Question

Why do financial managers refer to the opportunity cost of capital? How would you find the opportunity cost of capital for a safe investment?

Answer 1

Answer:

To find the opportunity cost of capital for a safe investment, managers and investors look at current interest rates on safe debt securities.

Explanation:

Opportunity cost of capital refers to the return that could have been earned by investing in another investment opportunity with comparable risk.

Answer 2

Answer:

Opportunity cost of the capital is usually (if we consider the tax implications on the returns demanded by the lenders) the return required by the investors

Explanation:

So assume that I am appraising a project and I need an investment of round about 1 million dollars. If I fund this investment from loan which costs me 10% and also increases the financial cost then its opportunity cost is 10% interest and additional risk increased. However I also have an offer from one of my friends who is willing to invest in this project and is offering me $0.5 million equity investment and demands 20% return on this investment alongwith lower financial risk. So the opportunity cost of this equity investment is 20% cost of equity along with lower financial risk.

We can find opportunity cost of capital for a safe investment from the yield of government gilts or treasury bond's yield on investment.