Question

Give at least 3 examples of how an interest rate represents a price for the Opportunity Cost. At least one of your examples must relate to a business decision, and why you, as a Financial Manager, would or would not recommend a transaction.

a) Opportunity Cost of financing a business expansion
b) Opportunity Cost of investing in bonds
c) Opportunity Cost of taking out a loan for a new project
d) None of the above

Answer 1

Interest rates reflect the opportunity cost of using capital, influencing business decisions on whether to finance expansions, invest in bonds, or take loans for projects by comparing potential returns against borrowing costs.

Step-by-step explanation:

An interest rate is essentially the price of borrowing money, reflecting the opportunity cost of using capital in one way instead of another. In a business context, the interest rate serves as a benchmark to gauge whether an investment's returns exceed its cost. For instance, when a Financial Manager considers financing a business expansion, they must compare the cost of borrowing capital at a certain interest rate with the potential returns from the expansion. If the returns are greater than the cost of capital (including the 15% interest rate mentioned), the investment may be recommended.

Conversely, if the opportunity cost of investing in bonds is lower than the projected returns, and assuming a risk profile that aligns with the company's strategy, investing in bonds could be the preferred option. Similarly, before taking out a loan for a new project, the Financial Manager would evaluate if the project's returns justify the loan's interest payments, factoring in the opportunity cost of not pursuing alternative investments.