Opportunity Cost of Capital

One of the doubtful concept in finance is opportunity cost of capital. If opportunity word is not attached with cost of capital, we can easily explain cost of capital. By attaching opportunity word with cost of capital, its meaning becomes  totally different which we define following way:


Opportunity cost of capital is rate of return on our capital which we get on the investment in one of best alternative. For example, we have made building of $ 10,00,000. It is our capital. We can use it for our business or for renting business. Both way, we can get benefit from this capital. If we give our this capital on rent, we have to sacrifice its use from our business. Our tenant will pay its cost of capital in the form of rent. But if we use this capital for our business, we will not get rent. At that time, our business will pay opportunity cost of capital for sacrificing rent in following way:

1st : We need not take the building on the rent because we have own. With this, we can save per month rent of building. With this, we can increase our per month net profit.

2nd : We can charge depreciation on our building. There will not decrease in cash which we earned from business. We will also not give tax on such depreciation because it is deductible from total incomes like rent of business building. So, it will be helpful to generate reserve from profit.

If we calculate both benefit in % form, it will be opportunity cost of our capital. Following table will explain it more deeply.

	Nature of Capital		Actual Cost of Capital		Opportunity Cost of Capital
	1. We borrow $ 1,00,000 on 10% interest		$ 10,000		-
	2.If we get $ 1,00,000 through issue of share capital @ 10% rate of dividend		$ 10,000		-
	3. If we invest own capital $ 2,00,000 without any rate		-		$ 20,000
	4. If get building on the rent of $ 20,000 per month		$ 20,000		-
	5. If we buy same building of $ 2,00,000 and charge depreciation with 10% p.a.		-		$ 20000 (Depreciation) + $ 20,000(tax benefit )
	Total		$ 40,000		$ 60,000