Why won’t my boss approve my project? I’ve done the math – it’s a good investment. Because it isn’t good enough. We learn the math and rationale behind these decisions in this article.
Opportunity cost is a financial metric generally applied to investment decisions made by companies. These decisions can be made about very large potential investments (acquisitions and company mergers), or they can be applied to smaller investments (individual projects). In this post, we will talk about opportunity cost as it applies to project-level decisions.
Definition of Opportunity Cost
Opportunity cost is the “lost opportunity”, of the best alternate way to spend the money.
Consider the following example of an investment decision without using opportunity cost:
We are considering a project to spend $100,000 to build a new website. We have calculated the expected value for the increased sales from the new website to be $110,000. This represents an ROI of 10%.
Without any additional information, we would make this investment. Every dollar we spend yields us $1.10 in returns.
Evaluating with Opportunity Cost
What would we do with the money if we didn’t spend it on this project? Imagine we had the following opportunity:
We have the option to invest $100,000 for a year in corporate bonds at a 20% interest rate. At the end of the year, we would have $120,000. This investment option represents our other opportunity for the money, with an ROI of 20%.
The opportunity cost for our website project is $120,000, the value of investing in bonds. The opportunity cost exceeds the value ($110,000) of our website project. As a company, we should not build the new website, we should invest the money in the bonds. We would be better off at the end of the day.
Using Opportunity Cost to Make Project Decisions
Every company always has an opportunity cost for any investment. It may not be obvious, and it may be very small, but it is always present.
Any given project will have a sponsor who has the ability to decide how to spend the company’s money (up to some dollar limit). For our example, we’ll use an IT department director as our sponsor. The sponsor is not expected to know what the company’s investment alternatives are, or what the corporate opportunity costs are. Our sponsor will, however, be expected to exceed the rate of return that the corporation could otherwise get if she didn’t spend the money.
This rate of return is called the hurdle rate. All investments by our sponsor should be expected* to exceed the hurdle rate. In fact – the hurdle rate is the minimal requirement, not the goal. A project that barely clears the hurdle rate is a marginal project, and probably shouldn’t be done at all.
Determining the Hurdle Rate
Companies have two sources of money – cash from investors and borrowed money. The investors and lenders expect a particular rate of return on their money – and that determines the hurdle rate for the company.
At a high level, some percentage of the company’s cash comes from investors (private investors, stock holders), and the rest comes from lenders (banks, bond holders). Each group has an expected rate of return on their money. Imagine we funded our company with $50,000 in cash from our rich uncle, and a $50,000 loan at 10% from the bank. Our uncle expects a 20% return on his investment (he expects us to convert his $50,000 into $60,000 by the end of the year). At the end of the year, we have to pay the bank $5,000 in interest and we have to show our uncle that we have an extra $10,000 in the bank. We started the year with $100,000 and we have to end the year with $115,000. This represents our weighted average cost of capital (WACC) of 15%. A detailed explanation of how to calculate the WACC for public companies can be found in this investopedia article.
We should only consider investing in projects that we believe will have an ROI of at least 15%, if we plan to meet our cost of capital expectations. This therefore defines our hurdle rate – the minimum return required to satisfy our investors and lenders.
Survival of the Fittest
We’ve established the hurdle rate, or minimum rate of return we should even consider. Think of it as the initial audition – if our project can’t meet the hurdle rate, it won’t be considered at all. But when we defined opportunity cost, we defined it as the return of the best alternative investment – not the minimum expectation of our investors. We have to compare our project to other projects.
If our company has a hurdle rate of 15% and we have a $50,000 project with an expected rate of return of 20%, but another $50,000 project is also being considered with an expected ROI of 25%, our sponsor should pick the other project. The value of our project is $60,000 (120% of $50,000), which is less than the opportunity cost of $62,500 (125% of $50,000). These comparisons are generally done as a percentage basis, to allow us to normalize and compare projects of different sizes.
*The degree to which the investment is expected to exceed the hurdle rate is a function of how the company is run. Some companies don’t explicitly manage project ROI for projects under a certain dollar amount (or managers below a specific level in the org chart). It varies with companies and with individual managers.