Question

1. What is opportunity cost and why is it an important concept in the capital budgeting process? The opportunity cost concept applies to almost every financial decision we make as individuals. Can you give an example from your own experience?

2. What is capital rationing from the perspective of capital budgeting?

3. Give an example of a strength and a weakness of the accounting rate of return approach.

Answer 1

Ans 1: Opportunity cost: Since we have limited resources, we cannot grab all the opportunities or alternatives. Thus, when we select an alternative we give up other alternatives. The cost of foregoing or giving up the next best alternative or opportunity, when we select one is known as opportunity cost.

The concept of opportunity cost is important in the capital budgeting process as it helps us in determining the discounting factor to be used to bring the future cash flows to their present values.

The opportunity cost concept is applicable is our daily life. For example, my father wanted to invest $10000. He had three investment opportunities providing return of 2.5%p.a., 4 %p.a. and 6% p.a., respectively. Since, he could invest a limited amount of money. He invested in the investment providing a return of 6% p.a. Thus, he has to let go the next best opportunity of investment that provided a return of 4% p.a.. Hence, the opportunity cost of investing the sum of money at 6%p.a. was 4%p.a..