Opportunity cost is one of the common financial concepts since it helps determine the capital structure of a given business. Generally, opportunity cost can be used to refer to the cost of an alternative that one is given to undertake a given action. In business settings, opportunity cost can be measured in terms of utilities or monetarily (Weiss & Kivetz, 2019). On most occasions, the opportunity cost in any business can be viewed as cash flow that can be generated from its assets. Opportunity cost is essential in capital budgeting since it helps one choose an alternative over the other available best option (Weiss & Kivetz, 2019). One example of opportunity cost in my life is when I was thinking of going on a vacation with my friends either internally or traveling to Seychelles. I decided to travel abroad since I would have long-lasting memories.
Capital rationing denotes the process of one placing certain restrictions on the number of new investments or any projects that a company needs to undertake. On most occasions, capital rationing is achieved by placing a higher cost of capital required for investment considerations (Weiss & Kivetz, 2019).
Accounting rate of return (AAR) is one of the formulas that are used to reflect the percentage rate of return on a given investment or asset. One of the strengths of AAR is that it is easy to calculate and understand the payback pattern that is used (Easton & Monahan, 2016). Additionally, AAR helps in showing the probability of a given investment. However, one weakness of the approach is that the technique is only based on accounting profits and cannot be used on projects that are made during different times or in small bits (Easton & Monahan, 2016).
Easton, P. D., & Monahan, S. J. (2016). Review of recent research on improving earnings forecasts and evaluating accounting‐based estimates of the expected rate of return on equity capital. Abacus, 52(1), 35-58. https://onlinelibrary.wiley.com/doi/full/10.1111/abac.12064
Weiss, L., & Kivetz, R. (2019). Opportunity cost overestimation. Journal of Marketing Research, 56(3), 518-533. https://journals.sagepub.com/doi/abs/10.1177/0022243718819474