While making an investment, it is essential to ensure that the cost of your investment is not eating into your returns. Here are the costs, prior to opting for an investment.
This refers to any cost that has already been incurred and that cannot be recovered. Both companies and individual investors can incur such a cost. For example, suppose you pay an advisor Rs 1,000 to get recommendations. Now, whether or not you actually use the advice, the money has been spent. This is called sunk cost. Another example is the cost of market-entry research – when a company conducts a survey about the potential of a new market for entry. This sunk cost, however, can often be misunderstood. It’s called the sunk-cost fallacy. This is when you invest in an asset that turns to be loss-making, but you refused to exit or stop investing simply to justify all your efforts.
Money can be used in a wide variety of ways, of which one can be more profitable than others. Opportunity cost helps you measure which option is more profitable. Quite simply, it is the profit you are giving up by investing the amount in another asset. For example, suppose you only have Rs 1,000 to invest; you have to choose between two options. One option (say Equity) can add Rs 110 value to your portfolio, while the other (say Bonds) gives you Rs 80 profit. If you chose to invest in Equity, then Rs 80 -- the profit you are giving up -- becomes the opportunity cost. This is why your opportunity cost should be lower than your investment return. Otherwise, it means you are missing out on the opportunity to earn higher returns. While calculating opportunity cost, you are essentially pitting the return potential of both options. Companies too weigh the opportunity cost while considered different projects for investments.
Whether you are a company or an individual, you may often borrow money to invest. As an individual, this could be in the form of margin money or a loan. Companies borrow by issuing bonds, debentures or taking a bank loan. Either way, this borrowing comes at a cost – the interest amount that you have to pay from your pocket. It thus eats into your total profits. Calculating this cost is slightly complicated for companies – you have to take into account the proportion of money borrowed through debt and cost of equity and then average the cost depending on the weightage. This is called Weighted Average Cost of Capital (WACC).
Companies often reinvest all their profits into the business. They do not distribute the income to shareholders. This is called retained earnings. Such companies are called ‘growth options’ – the opposite of high-dividend-yield companies. Reinvested profits can lead to higher growth. After all, this is a cheaper, interest-free source of funds than borrowing. However, it comes at a cost for you, the investor. This is called ‘Cost of Retained Earnings’. This is the return you would have earned if you had received the dividend money and used it reinvest.
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