of capital is different from these conventional notions about the risks of R D. Modern finance theory distinguishes between two different kinds of investor risk diversifiable risk and undiversifi-able risk (59). The wildcatting risks of drug R D are diversifiable the investor can invest in a large diversified portfolio of R D projects (or firms undertaking such projects) and obtain, on average, an expected dollar return that is very predictable,... 

The central finding of modern finance theory is that the cost of capital for a given investment must be adjusted only for the portion of risk that is undiversifiable. (See appendix C for an explanation.) The technical risks of project failure that weigh so heavily on the minds of R D managers and executives do not raise the opportunity cost of capital. 

Opportunity cost of capital for each specific R D investment. 

The full cost of bringing a new drug to market, as defined above, is clearly higher than the cash outlays spent to discover and develop successful new drugs. It also includes the cash outlays spent on projects that fail. And, it must include the opportunity cost of capital, the rate of interest that dollars invested at a given level of risk must earn in exchange for being tied up in the investment (59,285). 

The opportunity cost of capital for pharmaceutical R D is higher than the interest rate on safe investments, such as insured bank deposits or government bonds, but just how high the cost of capital for pharmaceutical R D projects is depends on how investors evaluate the risks of these investments, (See appendix C for a detailed discussion of the cost of capital.) The risk and, therefore, the cost of capital varies across different projects and even within the same R D project at different stages of development. The cost of capital for any investment also varies from year to year with underlying changes in the risk-free rate of interest (e.g., on bank deposits). Thus, the full cost of R D varies widely over time and across projects. 

Just as the R D investments in various years were compounded to their full net present value (NPV) in the year of market approval at an interest rate equal to the opportunity cost of capital, the future revenues (net of costs) must be discounted back to their NPV at the time of market approval, using an appropriate opportunity cost of capital. After that is done, the NPV of the fully capitalized costs of R D can be subtracted from the NPV of the net revenues. If the difference is greater than zero, then the overall investment in R D returned more than was necessary to repay the investors for the time their money was tied up and the risk they took. If the NPV of the investment as a whole was less than zero, then investors did not, on average, recover their cost of capital and could have done better by investing their funds in other industries. 

This chapter draws heavily from a background paper on the cost of capital prepared by Stuart Myers and Lakshin i Shyam-Suodei (285). The cost of capital is also referred to as the opportunity cost of capital, because the investor expects to get at least as much return as he or she can get from other opportunities to invest at the same level of risk. 

Opportunity cost of capital The rate of interest that dollars invested must earn in exchange for being tied up in an investment with a given level of risk. 

Holding or carrying costs These costs, expressed as a cost per unit of inventory per unit of time, model the cost associated with storage facilities, handling, insurance, pilferage, obsolescence, opportunity cost of capital, and so on. 

Economic surplus (ES) overcomes this limitation by accounting for the cost of capital, and helps focus investments on those opportunities that earn returns above the opportunity cost of capital. 

The discount rate should be equal to the actual rate of interest on long-term loans in the capital market or the average interest rate (cost of capital) paid by the borrower. The discount rate should basically reflect the opportunity cost of capital, which corresponds to the rate of return an investor would obtain if the funds were invested elsewhere with a similar level of risk. The discount rate therefore represents the minimum rate of return acceptable to the investor. When comparing alternative investmenis with different perceived risks, the discount rate can be increased for the more risky project investment so that a comparison can be made between the alternatives. 

The rate of return k is also referred to as the discount rate, hurdle rate, or opportunity cost of capital. Given a stream of cash flows Cq, Cj,. .., Ct over the next T periods, and a rate of return k, the net present value (NPV) of this cash flow stream is given by... 

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