I am going to deal with three financial principles in this lesson: Cost of Capital, Leverage, and Opportunity Cost because they are intimately related to one another. Opportunity cost is an important part of the cost of capital and the leverage provided by borrowing money incurs interest which is also part of that cost. So the basic issue we are discussing is the cost of capital.
This refers to the expenses incurred in acquiring or accessing capital (money) as opposed to the money itself. If you borrow money to acquire it, the cost of capital includes the interest you pay for it, but there are always other costs. They may be trivial, but should be ignored only after identifying and evaluating them. If you have to travel to see someone about acquiring capital, or if you have to spend time making phone calls, etc, those are costs of capital and should be included in your computations. Even though these costs may seem small at the time, later, when you figure out the return on your investment, that computation will be in error if you ignore any cost of capital (especially the opportunity cost, which is usually ignored).
Opportunity Cost
The cost of capital that is frequently missed is the cost of using your own money. Intuitively, this doesn’t make sense because there is no cost of acquisition. But beware: there is a real cost in the use of your own money. This is called “opportunity cost,” and corporations that have ignored it have done substantially poorer than those that added it to their cost of capital computations. An example will help.
Let’s say you want to start a lemonade stand on your corner and you need $30 to get into the business. Let’s also assume you have $20 in cash. So you go to your Mom and borrow $10 from her grocery money. She has just lost the ability to buy $10 worth of groceries. That’s her opportunity cost for investing in you (your business). Furthermore, if you use your own cash you lose the opportunity to set up a second stand down the street. Fact is, your Mom would have loaned you $30 and financed your corner stand leaving you the chance to borrow $10 from your Uncle and set up a second businss.
That is a lesson in “thinking outside the box” and in “thinking big.”
This somewhat elusive concept is critical to the Bank-Free Banking system because it puts every opportunity on an equal footing. For example: cash in a savings account that earns 2% is actually costing 8% when there is an opportunity to invest the funds at 10%. Here the opportunity cost is 8% of the funds in the savings account.
The opportunity cost of building MyForeverBank is the sacrifice of “wants” on the altar of “needs.” This is a huge obstacle for most of us. We are programmed by everything in our culture to see most of our wants as needs: a bigger house, a better car, a boat, an airplane, a yacht, a new suit. It takes patience, tenacity, and a vision of what MyForeverBank can deliver in the long run to overcome the “wants” we emotionally perceive as “needs.” Do you really need a bigger house, probably not (unless your family is growing) but you certainly don’t need a boat (unless you fish for a living). You get it but can you live it? Get a vision and keep that in front of you or you’ll probably make a MyAlmostBank.
Leverage
The lemonade stand loans were perfect examples of leverage. Loans provide additional capital and expand the field of available possibilities. The downsides of loans are that you incur the interest and the risk that when things go bad, you will not be able to pay them off. It takes careful thought, objective thought, to correctly evaluate opportunities and risks.
When we decided to buy the off-grid cabin, we saw the trade-offs involved. The cabin needed substantial labor and materials to make it livable. We could provide that but it pushed our planned schedule for the final development of the place at least a year. The clincher was that there would be no need for a mortgage. We own it free and clear.
Some Reflections on Opportunity Cost
This concept is not intuitive, hardly ever considered, yet crucial to wise choices so I want to just roll it around for you and let you see some aspects that will help you grasp this important principle.
The human being is an economic creature. It is immersed in its economy but largely unaware of the fact. So it makes decisions that seems to be best for it but with only a shallow comprehension that today’s decision will limited tomorrow’s options.
The wise human being will be aware that any particular choice he makes will automatically eliminate a thousand other possible choices. This is probably the most difficult awareness to acquire because the mind can only think one thought at a time. As it focuses on one goal, it cannot also focus on any of the thousand other opportunities.
This is the fundamental challenge that faces us as we break away from systems that were constructed by people whose goal was to help us reach our financial goals in such a way as to profit them handsomely. Drive through America’s small towns and cities and notice that biggest buildings in town are the banks. MyForeverBank already has a building – your house. You can see big savings right there.
You just had an “aha” moment. Welcome to Bank-Free Banking. There will be many more of those once we get through eating the sawdust. That’s how academic treatment of subjects always seems to me. Training is always lecture and “lab” (laboratory). Hear a lecture on how to ski and hit the slopes. I like the lab a lot better than the lecture, but unfortunately both are needed.
This is America and we still have the most freedom in the world. Build your own bank and build it according to your goals, according to your needs, and according to your rules. That’s how freedom should work. Free enterprise will always produce more than any other system and that’s why we are going to use Bank-Free Banking to build your “MyForeverBank.” MInimize costs and maximize profits.
He writes from a background as a family man (raised ten children) with degrees in Physics, Mathematics, and Business. HIs vocation has been mostly Engineering and Financial Business, Accounting and Banking software. He is a Christian, a Philosopher, and an Author writing mainly about rights and government. He lives off-grid most of the year in the tops of the Rocky Mountains.
- Fundamentals of Finance - February 19, 2025
- How to Be a MyForeverBanker - February 19, 2025
- Cost of Capital - February 17, 2025
