Opportunity cost

Definition

Opportunity cost is the value of the next best alternative that is forgone when making a decision. It represents the benefits you could have received by taking an alternative action.

5 Must Know Facts For Your Next Test

1. Opportunity cost is a fundamental concept in economics and finance, essential for decision-making.
2. In financial planning, opportunity costs must be considered when allocating resources to different projects or investments.
3. The concept is closely related to the time value of money (TVM), as it involves comparing potential returns over time.
4. When businesses extend trade credit, they incur an opportunity cost by not investing that capital elsewhere.
5. Understanding opportunity costs helps in evaluating the true cost of working capital and trade credit decisions.

Review Questions

• What is opportunity cost and why is it important in financial decision-making?
• How does opportunity cost relate to the time value of money?
• Why should businesses consider opportunity costs when extending trade credit?

Related terms

Time Value of Money (TVM): The principle that a sum of money has greater value now than an identical sum in the future due to its potential earning capacity.

Trade Credit: A type of commercial financing in which a supplier allows a buyer to purchase goods or services on account, deferring payment until later.

Working Capital: The difference between a company's current assets and current liabilities, used for day-to-day operations.