Question

Investing $1,000,000 in raw inventory today, mostly in Oil � should allow Carsons Machinery to increase production and earn an additional $1,100,000 next year. This payoff would cover the investment today, plus a 10% return. Carson's trades on the S&P/TSX. They are currently able to borrow money at 5%, and are receiving 2% on their cash balances. The CEO has studied the history of returns on investments in Oil and believes that investors in this commodity can reasonably expect a 15% return. What is the opportunity cost of capital and does that make Carson's Machinery's investment a good idea under the circumstances?

2%, Yes

10%, No

15%, Yes

15%, No

10%, Yes

Answer 1

The opportunity cost of capital is the alternative best use of funds or second-best use of funds.

In the above situation, we have two Opportunity costs.

Opportunity cost 1: Invest $1,000,000 @ 2% and receive $ 1,020,000 in 1 Year.

Opportunity cost 2: As Carson's trades are available on the S&P/TSX, and the reasonable expected return for an investor in commodities is 15%. We can get long on these commodity contract and receive $ 1,150,000 in 1 Year.

However, the return on project is $ 1,100,000 i.e 10% (without considering the interest on borrowed amount)

Hence, the opportunity cost to consider in this case is 15% and as 15%>10% the Carson's Machinery's investment NOT a good idea under the circumstances.

Answer: Option D: 15%, No