Question

Elinore is asked to invest $5100 in a friend's business with the promise that the friend will repay $5610 in one year. Elinore finds her best alternative to this investment, with similar risk, is one that will pay her $5508 in one year. U.S. securities of similar term offer a rate of return of 7%. What is the opportunity cost of capital in this case?

Answer 1

The opportunity cost of capital in this case is -2%.

Step-by-step explanation:

The opportunity cost of capital in this case can be calculated by finding the difference between the return on the best alternative investment and the return on the friend's business investment, divided by the initial investment amount.

Calculate the return on the best alternative investment: $5508 - $5100 = $408.

1. Calculate the return on the friend's business investment: $5610 - $5100 = $510.
2. Calculate the opportunity cost of capital: ($408 - $510) / $5100 = -0.02, or -2%.

Therefore, the opportunity cost of capital in this case is -2%.

Answer 2

The opportunity cost = 8%

Step-by-step explanation:

The opportunity cost of capital is the return or benefit sacrificed in order to take a decision. It is the value of the next benefit sacrifice or forgone in favor of a decision.

Where there exist two or more alternatives, the one with the highest return becomes the opportunity cost.

In the case of Elinore , we compare the return receivable on the the alternative investments, that with the highest return becomes the opportunity cost.

Return on Investment = 5610- 5100 = 510

Return on investment = 510/5100× 100 = 10%

Alternatives:

Alternative 1

Return on investment of similar risk = 5508 - 5100 = 408

408/5100 ×100 = 8%

Alternative 2

Return on US securities = 7%

The alternative 1 promises a return of 8% which is higher than the second alternative , hence the opportunity cost becomes 8%

The opportunity cost = 8%