Financial Literacy
Why you must consider the ‘Opportunity costs’ before investing
In investment, opportunity cost has to do with the cost of choosing one investment over another one, which has the potential to earn a higher return.
You most likely would have heard of the phrase ‘opportunity cost’, probably during your basic economics class back in secondary school. Simply defined, it means the relative cost of doing one thing instead of something else. You can also think of it as a forgone alternative.
Every decision you make to either purchase or sell something has an opportunity cost. As humans, we knowingly or intuitively make most of our spending decisions based on it. This is because knowing the opportunity cost of our expenditures helps us to prioritise our needs/wants.
In the investing world, the same rule applies. However, most of us do not take a critical look at the opportunity cost of some of the investments we make. Instead, we make impulsive decisions, throwing money at any investment opportunity that promises to deliver some supposedly ‘high returns’.
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Understanding opportunity cost in investing
In investment, opportunity cost has to do with the cost of choosing one investment over another one, which has the potential to earn a higher return. A simple formula used for calculating the opportunity cost of your investment, as developed by Investopedia, can be seen below:
Opportunity cost = Return on best forgone alternative – Return of chosen option.
For example, you have two investment opportunities:
- Option A: Invest in the stock of ABC Company which promises a return of 15%.
- Option B: Invest in a business that will generate 12%.
The opportunity cost of choosing the business over buying company ABC’s share is 3% (15%-12%).
A much more complicated reality
In reality, calculating your opportunity cost is much more complex than the example above. This is because there are hundreds or thousands of investment choices you are faced with. And they all have varying risks.
However, the logical thing for you to do will be to first create a list of possible investment opportunities, after which you scrutinize and analyze them, and then finally pick what fits your long term goals.
A comment I saw on Jonathan Clement’s blog really explains the concept of opportunity cost:
“Even if we ask about the tradeoff involved – or what economists call the opportunity cost – there’s no guarantee we’ll make the right choice. Often, acting on our first impulse is simply too alluring, but at least asking the question forces us to consider the issue, however briefly, and maybe we’ll have the presence of mind to weigh the alternatives and perhaps even summon the willpower to choose a different path.”
Personally, I use the 5yr FGN Bond yield as a minimum opportunity cost before I invest in any business. This is because FGN Bonds are risk-free, even as the Federal Government of Nigeria will never default on their debt obligation. Hence, the safety of my principal is guaranteed.
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On a final note, thinking in terms of opportunity cost before you invest will help you create a stronger capital allocation discipline. In other words, you will better able to deploy your money to its best use. This will, in turn, help you earn above average returns. It will also help you to prioritise better, not just for investing purposes, but also in terms of spending money and incurring expenses.
Investment Tips
Payback and Return on Investments
To calculate payback, the cash flow or return from the investment needs to be known.
In previous articles, we have explored various methods of fundamental analysis, including cash flow and earning. Two key questions every investor asks are — How much will I make from this investment? How soon can I get returns? These questions are broadly Return on Investment (ROI) questions and there are lots of ways to calculate it, including Breakeven Analysis and Internal Rate of Return. Let us look at their ROI tools in detail starting with Payback
Payback is how long it takes for an investment or business to recoup its initial investment. With Payback, the shorter the number, the better. Look at it this way, if you got an offer to build a railway from Lagos to Ibadan and you will get payback in 5 or 8 years, which would you prefer? 5 of course.
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Payback analysis is useful where the investor wants to know if the project is work the time and investment capital it is also easy to calculate. A shorter payback also means the project has a shorter time to be exposed to volatility and risk however this does not mean it eliminates risk, it just determines time frame during which the investment is subject to higher volatility without a full return of invested principal. Payback is like Breakeven calculation, but payback is focused on time while breakeven is focuses on time as a unit.
To calculate payback, the cash flow or return from the investment needs to be known. For instance, A company wants to set up an online platform to receive online orders. It estimates the project will cost N5m in total and will increase sales by N1.5m every year. The company projects that the equipment will be depreciated at 20% meaning it will last 5 years. What is the payback for this project?
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To calculate payback, we divide the total cash sum by the cash returns for the project. In this case, 5,000,000/1,500,000 that equals to 3.33. Note the company estimated the project equipment will last 5 years
Payback does not talk about profitability, rate of return or if the company investing will remain as a going concern. The calculations are simply focused on when the initial investment is repaid. From the example above, the N1.5 the earned from new project 1.5m is not profit, its cash received because of the new online ordering system. Payback does not also consider Time Value of money, thus again from our example, the Present Value of N1.5M received is not considered. This Payback is often used as a gateway analysis tool to determine if a project should be considered.
To enhance Payback calculations, many analysts will integrate time value calculation with discount rates to match the future cash flows to today’s cash outlay. This is known as Net Present Value (NPV) which is the present value of the cash flows at a discount rate compared to your initial investment. Thus, NPV compares future cash to today’s cash outlay to determine If project is viable. Eg you discount all future dividends from stock using a discount rate back to today and compare it with a market price to determine if you should buy the stock. If NPV is positive, then the project or investment is good, a negative NPV means the future cash flows are worthless, thus not a good investment. The main problem with NPV in my estimation is the assumption of the discount rate to use. A discount rate that too high or low will skew the results of the NPV and render the output false.
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The last ROI calculation I want to review is the Internal Rate of Return (IRR). Technically the IRR is the rate of return that makes all cashflows rates of return equal to zero, in other words, it is the rate of growth investment is expected to generate annually. The more positive the better. IRR integrates the elements of payback and NPV and is also use in comparing different options and picking the option with the highest value.
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Today, all these formulas are available on Excel sheets and financial calculators on our mobile devices you do not have to be a math’s geek to implement ROI, but I remain a useful tool in comparing projects.
MSME
GEEP provides COVID-19 palliative microloans to 87,614 traders
The loans were in line with the government’s policies to reduce poverty and boost productivity.
The Federal Government of Nigeria, through the Government Enterprise and Empowerment Programme (GEEP), has provided a COVID-19 palliative relief loans to about 87,614 traders across twenty states. This was disclosed earlier today through a brief press statement that was made available via the government’s official Twitter handle.
According to the disclosure, the microloans have helped to reduce extreme poverty and encouraged productivity following the easing of the lockdown. Part of the statement said:
“In line with the vision of the Nigeria Government to curb poverty and boost productivity in different parts of Nigeria, GEEP has provided palliative microloans to 87,614 petty traders hit by COVID19 pandemic in 20 states of the country in the first phase of disbursement.
“These palliative microloans have helped petty traders revive their businesses, as the government eases lockdown measures nationwide. The second phase of the disbursement will target 412,386 petty traders across the country.”
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In line with the vision of @NigeriaGov to curb poverty and boost productivity in different parts of Nigeria, @geep_ng has provided palliative microloans to 87,614 petty traders hit by #COVID19 pandemic in 20 states of the country in the first phase of disbursement.#GovtAtWorkNG
— Government of Nigeria (@NigeriaGov) August 10, 2020
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The Federal Government also announced that the second phase of the loans would be disbursed to a 412,368 trader across the country in a bid to restart economic productivity as the government eases the economic lockdowns that have heavily affected the informal and formal sectors.
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The palliative schemes under the GEEP scheme include FarmerMoni, TraderMoni, and MarketMoni.
FEATURED
FG releases new details on MSMEs support scheme, budgets N200 billion for loans
The Bank of Industry will also join to coordinate the implementation of the scheme.
The Federal Government has released new details on the Micro Small and Medium Enterprises (MSMEs) support scheme being rolled out under the National Economic Sustainability Programme.
According to estimates provided, the sum of N50 billion will be used to provide payroll support, N200 billion for loans to artisans, and N10 billion support to private transport companies and workers
The government disclosed in a tweet on the official handle of the government, the support scheme will include a Guaranteed Off-take Scheme for priority products, and an MSMEs Survival Fund.
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The Federal Govt is rolling out, under the NESP, support schemes for MSMEs nationwide, including a Guaranteed Offtake Scheme (guaranteeing off-take of priority products); and an MSMEs Survival Fund that will make payroll support available to save jobs & sustain local production. pic.twitter.com/yLkHQn6zy3
— Government of Nigeria (@NigeriaGov) August 10, 2020
Modalities for the take-off scheme
The first track is a Guaranteed Off-take Scheme which will ensure continued local production and safeguard 100,000 existing small businesses to save 300,000 jobs.
Priority products include processed foods, personal protective equipment, hand sanitizers, face-masks, face-shield, shoe-covers and pharmaceuticals.
The implementation committee chaired by Ambassador Mariam Katagum, Minister of the Federal Ministry of Industry Trade and Investment, will collaborate with private sector MSME associations to verify and screen applications from bidding MSMEs, define quantity and price of products required, and also get participants to join in the procurements.
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SME survival fund
With a budget of N15 billion, the SME survival fund is expected to sustain 500,000 jobs in 50,000 SMEs.
Major sectors to benefit from the SME survival fund include hotels, restaurants, creative industries, road transport, tourism, private schools and export-related businesses.
The committee will identify eligible SMEs and screening and verification for this fund will be based on company registration, and tax registration. The implementation committee will approve disbursements through microfinance banks and fin-tech credit providers.
MSMEs that are unregistered will receive support to complete registration with the Corporate Affairs Commission (CAC), and all participants will be expected to make payments based on signed agreements.
The Bank of Industry will also join to coordinate the implementation of the scheme.
The scheme will last 3 months with Ambassador Mariam Katagum as Chairman, while Ibukun Awosika, Founder of The Chair Centre Limited (TCCL), and First Bank Nigeria will serve as the Vice Chairman.
More details are to be released subsequently from the Implementation Committee.
The Backstory
In July 2020, the Federal Government announced plans to roll out a N2.3 trillion stimulus package and survival fund for Micro Small and Medium Enterprises (MSMEs) to stay afloat amid the economic challenges imposed by the pandemic.
The Vice President Yemi Osinbajo, who also heads the Economic Sustainability Committee, announced it at the 2020 edition of the Micro MSMEs Awards held virtually in July.
To benefit from the scheme, MSMEs would have to go through a rigorous and painstaking verification process which will be based on certain criteria.
MSMEs that have between 10 to 50 staffs are qualified for this fund. The businesses must make their payroll available to the government for verification while applying for the fund. Once qualified, the MSMEs will be eligible to have their staff salary paid directly from the fund for 3 months.
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Oluwaseun
March 11, 2019 at 10:55 am
So how does the topic/subject matter relate to the picture used please?
Emmanuel Abara Benson
March 11, 2019 at 11:19 am
Hello. Please, look at the picture again. You will understand.
Anonymous
March 11, 2019 at 4:11 pm
A choice between buying a car or buy or build a house
Anonymous
December 14, 2019 at 9:43 pm
In opportunity cost, two options at least are available. The diagram just hypothetically made use of just two baskets of choices amid varied alternatives. Yours or that of anyone at all may be different from those depicted. So look again and get the concept. Ok.
Gregory Igbodudu
December 12, 2019 at 3:50 pm
Great economic advise. Universal
Michael Adegoke
December 14, 2019 at 11:25 am
Good advice. However, you have to account for the present value and time value of money. Follow the principle of a dollar today is worth more than a dollar tomorrow.