Opportunity Cost of an Investment
Every investment decision should take care because the opportunity cost of an investment is involved in every financial decision. Here the first question may arise, what does an opportunity cost? Opportunity cost is the cost of selecting the best from the available alternatives. Opportunity cost starts generating when we decide to invest our valuable money for a particular thing by sacrifice our other opportunities.
Do you think, the opportunity cost is calculated for organizational investment decision making purpose only? No, the opportunity cost is calculated and evaluated or must be calculated both for individuals and organizations/ corporations. The question may arise why? The reason is investment decision is taken to make a profit from the investment by ensuring optimal use of the financial resources. Every financial decision is cost worthy and our intention is to always become gainer. So, investment is to be in the right platform, with the right amount that may provide us maximum return with minimum opportunity cost. Although investment decision also depends on the investment behavior of the investor.
Things you need to Do Before Calculating Opportunity Cost of an Investment
- Identifying all the investment alternatives
- Collect each and every information that is related to these investment alternatives
- What will be the investment cost of all these opportunities?
- Acquire knowledge of time value of money and its implications on valuation
- Identify the potentiality of each and every investment alternatives
Importance of Evaluation of Opportunity Cost of an Investment
Evaluation of opportunity will help to through:
- Identifying and selecting the best investment opportunity
- Calculate the Opportunity cost of an investment and any other related opportunities
- The result of the evaluation will guide you to pick an investment alternative where opportunity cost is minimum.
Example of Opportunity Cost of an Investment
Suppose you have two investment opportunities. Either you can deposit your money into a bank or you can invest for your own business to become an entrepreneur. Both will give you benefit, but you need to choose only one of these two. If you choose bank deposit option, then your opportunity cost of this investment is to be the rate of earnings from another investment opportunity that is invested in your business. On the other hand, if you choose your business investment opportunity then your opportunity cost will be the earnings opportunity of the bank interest rate.
You have 1 million Tk in your hand. Either you can invest this money into a bank by depositing into a fixed deposit at 10% interest rate, or you can invest the same amount to start your own coffee shop, where you will earn more than 15% annually. But you know, the return from business always uncertain where higher the risk, higher the expected rate of return. That’s why you expect more return from business. On the other hand, if you can avoid the investment opportunity in business and accept the opportunity of bank deposit, where there is nearly zero percent risk is involved.
So, in these examples, the expected rate of earnings from the business is the rate of the opportunity cost for depositing money into a bank.
For your day to day business operation, you always need to take a decision of whether you want to make or buy. In the case of small garments sometimes, you outsourced your work. Instead of making, if you buy from the third party then, you are losing an investment opportunity of making. So, in this case, the opportunity cost of an investment will be the benefit you are losing because of buying rather than making.
Finally, you need to understand that, whatever decision you take, you just need to sacrifice an opportunity. So, the opportunity cost is always there. But the most challenging task is to take an investment decision where the opportunity cost is lower.