Opportunity Cost in Finance

Suppose a firm has Rs. 100 million at its disposal and there are only three alternative uses :-

Alternative:-

  1. To expand the size of the firm
  2. To set up a new production unit in another locality and
  3. To buy shares in another firm

Suppose the expected annual return from the three alternatives uses of finance are :-

Alternative 1:- Expansion of the size of the firm – Rs. 20 million

Alternative 2:- Setting up a new production unit – Rs. 18 million

Alternative 3:- Buying shares in another firm – Rs. 16 million

All other steps being the same , rational decision-making would suggest invest the money in alternative – 1. This implies that the manager would have to sacrifice the annual return of Rs. 18 million expected from Alternative – 2.

In economic jargon Rs. 18 million is called annual opportunity cost of an annual income of Rs. 20
million.