What is opportunity cost of capital?

The opportunity cost of capital refers to the potential return lost when choosing one investment option over the next best alternative. It represents the benefits an investor could have earned had they chosen a different investment with comparable risk. This concept is fundamental in finance, as it helps investors and firms evaluate whether an investment will generate sufficient returns relative to what they might have earned through alternative investments.

For example, if an investor has a choice between investing in a new project with an expected return of 8% or letting their money sit in a savings account with a guaranteed return of 3%, the opportunity cost of capital for choosing the project is the 3% they would miss out on by not choosing the savings account. Therefore, option B accurately reflects this idea by articulating that opportunity cost is related to the potential returns lost from not pursuing the best investment alternative available.

In contrast, the other choices focus on specific costs associated with capital, such as costs incurred from borrowing or mandatory expenses related to equity, but they do not capture the broader and more fundamental concept of opportunity cost.