Question

Calculation and example of how opportunity cost of two investment options to use a company’s capital can differ. Calculate the future value of both types of investment options

Answer 1

OPPORTUNITY COST

You can think of opportunity cost as the benefit or value you give up by picking one course of action over another. In other words, the opportunity cost of a decision is the difference between the value you receive from pursuing a course action and the value that you would have received from the alternative you did not pursue. Let's look at Lilith's tech company to illustrate the concept.

HOW TO CALCULATE OPPORTUNITY COST

FORMULA TO CALCULATE OPPORTUNITY COST

• Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue

FORMULA EXAMPLE

• Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
• Opportunity Cost = 18% (return on tablets) - 10% (return on cell phones)
• Opportunity Cost = 8%

SCENARIO

You receive a call from a notary one morning telling you that you inherited $100,000 from a distant, wealthy relative. You are so happy with this surprise - Finally, a path to wealth! You wish to invest this money for a year before using the proceeds to put a down payment on a house. You call your financial advisor and he presents you with a variety of options for investing the money. All investments are deemed to have the same risk-profile (medium-high) since you are comfortable taking the risk.

The following options are available to you.

Investment	Expected rate of return
Low-grade corporate bonds	8%
Software company stock	10%
Preferred shares in a steel company	6%

You are particularly fond of the software company as it is a brand that you trust and you want to encourage the company's sustainability practices. However, the bonds seem more interesting since you will not have to look at stock quotes every day seeing that the bond matures in 1 year's time.

SOLUTION

The next best alternative is the low-grade corporate bonds since its rate of return is higher than the preferred shares.

Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue

Opportunity Cost = 10% - 8%

Opportunity Cost = 2%

The opportunity cost of selecting the software company stock as an investment vehicle is 2%.