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Opportunity Cost for Capital Budgeting Processes

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What is opportunity cost and why is it an important concept in the capital budgeting process? The opportunity cost concept applies to almost every financial decision we make as individuals. Can you give an example from your own experience?

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Solution Summary

The financial impact of opportunity cost as it relates to investment strategy.

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Let's start with a basic definition of opportunity cost:

In microeconomic theory, the opportunity cost of a choice is the value of the best alternative foregone, where a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would be had by taking the second best choice available.[1] The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen". Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice".[2] The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently.[3] Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs. (Wikipedia)

In essence we are saying that by choosing one alternative, we forego another alternative which may have potentially more value (or even the same value). By foregoing this alternative opportunity, we can never gain the ...

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