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

1. Opportunity cost is the cost of next best alternative.

For Decision making purpose, Opportunity cost are relevant rather than sunk cost.

As the sunk costs are already incurred and can't be changed with this decision.

Where as opportunity costs will depend on capital budgeting decision.

Ex: Idle building is there , which can be used for proposed project, else can be rented to third paty.

in such case The proposed rent is opportunity cost in decision making.

2. Capital rationing: It refers to lack of Capital to meet all capital projects requirements.

EX: there are 3 projects which requires $ 4M

but available funds are only $ 3M

3. ARR : = Net Income / Capital Investment

STrength:

It considers Accounting profit to calculate rate of Return

It is simple to calcuate

Weakness:

It ignores Time Value of Money

It considers Non Cash Items

It doesn't consider external factors affecting the Profitability of the project

It is not useful where the investments are made at diff times.