The opportunity cost of capital is the difference in return between two sequences of a task. There are various ways of calculating returns. Opportunity cost comes about when there is a need to forgo one task to benefit the other. It applies to organizations when there are more than one investment and a decision has to be made.
Organizations are often faced with the need to decide on various projects. The decision is usually accepting or rejecting the project. Taking an example of Bayside’s MRI project, they are faced with the need to choose between the enclosed and the open MRI system (Reiter & Song, 2018) . They use various capital budgeting techniques to help come up with the best financial decision. The NPV of the open system gives positive feedback of $82,493, which is a clear indication of a good return and a positive impact on Bayside’s financial condition.
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NPV is not relied upon by the organization but also the IRR, which gives better results. This is because the IRR technique measures the project’s profitability which is the expected rate of return. Bayside’s open system allowed them to have a 10% return rate, which made the investment financially attractive. The decision to accept or reject the project is necessary, but there is an option to venture into both projects. Thus, there is an opportunity cost of capital.
Regarding the various techniques involved in capital budgeting, one or two methods can help with the investment decision. The project with the higher return is often considered, but one can consider accepting both. At this point, they get to use the opportunity cost of capital, making use of both returns.
References
Reiter, K. L., & Song, P. H. (2018). Gapenski’s fundamentals of healthcare finance (3rd ed.). Health Administration Press.
