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chap 1 opportunity cost of capital page 16

  • Thread starter divyam sankharva
  • Start date
D

divyam sankharva

Member
Hiii,

i am not able to understand what is opportunity cost of capital and how does it helps in determining the projects to be undertaken to maximize shareholders wealth

thanks in advance

divyam:)
 
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Opportunity cost is what is missed out on when an alternative option is pursued.

For example, if a company has £1m of capital available it could leave this sat in the bank earning, say, 1% pa (£10,000)

Or it could invest this £1m capital in a safe project yielding 4% (£40,000).

So, if the company puts the money in the bank it is earning 1% for shareholders, but it is missing out on an additional 3% it could have earned from the project.

If it invests in the project it is earning an additional 3% over and above the alternative.
 
I got what is opportunity cost of capital , but why it is used to find NPV , shouldent the cost of borrowing be used instead
 
divyam sankharva said:
I got what is opportunity cost of capital , but why it is used to find NPV , shouldent the cost of borrowing be used instead
Click to expand...

If you use cost of borrowing, then you're gonna get +ve NPV
If you use opportunity cost of capital, the you're gonna get desired +ve NPV.
That's it.
 
For ex:-
If you borrow a amount with rate of interest 10% pa
You have 2 options.
i) invest in debenture which gives 11% pa(opportunity cost of capital)
ii) invenst in some business with some expected cash flows.

Now you have to decide where to invest
If you chose rate of borrowing 10% to find NPV of (ii) , there are chances that NPV is +ve & you get option (ii) is better. But for example if option (ii) gives less than 11%, that leads you missed option (i) ( in other words if NPV of option 2 is +ve @10% but -ve @11%)
Hence, it is better to get NPV @11% pa(opportunity cost of capital).
 
Thank you very much , that cleared all my doubts
 
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