Question

Discussion Questions 1. What is the opportunity cost of capital? 2. Why do different interest rates exist in a competitive market? 3. Why is the opportunity cost of capital the best available expected return offered in the market on an investment of comparable risk and return? 4. How does the opportunity cost of capital provide the benchmark against which the cash flows of a new investment should be evaluated?

Answer 1

1) The opportunity cost of capital is the investment return that is estimated to be generated on a comparable alternative opportunity with similar risk profile and needing a similar upfront investment.

2) Various different interest rates exist in the market because of difference in the quantum of required investment, difference in risk profile and also the period of required investment. Higher risk projects with longer period would be funded at a higher interest rate as compared to lesser risky projects.

3) By definition, the opportunity cost of capital is the best alternative return opportunity which was foregone to take up the current opportunity. So a comparable cash flow is the benchmark against which the rate of return generated by a project is compared to calculate the opportunity cost of capital.

4) If the returns available from the cash flows generated by a project are higher than the opportunity cost of capital, then the project is selected for investment and execution. Otherwise, the alternative project which is the benchmark for calculating the opportunity cost of capital is taken up for implementation.