Opportunity Cost Sample Question

Which of the following represents the opportunity cost of investments from a potential
shareholder's point of view?

(a) The inverse of the the P/E Ratio.
(b) Return on Total Assets.
(c) Return on Common Equity.
(d) The inverse of the Asset Turnover Ratio.
(e) None of the above.

Correct answer: c

Opportunity cost is the value of the "next best thing forgone," or the runner-up in your list of choices. The opportunity cost is what you don't get, as a result of the decision you made. If your choices are between chocolate cake and cherry pie and you choose the cake, the opportunity cost is not getting to eat the pie.

A potential shareholder's choices are: do nothing, or, become a shareholder. The opportunity cost of investing is not having that money in your pocket now. The opportunity cost of not investing is not getting the potential earnings on that investment, should there be any.

Detailed look:

(a) The inverse of the the P/E Ratio.

No. The P/E (Price per share/ Earnings per share) shows what the market is currently paying for a share of stock (price based on earnings); Inverse P/E indicates what to expect in the future for paying that price today (earnings based on price). As an expectation, this cannot be the value of a thing foregone.

(b) Return on Total Assets.

No. Return on Total Assets (Earnings Before Interest and Taxes/ Average Total Assets) reflects how well the company is using all of its assets, but does not reflect what's left over after it pays interest and taxes. This has no direct impact on a potential investor.

(c) Return on Common Equity.

Yes. This shows the amount of profit made on shareholder dollars, after interest and other expenses have been paid. It is the amount available to divvy up among the common stockholders. By holding on to one's money, remaining a potential shareholder, and not investing, one forgoes this return.

(d) The inverse of the Asset Turnover Ratio.

No. The inverse of how well a firm uses its assets is how well those assets serve the firm. This has no direct impact on a potential investor.

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