3. Opportunity Costs of Resources

Another potentially tricky element are the so-called opportunity costs of the firm's resources, which a specific investment decision uses. To correctly value the project, we need to understand what else we could do with these resources and then factor the associated costs into our calculations.

  

Examples
  • A new product is produced with machines that could otherwise be sold for, say, $1 million. If we decide to proceed with the product, selling the machines is no longer an option. Consequently, the foregone cash inflow of $1 million from the sale has to be factored into the valuation of the project as a cash outflow.
     
  • A firm owns a warehouse, which a new project wants to use as a storage facility. What are the relevant costs that we should charge the project to use the warehouse? It depends...
     
    • If the warehouse is currently empty and has no other use, the incremental costs are zero.
        
    • In contrast, if the warehouse could be rented out to a third party, the foregone rent should be reflected as a cash outflow in the valuation of the project (foregone cash inflow).