How do you compare the opportunity costs of different financing options for a capital project?

2 Why is opportunity cost important?

Opportunity cost is important because it helps you measure the true cost of your financing options. For example, if you use internal funds to finance a project, you may think that you have no cost because you are not paying interest or dividends. However, you are giving up the opportunity to invest those funds elsewhere or retain them for future needs. Similarly, if you use debt or equity, you are committing to pay interest or dividends to your lenders or shareholders, which reduces your net income and cash flow.

4 How do you compare opportunity costs?

To compare opportunity costs, you need to use a common metric that reflects the profitability and risk of your project and your financing options. One such metric is the weighted average cost of capital (WACC), which is the average cost of all your sources of funds, weighted by their proportions. The WACC represents the minimum return that your project should earn to cover your opportunity costs and create value for your company.

5 How do you use WACC to evaluate a project?

To use WACC to evaluate a project, you need to compare it with the internal rate of return (IRR) of the project, which is the discount rate that makes the net present value (NPV) of the project zero. The NPV is the difference between the present value of the cash inflows and the present value of the cash outflows of the project. If the IRR is higher than the WACC, the project is profitable and worth investing. If the IRR is lower than the WACC, the project is unprofitable and should be rejected.

6 What are some factors that affect opportunity costs?

Opportunity costs are not fixed and may change over time due to various factors, such as market conditions, risk preferences, tax rates, and inflation. For example, if the interest rates increase, the opportunity cost of debt also increases, making debt financing more expensive. If the risk of the project increases, the opportunity cost of equity also increases, making equity financing more costly. If the tax rates decrease, the opportunity cost of internal funds also decreases, making internal financing more attractive.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?