Suppose I want a car that costs $20,000. If I've borrowed the money at 5% interest per year, compounded annually, and I pay it back over 5 years, the amount I will have spent on the car is $25526 total.
My next best alternative is to save up for 5 years until I have enough money to buy the car outright. Let's say that inflation is approximately 2%. The $20,000 car I could have bought now will cost $22,081 in 5 years. So the opportunity cost of buying the car right away is about $25526 - 22081 = 3445. However, the opportunity cost of not buying the car is having the use of it for 5 years, plus whatever transportation expenses I incur.
A business scenario is: I am considering investing in a retail store that will require a $20,000 up-front investment. I want to keep the investment for about 5 years. Looking at statistics on stores like it, I think there is a 10% chance my investment will triple, a 20% chance my investment will double, a 30% chance I'll break even, and a 40% chance I'll lose the entire amount after 5 years.
In order to determine whether I should make the investment, I must calculate the expected return on investment.
The expected value is exactly the same as my investment. However, that doesn't mean I should make the investment. The other option is for me to put the money into a mutual fund which historically has returned 5% per year. After 5 years, I'd expect to have $25526. Therefore, investing in the mutual fund has a higher expected value over time.
Nov 11th, 2014
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