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
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
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).
