Opportunity cost is a choice that you consciously make to pursue one course of action over another. If you spend all your money on a fancy vacation, the opportunity cost is that you can’t buy a car. In business, opportunity cost often means the potential benefit from one choice is gone by not following another course of action.
If you had two projects, one with an estimated return of 20% over 3 years and the other with an estimated return of 13% over 18 months, which one would you choose? More than likely the one with a 20% return, however, what if you needed the capital in 2 years, then you may choose the 13% return.
(Excerpts from Financial Intelligence, Chapter 26 – The Building Blocks of ROI)
There is always some judgment involved in establishing a hurdle rate, but the judgment isn’t wholly arbitrary. One factor is the opportunity cost involved. The company has only so much cash, and it has to make judgments about how best to use its funds. That 2 percent return is unattractive because the company could probably do better just by buying a treasury bill, which might pay 3 percent or 4 percent with almost no risk.