Suppose a friend offers to borrow 110 in one year. What should you do?
- Your decision depends on what the opportunity cost is of lending your money to your friend.
- Looking in the market for other options for investing the $100, you find your best alternative option that you view as equally risky as lending it to your friend. That option has an expected return of 8%.
- If you lend her the 110 in one year.
The best available expected return offered in the market on an investment of comparable risk and term to the cash flows being discounted. Also referred to as the cost of capital. The return that an investor (or firm) gives up when she (the firm) takes on the new investment.