The Concept of the Opportunity Cost of Capital
Decision making is a process of choosing among alternatives. In the investment decisions, an individual or a manager encounter innumerable competing investment opportunities to choose from.
For example, you may invest your savings of 1000$ either in 7% 3 year postal certificates or in 6.5% 3 year fixed deposit in a nationalized bank. In both the cases, government assures the payment; so the investment opportunities reflect equivalent risk. You decide to deposit your savings in the bank. By this action, you have foregone the opportunity of investing in the postal certificates. You have, thus, incurred an opportunity cost equal to the return on the foregone investment opportunity. It is 7% in case of your investment.
The opportunity cost is the rate of return foregone on the next best alternative investment opportunity of comparable risk. Thus, the required rate of return on an investment project is an opportunity cost.
In our next posts we will discuss,
- Shareholders opportunities and values
- Creditors claims and opportunities
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