Capital Budgeting Methods
Opportunity Costs are Relevant in Decision Making
An opportunity cost is a hypothetical cost incurred by selecting one alternative over the next best available alternative. Opportunity costs are relevant in business decision making and are commonly used in evaluating corporate projects. Opportunity Cost Analysis
When evaluating a potential investment, it is necessary to include opportunity costs in the analysis.
For a capital investment project, a company should evaluate the expected return of the investment compared to the opportunity cost, or the expected returns of an alternative investment of equal risk. If the project is expected to yield returns above the opportunity cost it may be a good investment.
For example, imagine a company is currently renting out a warehouse. Then the company considers an investment that would require using that warehouse. When evaluating the project, the company would need to consider the value of the rent it will no longer be receiving by using the warehouse in the new project, and subtract that value from the expected value of the project.
The concept also applies to investing in securities. For example, if an investor takes money out of a savings account to invest it in government bonds, then the investor should consider the opportunity cost of the interest the money would have earned in the savings account when evaluating the expected returns from investing the money in bonds. Opportunity Cost in Economics
In economics, opportunity cost is any utility foregone by choosing one alternative over another and does not necessarily refer to a monetary amount. When faced with two desirable and mutually exclusive choices, the value of the option not chosen is considered an opportunity cost. An opportunity cost could refer to the satisfaction an individual would get from the leisure time that is sacrificed for time spent working. Or if an individual decides to leave a salaried job to go back to school, the salary given up would be considered an opportunity cost.