The opportunity cost of capital is defined as the return on capital which might be obtained by its employment when the central objective of planning policy is to use capital so its return to employment in any one investment is at least as high as its return from employment in any alternative investment. Similar to the cost of capital to equity shareholders, we have to allow for any risk differential.
In other words, the opportunity cost of capital is the marginal productivity of additional investment in the best alternative uses. It is, therefore, not surprising that the marginal productivity of capital in the private sector is frequently suggested as an appropriate value for the opportunity cost of capital to be used in public investment projects. It seems reasonable to say that if the marginal investment can earn x percent in the private sector, no public investment project should be allowed to earn less, and vice versa. However, the suggestion does not lead to a solution, since measurement of marginal productivity of capital is a formidable (if not impossible) task due to the fact that capital is not a homogeneous good. That is, marginal products from different capital goods may differ. A more practical way to determine the value of the opportunity cost of capital is to use some market rate of interest.
The use of a market rate of interest corresponds to the neoclassical approach of perfect competition, which assumes the existence of a capital market that generates efficient prices. That is, the price system equates marginal costs and benefits and results into efficient allocation of resources. Thus, efficient prices are the prices at which there would be a competitive equilibrium between supply and demand. In other words, they are equilibrium prices for the various factors in an optimum situation when all alternative uses have been taken into account. Naturally, an efficient price system rarely exists due to various market imperfections–tariffs, taxes, quotas, increasing returns to scale, monopoly and monophony power by various buyers and sellers, or a lack of necessary market institutions. Nevertheless, the use of a market rate of interest for the opportunity cost of capital is often a good approximation.
In practice, the use of a market interest rate follows the following procedure: (1) selection of relevant interests rates; (2) estimation of the prime interest rate or the rate charged borrowers having the highest credit training; and (3) adjustment of the prime interest rate by including a corresponding risk premium, if necessary. From a broad viewpoint, the selection of relevant interest rates calls for a reflection of what determines the rate of interest in an economy. In brief, it is the result of the interplay between the supply of and demand for capital. Basically, the supply depends on the level of savings in a country and the flows of capital from abroad. The demand stems from investment plans by private business and government. Thus, we could consider the following array: interest rates related to the short-term funds, medium- and long-term loans, preferred shares and equity capital, interest rates on time deposits, rates for consumer credits, rates of return on real assets (fixed assets and inventories), and interest rates charged by private money lenders operating in unorganized markets.
The selection of relevant interest rates relates to the choice of the interest rate that is a prime rate (as free of risk as possible) and not subject to random short-term fluctuations. Consequently, we eliminate from the above array interest rates related to equity capital, preferred shares, and short-term funds.
The rates of return on real assets are not recommended for consideration either, since the establishment of these rates calls for the evaluation of such assets, which is a Herculean task if one considers the variety of existing real assets. Moreover, prices of similar fixed assets vary from location to location.
Interest rates charged by private money lenders in unorganized markets primarily take place in developing countries where private money lending sometimes accounts for a large portion of the total volume of credit extended. However, such rates are also not recommended for consideration since they often reflect the default of borrowers, and frequently exist in quasi-monopolistic environments (the loans are frequently made by small businessmen and farmers in rural areas with a lack of good communications and money markets).
The above eliminations leave us with interest rates of medium- and long-term loans, interest on time deposits, and rates for consumer credits to estimate the prime interest rate. In the United States, Canada, and most western European nations, the capital markets are essentially free, and governments, in their borrowings, pay a competitive price. In addition, government bonds in these countries are regarded as the prototype of investments with a prime interest rate. Therefore, it is reasonable to use the yields on long-term government bonds for the opportunity cost of capital in the United States, Canada, and most western European nations.
In developing countries, however, capital markets are usually imperfect, and governments do not always enjoy the highest credit rating. Depending on local conditions, it is frequently better to use first-rate corporate bond yields, long-term private borrowing rates on high-grade loans of commercial and specialized credit institutions, first trusts granted by mortgage banks, or a weighted average of these.
The adjustment of the prime interest rate by including a corresponding risk premium is necessary when there are risky investment plans. The correct adjustment relies largely on judgment, since there is no practicable way to analyze systematically and to transform price risks and risk of failure of the investment into one risk premium. The difference between short-term and long-term lending rates for prime risk capital may give an indication of the market’s assessment of the adjustment necessary for price risks. In addition, the yields on purchasing power bonds (those bonds whose nominal value is tied to a value standard such as a general price index) may, if they exist, be compared to ordinary financial bonds of similar terms. An indication of the adjustment necessary for risk of failure of the investment may also be obtained on the basis of past trends and forecasts of probable failures of ventures.
The use of competitive growth models is sometimes suggested for the determination of the opportunity cost of capital. The models are based on highly abstract production functions of the Cobb-Douglas type with variables and parameters that are difficult or impossible to measure empirically. In addition, the underlying assumptions appear to be unrealistic in real-world situations. The application of growth models to the establishment of the opportunity cost of capital may become more promising once the approach has been further developed through the relaxation of unrealistic assumptions and the inclusion of variables which are easier to measure. So far, little progress along these lines has been made.