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Apr'07 Q1

S

StartedThinking

Keen member
Hi,

The question says that the project is funded by means of issue of loan stock which has already been arranged and to which the company is committed. Finance raised from loan stock is 8% interest payment, and if the project is not undertaken, the proceeds invested at a return of 6%. The project has +ve NPV at 10%.

Why is the opportunity cost 6% instead of 8% because I need to pay a interest payments on the loan raised although I get 6% by investing in financial instrument. Please explain. Thanks in advance.
 
This was a slightly strange question. The core reading does describe the opportunity cost of capital as the return on a stock market investment that you forego in order to invest in the project that is being selected. As you say, the money is being borrowed, so the idea of something being foregone is not quite there. But if the project is not undertaken, the question does make it clear that any funds will be invested at 6% in the market.
 
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