Final answer:
The pre-tax opportunity cost of capital is an expected rate of return from an alternative investment with similar risk, neglected when investing in a current project. For example, an investor may use a 15% interest rate to value future payments, considering this as the opportunity cost of the capital invested.
Step-by-step explanation:
The pre-tax opportunity cost of capital refers to the expected rate of return that an investor could earn in an alternative investment of equivalent risk. It represents the potential gains that are foregone by investing in a current project instead of the next-best alternative. As a pre-tax measure, it does not take into account the tax liabilities that might apply to the potential gains from other investment opportunities.
When an investor evaluates future payments from an investment, they must consider the appropriate interest rate that compensates for the time value of money, the returns from alternative investments (the opportunity cost), and a risk premium for the uncertainty of the investment. In the given example, an investor has decided on a 15% interest rate to value future payments, which implies this is the opportunity cost of capital for the investment under consideration. This rate should align with similar investments in terms of risk and duration to reflect the true opportunity cost of capital.