Opportunity costs are a representation of the gains a person, business, or investor missed out on when opting for one alternative over another (Bornholt, 2017). Although fiscal records do not indicate opportunity cost, business individuals can utilize it to make educated decisions when having numerous alternatives before them. The main idea behind opportunity cost is that a business owner's resources are always restricted (Canace & Salzseider, 2016). It is also an important concept in the capital budgeting process because it assesses various options as a way of ensuring that the best course of action has the lowest downside (Bornholt, 2017). A good illustration of how opportunity cost applies to fiscal decisions people make is when purchasing a home or starting a business (Canace & Salzseider, 2016). Here, people weigh the pros and cons and check their balances prior to spending cash.
Capital rationing refers to a strategy used by investors or organizations to restrict the number of projects they take on at a given moment (Bornholt, 2017). This means that organizations choose the most profitable projects to invest the available cash. Those who employ capital rationing strategies normally produce a much superior Return on Investment (ROI) because they invest their resources where there is higher gains possibility (Canace & Salzseider, 2016). Capital rationing can either be soft or hard. The former is where an organization voluntarily has particular limitations to the amount of cash available for investments (Bornholt, 2017). However, these can be altered in future. Contrarily, hard capital rationing takes place when organizations face issues in raising cash in the external equity market
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One strength associated with accounting rate of return approach is that it is simple to comprehend. The higher the accounting rate of return, the more attractive the investment will be (Bornholt, 2017). On the other hand, Canace and Salzseider (2016) state that a weakness associated with this particular approach is that it fails to account for the timing of gains. For instance, a USD90, 000 profit 5 years away is given as much weight as a USD90, 000 profit next year (Canace & Salzseider, 2016).
References
Bornholt, G. (2017). 'What is an investment projects implied rate of return?' Abacus , 53(4). Pp. 513 - 526.
Canace, T.G., & Salzseider, L. (2016). 'The timing of asset purchase to achieve earnings thresholds.' Journal of Management Accounting Research , 28(1). Pp. 81 - 106.
