Opportunity Cost

Money can only sit in one place at a time. Put it in a bond and you cannot also put it in a fixed deposit. Whatever the other choice would have paid you is the cost of the choice you made. That is opportunity cost.

The workbook uses a small example. A bond pays 10% a year. A fixed deposit pays 7%. The bond earns 3 points more than its opportunity cost. So the bond looks like the better call.

There is a second step, though. You still have to ask whether that extra 3 points pays for the extra risk. A bigger number on its own does not settle anything.

This matters a lot in an AIF. An AIF locks money away for years. The investor gives up every other use of that money for the whole of that time. So the fund does not just have to make a profit. It has to beat what the same money could have earned somewhere else.

The workbook puts opportunity cost to work in four places, and each one is examinable.

1. As the yardstick for both families of return metric (section 6.1). There are two ways to measure a return. Absolute-return metrics compare the result with the opportunity cost on an annualised basis. Discounted metrics do the same thing on a discounted basis. Either way, the comparison is against the opportunity cost — the definition of a good return is relative, not absolute.

2. As the reason FIRR alone can mislead (section 6.6.1). The workbook contrasts an FIRR of 20% earned over two years on a traditional asset with 25% earned over eight years on illiquid AIF assets, and says the two are vastly different. The eight-year lock-up carries eight years of foregone alternatives.

3. As the rate inside MIRR (section 6.6.2). Illustration 6.3 has capital calls of 20 and 30 in Y0 and Y1 and distributions of 20, 30, 40 and 50 in Y4 to Y7, giving an FIRR of 22%. The workbook objects that 22% may not be the cost of capital of an investor or the opportunity cost of other investments in the market, because IRR discounts everything at its own rate. So the MIRR sets the opportunity cost at 10%, discounts the calls back to Y0 at 10% and compounds the distributions forward to Y7 at 10%.

4. As the investor cost of idle capital (section 6.6.9). Gross return metrics sometimes factor in the opportunity cost of cash management by the investor during the investment cycle, while dry powder is still sitting in the fund system uncalled.

And in valuation, Box 11.1 defines the cost of equity itself as the opportunity cost of the shareholder — the CAPM return of risk-free rate plus equity beta times the market risk premium.

Anjali has Rs 50 lakh to place for three years. Two choices, at the two rates the workbook itself uses:

The three-year arithmetic ignores compounding, purely to keep the comparison to the workbook's two rates.

The bond beats its opportunity cost by Rs 4.5 lakh. On the workbook's reasoning the bond makes better sense because it yields more than its opportunity cost — but only once the extra risk has been weighed.

Now change the alternative. Anjali instead commits Rs 2 crore to a Category II AIF with a seven-year tenure, and the fixed deposit at 7% is what she gave up.

Foregone FD interest over 7 years  =  Rs 2 crore x 7% x 7  =  Rs 98 lakh
So Rs 2 crore + Rs 98 lakh = Rs 2.98 crore is what the AIF has to return
just to stand level with the deposit she did not make.

If the fund distributes Rs 3.1 crore in total, the headline looks fine — Rs 1.1 crore of gain on Rs 2 crore. Against its opportunity cost it is thin: Rs 12 lakh of extra money for seven years of illiquidity, no exit route and the full risk of unlisted equity. That is the judgement the workbook says opportunity cost is a useful tool for.

Chapter 6 (Risk and Return — Investor and Fund Perspective) introduces opportunity cost in footnote 115 on its opening page, at section 6.1, and then leans on it three more times: in section 6.6.1 to explain why an FIRR figure is meaningless without its holding period, in section 6.6.2 to justify the MIRR, and in section 6.6.9 on gross versus net metrics. Chapter 11 (Valuation) reuses it in Box 11.1 as the definition of cost of equity.

The questions are definitional and comparative: what does opportunity cost mean, why is MIRR considered an improvement on IRR (because it brings in the investor's opportunity cost rather than the IRR's own rate), and the comparison question that pits 20% over two years against 25% over eight years.

• Opportunity cost is not a cost you pay. Nothing leaves your bank account. It is the return you did not get, used as a comparison.
• Beating the opportunity cost is not the end of the test. The workbook is explicit: the additional return has to be weighed against the additional risk before the decision is made.
• IRR and opportunity cost are two different rates. IRR discounts at whatever rate makes the cash flow balance. MIRR is the version that imports the opportunity cost — 10% in the workbook's illustration, against an IRR of 22%.
• Opportunity cost is not the hurdle rate. A hurdle rate is written into the fund documents and decides when the manager earns carry. Opportunity cost is the investor's own comparison and appears in no contract.
• A higher FIRR over a longer holding period can be the worse investment. 25% over eight illiquid years against 20% over two liquid ones is the workbook's own example.
• In CAPM, cost of equity IS the shareholder's opportunity cost — the same idea wearing a formula.