THE COST OF CAPITAL AS AN OPPORTUNITY COST

An important implicit cost of almost every business is the opportunity cost of the financial capital that has , been invested in the business. Suppose, for instance, that Helen used $300,000 of her savings to buy her . cookie factory from the previous owner. If Helen had instead left this money. deposited in a savings account that pays an interest rate of 5 percent, she would have earned $15,000 per year. To own her cookie factory, therefore, Helen has given up $15,000 a year in interest income. forgone $15,000 is one of the implicit opportunity costs of Helen’s business.

As we have already noted, economists and accountants treat costs differently, and this is especially true in their treatment of the cost of capital. An economist views the $15,000 in interest income that Helen gives up every year as a cost of her business, even though it is an implicit cost. Helen’s accountant, however, will not show this $15,000 asa cost because no money flows out of the business to pay for it.To further explore the difference between economists and accountants, let’s change the example slightly.

Suppose now that Helen did have the entire $300,000 to buy the factory but, instead, used $100,000 of her own savings and borrowed $200,000 from a bank at an interest rate of 5 percent. Helen’s accountant, who only measures explicit costs, will now count the $10,000 interest paid on the bank loan every year as a cost because this amount of money now flows out of the firm. By contrast, according to an economist, the opportunity cost of owning the business is still $15,000. The opportunity cost equals the interest on the bank loan (an explicit cost of $10,(00) plus the forgone interest on savings (an implicit cost of $5,(00).

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