Opportunity Cost
The value of the best alternative foregone when a choice is made.
What is Opportunity Cost?
Opportunity cost is the value of the highest-valued alternative that must be given up when making a decision. It is a foundational concept in economics, recognizing that all resources — money, time, and capital — are finite, so choosing one option means forgoing another. Explicit opportunity costs involve actual cash outflows; implicit opportunity costs represent foregone alternatives without direct cash payment. In corporate finance, the opportunity cost of using equity capital is the return shareholders could earn on alternative investments of similar risk — a key driver of the cost of equity and WACC. In capital budgeting, projects should be evaluated against the opportunity cost of capital, not just whether they generate positive cash flows.
Example
A company has $10 million in cash. Option A: invest in a new factory with expected 8% return. Option B: return the cash to shareholders via dividend, who could earn 10% in the market. If management pursues the factory, the opportunity cost is 10% — the shareholders' foregone market return. If the factory only earns 8%, it is destroying value even though it earns a positive return, because it fails to clear the opportunity cost of capital.
Source: CFA Institute — Economics