Concept of Opportunity Cost

Opportunity costs represent the benefits an individual, investor or business misses out on when choosing
one alternative over another. While financial reports do not show opportunity cost, business owners can
use it to make educated decisions when they have multiple options before them.

The term “opportunity cost” comes up often in finance and economics when trying to choose one
investment, either financial or capital, over another. It serves as a measure of an economic choice as
compared to the next best one. For example, there is an opportunity cost of choosing to finance a
company with debt over issuing stock.

Opportunity cost cannot always be fully quantified at the time when a decision is made. Instead, the
person making the decision can only roughly estimate the outcomes of various alternatives, which means
imperfect knowledge can lead to an opportunity cost that will only become obvious in retrospect. This is a
particular concern when there is a high variability of return. To return to the first example, the foregone
investment at 7% might have a high variability of return, and so might not generate the full 7% return
over the life of the investment.

The concept of opportunity cost does not always work, since it can be too difficult to make a quantitative
comparison of two alternatives. It works best when there is a common unit of measure, such as money
spent or time used.

Opportunity cost is not an accounting concept, and so does not appear in the financial records of an entity.
It is strictly a financial analysis concept.

How is Opportunity Cost Calculated?

In financial analysis, the opportunity cost is factored into the present when calculating Net Present Value
formula.

NPV Formula

Where:

NPV: Net Present Value

FCF: Free cash flow

r: Discount rate

n: Number of periods

When presented with mutually exclusive options, the decision-making rule is to choose the project with
the highest NPV. However, if the alternative project gives a single and immediate benefit, the opportunity
costs can be added to the total costs incurred in C0. As a result, the decision rule then changes from
choosing the project with the highest NPV into undertaking the project if NPV is greater than zero.

Financial analysts use financial modeling to evaluate the opportunity cost of alternative investments

Application of Opportunity Cost

For example, assume a firm discovered oil in one of its lands. A land surveyor determines that the land
can be sold at a price of $40 billion. A consultant determines that extracting the oil will generate an
operating revenue of $80 billion in present value terms if the firm is willing to invest $30 billion today.
The accounting profit would be to invest the $30 billion to receive $80 billion, hence leading to an
accounting profit of $50 billion. However, the economic profit for choosing to extract will be $10 billion
because the opportunity cost of not selling the land will be $40 billion.

Cost of Debenture
If a company needs funds for extension and development purpose without increasing its share capital, it
can borrow from the general public by issuing certificates for a fixed period of time and at a fixed rate of
interest. Such a loan certificate is called a debenture. Debentures are offered to the public for subscription
in the same way as for issue of equity shares. Debenture is issued under the common seal of the company
acknowledging the receipt of money.

Features of Debentures
The important features of debentures are as follows-

1. Debenture holders are the creditors of the company carrying a fixed rate of interest.
2. Debenture is redeemed after a fixed period of time.
3. Debentures may be either secured or unsecured.
4. Interest payable on a debenture is a charge against profit and hence it is a tax deductible
expenditure.
5. Debenture holders do not enjoy any voting right.
6. Interest on debenture is payable even if there is a loss.

Advantage of Debentures
Following are some of the advantages of debentures-
(a) Issue of debenture does not result in dilution of interest of equity shareholders as they do not have
right either to vote or take part in the management of the company.

(b) Interest on debenture is a tax deductible expenditure and thus it saves income tax.

(c) Cost of debenture is relatively lower than preference shares and equity shares.

(d) Issue of debentures is advantageous during times of inflation.

(e) Interest on debenture is payable even if there is a loss, so debenture holders bear no risk.

Disadvantages of Debentures
Following are the disadvantages of debentures-

(a) Payment of interest on debenture is obligatory and hence it becomes burden if the company incurs
loss.

(b) Debentures are issued to trade on equity but too much dependence on debentures increases the
financial risk of the company.

(c) Redemption of debenture involves a larger amount of cash outflow.

(d) During depression, the profit of the company goes on declining and it becomes difficult for the
company to pay interest.

Different Types of Debentures

A company can issue different types of debentures for raising funds for long term purposes.

Different forms of debentures are given and discussed below:

(i) Ordinary Debenture

Such debentures are issued without mortgaging any asset, i.e. this is unsecured. It is very difficult to raise
funds through ordinary debenture.

(ii) Mortgage Debenture

This type of debenture is issued by mortgaging an asset and debenture holders can recover their dues by
selling that particular asset in case the company fails to repay the claim of debenture holders.

(iii) Non-convertible Debentures

A non-convertible debenture is a debenture where there is no option for its conversion into equity shares.
Thus the debenture holders remain debenture holders till maturity.

(iv) Partly Convertible Debentures

The holders of partly convertible debentures are given an option to convert part of their debentures. After
conversion they will enjoy the benefit of both debenture holders as well as equity shareholders.

(v) Fully Convertible Debenture

Fully convertible debentures are those debentures which are fully converted into specified number of
equity shares after predetermined period at the option of the debenture holders.

(vi) Redeemable Debentures

Redeemable debenture is a debenture which is redeemed/repaid on a predetermined date and at

predetermined price.

(vii) Irredeemable Debenture

Such debentures are generally not redeemed during the lifetime of the company. So, it is also termed as
perpetual debt. Repayment of such debenture takes place at the time of liquidation of the company.

(vii) Registered Debentures

Registered debentures are those debentures where names, address, serial number, etc., of the debenture
holders are recorded in the register book of the company. Such debentures cannot be easily transferred to
another person.

(viii) Unregistered Debentures

Unregistered debentures may be referred to those debentures which are not recorded in the company’s
register book. Such a type of debenture is also known as bearer debenture and this can be easily
transferred to any other person

Preference and Equity Capital

Preference Capital
The Preference Capital is that portion of capital which is raised through the issue of the preference shares.
This is the hybrid form of financing that has certain characteristics of equity and certain attributes of
debentures.
Advantages of Preference Capital

 There is no legal obligation on the firm to pay a dividend to the preference shareholders.
 The redemption of preference shares is not distressful for a firm since the shares are
redeemed out of the profits and through the issue of fresh shares (preference shares and
equity shares).
 The preference capital is considered as a component of net worth and hence the
creditworthiness of the firm increases.
 Preference shareholders do not enjoy the voting rights, and thus, there is no dilution of
control.

Disadvantages of Preference Capital

 It is very expensive as compared to the debt-capital because unlike debt interest,

preference dividend is not tax deductible.
 Although, there is no legal obligation to pay the preference dividends, when the payment
is made it is done along with the arrears.
 The preference shareholder can claim prior to the equity shareholders, in case the
dividends are being paid or at the time of winding up of the firm.
 If the company does not pay or skips the preference dividend for some time, then the
preference shareholders could acquire the voting rights.

The preference capital is similar to the equity in the sense: the preference dividend is paid out of the
distributable profits, it is not obligatory on the part of the firm to pay the preference dividend, these
dividends are not tax-deductible.

The portion of the preference capital resembles the debentures: the rate of dividend is fixed, preference
shareholders are given priority over the equity shareholders in case of dividend payment and at the time
of winding up of the firm, the preference shareholders do not have the right to vote and the preference
capital is repayable.

Equity Capital
Invested money that, in contrast to debt capital, is not repaid to the investors in the normal course of
business. It represents the risk capital staked by the owners through purchase of a company’s common
stock (ordinary shares).

The value of equity capital is computed by estimating the current market value of everything owned by
the company from which the total of all liabilities is subtracted. On the balance sheet of the company,
equity capital is listed as stockholders’ equity or owners’ equity. Also called equity financing or share
capital.

Advantage of Equity Capital

(i) Fixed Costs Unchanged By Equity Capital
Equity financing has no fixed payment requirements. As a result, the investments do not increase a
company’s fixed costs or fixed payment burden. In addition, dividends to be paid to equity investors can
be deferred and cash can be directed to business opportunities and operating requirements as needed.

(ii) Collateral-Free Financing

Equity investors do not require a pledge of collateral. Existing business assets remain unencumbered and
available to serve as security for loans. In addition, assets purchased with equity capital can be used to
secure future long-term debt.

(iii) Long-Term Financing

Equity investors are focused on future earnings and increasing the value of a business rather than the
immediate return on their investment in the form of interest payments or dividends. As a result,
businesses can rely on equity capital to finance projects for which the earnings or returns may not occur
for some time, if at all.

(iv) Convenant-Free Financing

A lender is concerned with the repayment of debt. The lender wants to ensure that loan proceeds increase
company assets, which generate cash to repay loans. Therefore, lenders establish financial covenants that
restrict how loan proceeds are used. Equity investors establish no such covenants; they rely on
governance rights to protect their interests.

Disadvantage of Equity Capital

(i) Investor Expectations

Neither profits nor business growth nor dividends are guaranteed for equity investors. The returns to
equity investors are more uncertain than returns earned by debt holders. As a result, equity investors
anticipate a higher return on their investment than that received by lenders.

(ii) Business Form Requirements

Legal restrictions govern the use of equity financing and the structure of the financing transactions. In
fact, equity investors have financial rights, including a claim to distributed dividends and proceeds from
the sale of the company in which they invest. The equity investors also have governance rights pertaining
to the board of directors election and approval of major business decisions. These rights dilute the
ownership and control of a company and increase the oversight of management decisions.

(iii) Financial Returns Distribution

Each investor in a company has a right to the cash flow generated by the business after all other claims
are paid. If the business is sold, the owners share cash equal to the net proceeds of the business if a gain
occurs on the sale. The investors’ net return is equal to the net proceeds of the sale less the cash they
invested in the business. The legal restrictions that govern the use of equity financing determine the return
received by an individual.

Concept Of Cost Of Capital :

It is the minimum rate of return the firm earns as its investment in order to satisfy the expectations of
investors, who provide funds to the firm.

It is a rate of returns expected by the investors i.e., K = ro + b + f. i.e., the cost of capital includes the rate
of return at zero risk + premium for business risk + premium for financial risk.

For Investor:
Cost of capital is the measurement of disutility of funds in the present as compared to the return expected
to future.

For Company:
Cost of capital is the required rate of return to justify the use of capital so that expected rate of return can
be maintained on equity shares and the market value of share remains unchanged or should not be
reduced at cost.

Classification of Cost of Capital

Some of the classification of cost of capital are as follows:

1) Marginal cost of capital & Average cost

2) Explicit cost and Implicit cost

3) Future cost and Historical cost

Marginal Cost
 It is the additional cost of manufacturing an additional unit. Marginal cost is the average
cost of a new fund required to be raised by the company. So the current rate of interest on
long term debt is treated as the marginal cost of capital.
Average cost of Capital
 Average cost is the combined cost of various sources of capital such as debentures,
preference shares and equity shares. It is the weighted average cost of the costs of various
sources of finance.
 So the average cost is the cost per unit. It is calculated by dividing total cost by the
number of units produced.

Explicit Cost and Implicit Cost:

 Explicit cost arises when funds are raised, whereas the implicit cost arises when funds are
used.
 Explicit cost involves the payment of fixed charges in the form of interest or dividend.

Distinction between Explicit Cost and Implicit Cost:

Explicit Cost:

a) Arises – It arises when the funds are raised

b) Base – It is based on the concept of net present value

c) Effect – Cash outflows in the form of payment for fixed charges

Implicit Cost:

a) Arises – It arises when the funds are used.

b) Base – It is an opportunity cost.

c) Effect – It will not affect the outflows and inflows of cash.

Future Cost (Estimated Cost):

 It refers to the cost of funds intended to finance the expected project. All financial
decision making expected rate of return and expected (Future) cost of capital are
considered. Future cost are widely used in capital budgeting and capital structure
designing decisions.

Historical Cost (Book Value):

 It is the cost which has already been incurred for financing a particular project. Historical
costs are useful in analysing the existing capital structure, in projecting the future costs
 and providing an appraisal of the post-performance, when compared with standard or
predetermined cost. So historical costs are the basis of existing capital structure.

Composite Cost of Capital

Composite cost of capital is a company’s cost to finance its business, determined by, and also referred to
as “weighted average cost of capital” or WACC. The calculation involves multiplying the cost of each
capital component by its proportional weight and taking the sum of the results. A company’s debt and
equity, or its capital structure, typically includes common stock, preferred stock, bonds and any other
long-term debt. A high composite cost of capital, indicates that a company has high borrowing costs; a
low composite cost of capital implies lower borrowing costs.

To help understand composite cost of capital, think of a company as a pool of money from two separate
sources: debt and equity. Proceeds earned through business operations are not considered a third source
because, after a company pays off debt, the company retains any leftover money that is not returned to
shareholders (in the form of dividends) on behalf of those shareholders.

A company’s management uses the company’s composite cost of capital in internal decision making. For
example, it might use it to help decide whether the company could profitably finance a new project.
Investors may use a company’s composite cost of capital as one of several factors in deciding whether to
buy the company’s stock. While the cost of issuing debt is fairly straightforward, the cost of issuing stock
has more variables. A company with a relatively low WACC may be better positioned to grow and
expand, potentially rewarding shareholders.

How Investors Use Composite Cost of Capital?

Securities analysts frequently use WACC when assessing the value of investments. For example, in
discounted cash flow analysis, the WACC can be applied as the discount rate for future cash flows in
order to derive a business’s net present value. WACC may also be used as a hurdle rate against which to
gauge ROIC performance. WACC is also essential in order to perform economic value added (EVA)
calculations.

While composite cost of capital is important, the average investor would find that calculating WACC is a
complicated process requiring detailed company information. Nonetheless, understanding WACC can
help investors understand its significance when they see it in brokerage analysts’ reports.

Because certain elements of the WACC formula, like cost of equity, are not consistent values, various
parties may report them differently for different reasons. As such, while WACC can often help lend
valuable insight into a company, one should always use it along with other metrics when determining
whether or not to invest in a company.

Cash Flows as Profit and Components of Cash

Flows
Cash flow and profit are two different financial parameters, but when you’re running a business, you
need to keep track of both. Here’s how they’re different, why they’re both important and how they
intersect with other corporate issues, especially when a company grows rapidly.

Cash Flow
Cash flow is the money that flows in and out of the firm from operations and financing and investing
activities. It’s the money you need to meet current and near-term obligations. But there are two things to
keep in mind about cash flow:

A Business Can Be Profitable and Still Not Have Adequate Cash Flow

In the worst case, insufficient cash flow in a profitable business can send it into bankruptcy. For example,
you’re making widgets and selling them at a profit. But your product goes through a long sales chain and
some of your biggest and most important wholesale customers don’t pay on invoices for 120 days. This
sounds extreme, but many large US corporations in the 21st century don’t pay an account payable for
three or four months from the receipt of the invoice.

Since you’re the little guy, the suppliers of materials you need to make those widgets often want to be
paid either upon receipt or in 15 or 30 days. Ironically, if you’re caught between suppliers who want their
money now and buyers who’re slow to pay, a successful product with increasing sales can create a real
cashflow crisis. Even though your unit sales are increasing and profitable, you won’t get paid in time to
pay your suppliers and meet payroll and other operational expenses. If you’re unable to meet your
financial obligations in a timely way, your creditors may force you into bankruptcy at a period when sales
are growing rapidly.

Your Sales May Be Growing and the Money Keeps Pouring In, but That Doesn’t Mean You’re
Making a Profit

If you borrow money to solve the cash flow problem, for instance, the rising debt costs that result can
raise your costs above the breakeven point. If so, eventually your cash flow will dry up and eventually
your business will fail.

Profit
Profit, also called net income, is what remains from sales revenue after all the firm’s expenses are
subtracted. It’s obvious in principle that a business cannot long survive unless it is profitable, but
sometimes, as with cash flow, the very success of a product can raise expenses. It may not be immediately
apparent that this is a problem. In other cases, you may be aware of the problem, but believe that by
reducing production costs you can restore profitability in time to avoid a crisis. Unfortunately, unless you
have a clear understanding of all the relevant cost data, you may not act effectively or promptly enough to
make the firm profitable again before it runs out of money.

Components of Cash Flows

(i) Cash Flow from Operating Activities
The net amount of cash coming in or leaving from the day to day business operations of an entity is called
Cash Flow from Operations. Basically it is the operating income plus non-cash items such as depreciation
added. Since accounting profits are reduced by non-cash items (i.e. depreciation and amortization) they
must be added back to accounting profits to calculate cash flow.

Cash flow from operations is an important measurement because it tells the analyst about the viability of
an entities current business plan and operations. In the long run, cash flow from operations must be cash
inflows in order for an entity to be solvent and provide for the normal outflows from investing and
finance activities.

(ii) Cash Flow from Investing Activities

Cash flow from investing activities would include the outflow of cash for long term assets such as land,
buildings, equipment, etc., and the inflows from the sale of assets, businesses, securities, etc. Most cash
flow investing activities are cash out flows because most entities make long term investments for
operations and future growth.

(iii) Cash Flow from Finance Activities

Cash flow from finance activities is the cash out flow to the entities investors (i.e. interest to bondholders)
and shareholders (i.e. dividends and stock buybacks) and cash inflows from sales of bonds or issuance of
stock equity. Most cash flow finance activities are cash outflows since most entities only issue bonds and
stocks occasionally.