The Opportunity Cost of Capital

Fotolia_32516818_MThe universe is comprised of a lot of energy, of the type we sort of understand and of types we sort of understand a little bit less (so called “dark” energy is causing the accelerating expansion of the universe). While there is a lot of energy, it appears that it is nonetheless in limited supply. It is also understood that energy cannot be created or destroyed. This clearly imposes constraints on the extent to which mankind can develop over time – the limitation being the rate of improvement in the efficiency with which we use the available energy, meaning the energy available to humans for creation and development of products and services intended to serve humans.

When we apply energy, in the form of ideas within human brains and the effort to make it happen in the ‘real world’, to develop and build schools, or houses, or hospitals, that is energy which now cannot be applied to do something else. On this basis, the somewhat popular saying “there’s no such thing as a free lunch” (also known by its acronym tanstaafl) is easily interpreted – anytime you wish to have something, attaining it will require an application of energy, and this mandates that the energy now cannot be used to provide something else. This is the opportunity cost concept, with which we are all familiar. More carefully, because any application of energy to a pursuit thereby prevents the energy from being available to alternative pursuits, in order for the chosen pursuit to be accepted, it must provide a minimum acceptable “return” measured in terms of happiness delivered to those involved. If an alternative application of the energy, to an alternative pursuit, would have delivered more happiness to those involved, then ‘natural forces’ will reject the chosen application in favor of the better alternative. Now, considering our two definitions of value (for individual consumers Value is Happiness and for legal entities Value is the expected future free cash flow discounted at the opportunity cost of capital, the corresponding opportunity cost of capital depends upon which definition we are considering.

ValueChain

While happiness from the perspective of the consumer is complicated, value from the perspective of a legal entity is more manageable. The opportunity cost of capital refers to what expected future free cash flow could have been realized in the alternative use as a percentage of the investment amount going into the chosen application. The key to comprehending finance is to understand the concept of opportunity cost of capital from the correct perspective.

Consider the perspective of a marketing manager with 4 alternative uses of her budget of €1,000,000. Each of the four alternatives, A, B, C, and D, has a different expected payback (in present, discounted, value) of €600,000, €650,000, €700,000, and €750,000 respectively. Which alternative should she pursue? Of the four, D has the best payback – €750,000 of the €1,000,000. Based upon the other opportunities available to her, this is the best one, and therefore, one might argue, she should do this one. What this misses is the perspective on opportunity cost. While the marketing manager may only have 4 alternative uses for the cash and the energy it can hire, the cash and the energy of the people hired could be used for many alternatives which are independent of the marketing manager. Consider the possibility that the €1,000,000 could be used by a different manager within the company (the HR manager, or Operations manager, or IT manager) and could have realized more than the €750,000. Or, looking at a larger perspective still, the money could have been used by a manager in a completely different company in the same country, who could have used it to engage people to follow a completely different pursuit. Looking from still a larger perspective, the money could have been used by a manager in a company in a distant country to follow an altogether different pursuit. The Value Perspective is not narrow. It is the most broad perspective possible. If the cash could have been used to engage energy anywhere else on the planet to follow any other pursuit and that would have resulted in more happiness for end consumers, and therefore more expected future free cash flow as a percentage of the money spent, then the Value Creation Imperative requires that the money go there.

Fotolia_33442661_SThis defines, and clarifies, the perspective we are using when we say “the opportunity cost of capital.” We do not mean the marketing manager’s opportunity cost. We mean the opportunity cost as viewed from a global, or “nature’s,” perspective. This number has been estimated to be approximately 6.5% on a global, average risk, basis (ignoring inflation, which is the expected decline in the purchasing power of the currency – its exchangeability into energy). With this concept, we can now say that a pursuit is value creating if it delivers an expected return in excess of the opportunity cost of capital, which is 6.5% for an investment of average risk, as viewed from a globally diversified investor’s perspective – otherwise known as nature’s perspective.

Posted in: Blue line learning

Post a Comment