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.

Abey Francis – About the Author:
Full time blogger engaged in the areas of management and technology. Author and Moderator of famous business management blog Management Articles and Business Case Studies.

Image source: http://www.tutorsonnet.com/

Avoiding Business Failure

Neither the employees nor creditors can be paid on time unless the business receives monthly invoices on time from customers. It is very challenging to wait for 30-45 days till customers pay up. Small businesses need that money for vital payments. It is enough for them to be put out of business. This is where invoice factoring comes in. Invoice factoring is very helpful as it makes available ready cash within 28-48 hours of selling the invoices. This money can be used for all pressing payment issues.

Timely Payment of Bills

A business that deals with an experienced invoice factoring institution can improve its business in many ways. It can improve its credit worthiness and also fulfill orders on time besides meeting payroll requirements and making timely tax payments. Credit worthiness is improved by resorting to invoice factoring because the additional cash can be used to pay off creditors. A business can expect to grow rapidly by resorting to invoice factoring. Cash flow issues are settled thus making it easier to handle more orders. The increase in working capital makes having bigger and more number of customers a viable possibility.

Advantage Over Bank Loans

It is impractical for small businesses to wait for bank loan approvals and funds as they can be time consuming processes. Companies would also be required to establish some credit line which new businesses are less likely to have. A small business may not be in a position to wait for release of bank funds, especially if there is an urgent order from customer that has to be fulfilled. Banks also require some form of collateral, which is another factor that keeps away small businesses. Invoice factoring, on the other hand, is not a form of loan or debt. It is merely the sale of invoices. It does not require lengthy waiting period or any form of collateral.

With invoice factoring services, small businesses can no longer be held back because of cash flow problems.

Source:
Alex Martin – About the Author:
1st American Factoring providing best invoice factoring solutions for minimizes debt consolidation to your organization at very affordable price. Visit www.1stamericanfactoring.com to know more about invoice factoring.

http://www.articlesbase.com/accounting-articles/know-the-importance-of-invoice-factoring-5620041.html

Image source: http://www.businessfinancestore.com

Most people need help with their investment decisions. It is not easy to try and decide how to invest money that you have worked hard for. You want to make the right decision and you don’t want to loose your money.

The point behind investing is to make your money work for you. You worked for it now it is time for the pay back. The question is just how hard do you want your money to work? This is known as your risk profile. If you try to get your money working too hard the risk is that you will loose it. The rule of thumb is that the higher the return, the more risk associated with the investment.

So who is going to help you make your decisions? I would suggest to you now that you are only one who can decide your risk profile. You know just how much risk you are prepare to take on.

You might think an investment adviser will tell you what to invest in and how to invest in the various investment vehicles. Some people go down this track and fully believe that this is the only way to invest. Just hand it all over to an investment advisor. I believe that this is the wrong approach to getting investment help.

Ultimately, the decision about how to invest and what to invest in must be yours. If you see that your investment adviser is a millionaire and has a lifestyle to be envied, by all means just do what he says to do. But if he is not, then he must be looked at carefully and his advise considered carefully.

An investment adviser can assist you with information. He has access to information that you do not. He can recommend funds and various investments that are performing well at the present. He cannot tell you how those investments will perform in the future. This decision is yours, and at the best it will an educated guess and as good as anybody else who wants to give an educated guess.

Knowledge is power. The knowledge you will gain from your investment adviser will be extremely helpful in making your decision. You must look for other sources of this knowledge.

So where can you find this information?

Look to financial newspapers and web sites. Read as much as you can, and educate your self about your investment area. Find somebody who is wealthy and at the appropriate time ask them how they made their investment decisions. Learn from the mistakes of others. It is a far less costly way to learn. Go to financial investment seminars. Talk to people about their investment strategies and their sources of financial information.

When you look for investment help, look for information to learn. Do not seek out the most profitable investment. You may find it, but there is no guarantee that is will be profitable when you invest in it. The information and knowledge you gather from these sources will most likely give you the results you seek, and is therefore more valuable than a hot tip in the market.

Source: http://www.articlesbase.com/finance-articles/how-to-get-investment-help-400288.html
Author: Mika Hamilton

Image source:

http://financecp.com