Cost of money

Cost of money
See also
Market Risk Premium WACC Quick assets Money-weighted rate of return Financial performance Free cash flow yield Fee structure Preservation Of Capital Simple rate of return

The cost of money, also known as the opportunity cost of money, is the value of the next best alternative that must be given up in order to acquire or use a certain amount of money. It is the return that could have been earned if the money had been invested in an alternative investment. The cost of money can be expressed as an interest rate, such as the Federal Reserve's target interest rate, or as a percentage of the investment's return.

Cost of money examples

Some examples of the cost of money include:

• Interest rates on loans: When borrowing money, the cost of money is the interest rate that must be paid on the loan.
• Return on investment: If an investor is considering investing in a stock, bond, or other financial instrument, the cost of money is the potential return that could be earned if the money were invested elsewhere.
• Inflation: The cost of money can also be thought of in terms of inflation, which represents the loss of purchasing power over time.
• Foregone income: the cost of money can also be thought of as the income or profit that could have been earned if the money had been invested in another venture or opportunity.
• Lost opportunity: The cost of money can also refer to the value of a missed opportunity, such as not investing in a profitable business venture because the required funds were not available.

Cost of money applications

The cost of money is a relevant concept in a variety of financial decisions, including:

• Investment decisions: Investors use the cost of money to evaluate the potential returns of different investment opportunities. They compare the return on investment (ROI) to the cost of money to determine the most profitable investment.
• Capital budgeting: Businesses use the cost of money to evaluate the potential returns of different capital projects. They compare the net present value (NPV) of a project to the cost of money to determine whether to invest in the project.
• Financing decisions: Companies use the cost of money to evaluate different financing options, such as issuing debt or equity. They compare the cost of debt and the cost of equity to determine the most cost-effective way to raise capital.
• Monetary policy decisions: Central banks use the cost of money to set interest rates and control inflation. They adjust interest rates to balance the goals of economic growth and price stability.
• Personal finance: Individuals use the cost of money when making decisions about savings, spending, and borrowing. They compare the interest rate on a loan or the return on an investment to the cost of money to determine the best course of action.

References

• Barnett, W. A. (1978). The user cost of money. Economics letters, 1(2), 145-149.
• Faber, J. W. (2019). Segregation and the cost of money: Race, poverty, and the prevalence of alternative financial institutions. Social Forces, 98(2), 819-848.
• Somers, H. M. (1954). Cost of Money As the Determinant of Public-Utility Rates. Buff. L. Rev., 4, 289.