Suppose a firm has Rs. 100 million at its disposal and there are only three alternative uses :-
- To expand the size of the firm
- To set up a new production unit in another locality and
- 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
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