What I understand : The opportunity cost of capital= what you’d be loosing if you spent money on the investment. if NPV is +, then investment adds value, so you should get it.
What I don’t understand : in computing NPV, why do you need to either determine opportunity cost or discount rate ®? Isn’t it always just r that you need to determine the NPV? I mean, how do you determine NPV computing opportunity cost?
Opportunity cost and discount rate are the same int his case. When you consider an appropriate discount rate/opportunity cost you are essentially using it a proxy for your cost of capital.for eg, if your cost of capital is 20% then the project must add value to the firm at the 20% rate else, you would be better off returning the capital to the sources. Hope this make sense.
I agree wtih C3Po NPV is calculated with weighted average cost of capital and it acts as an opportunity cost in a way that that amount, which is needed to be spend on the project, have alternate uses and if the project is adding that value to the firm then it must be chosen otherwise its better to return the capital to the sources, which will reduce weighted average cost of capital (WACC) or utilize it in a way which could add incremental value to the firm.
crystal clear. Thank you!
Want to add further. The word ‘opportunity’ refers to the next best use of money. We use the term ‘opportunity cost of capital’ becasue the next best use (opportunity) would earn at least this return. Therefore a project should earn at least this return hence no point in carrying on business as we dont add value. To give an example consider investing in a project to earn 15% return. How this 15% is decided? If this project were not available then the money that is suppossed to have invested in the project would have been deployed elsewhere. Assume that there is an opportunity to earn a return of 15% there. Therefore 15% becomes the opportunity cost of capital for this project under consideration. Since the company can add value only when it earns more than 15%, we use this rate as a discount rate for evaluating projects (i.e. in NPV) and accept the project only when NPV > 0.
Ok, the missing link here is that “r” is the *risk adjusted* opportunity cost of any given investment. It is not your personal opportunity cost. For instance, say you have two investments which return $1 million in one year. However, one is more risky than the other. If you are to value these two investments using DCF, you would not use the same r for both - you will need to use a higher r for the riskier investment. So, r is the opportunity cost of the risk capital. It is not the opportunity cost that is intrinsic to the investor.
Old thread, but pertinent information.
Just a question… the assumption here is that the two investments are of the same size? E.g. $10M?
Sorry I’m not following something here… how do you then calculate the opportunity cost of capital?
I too thought that the people sit down, open up a newspaper, look for the financial section, find the highest returns that were seen… assume they will continue into the future and use these values to derive the opportunity cost of capital.
The book also seems to contradict ohai’s view:
“The opportunity cost of capital is the alternative return that investors forgo in undertaking the investment.”
(Institute 335)
Institute, CFA. 2016 CFA Level I Volume 1 Ethical and Professional Standards and Quantitative Methods. CFA Institute, 07/2015. VitalBook file.
The citation provided is a guideline. Please check each citation for accuracy before use.
Similarly, a bit futher down, there’s further evidence of this contradiction:
The NPV rule’s assumption about reinvestment rates is more realistic and more economically relevant because it incorporates the market-determined opportunity cost of capital as a discount rate.
(Institute 341)
Institute, CFA. 2016 CFA Level I Volume 1 Ethical and Professional Standards and Quantitative Methods. CFA Institute, 07/2015. VitalBook file.
The citation provided is a guideline. Please check each citation for accuracy before use.
I’m not sure how that contradicts Ohai’s answer: both say that it’s the return you forgo by choosing this investment. Ohai elaborated a bit, explaining that you have to take the riskiness of the investment into account. That’s true, and is implicit in CFA Institute’s description. (It would have been clearer if they’d been explicit about it, but that’s the way it goes.)
This is talking about the reinvestment rate of cash flows, not the risk-adjusted discount rate per se.
In any case, the opportunity cost is the return you could get on your next-best investment of equal risk.