Understand opportunity cost

I am going to take a stab at explaining, in terms I understand, the phrase ‘opportunity cost’ since you will hear it from administrators and business managers like it was some mysterious term known only to the elite. Take an example. You win the lottery. You have to decide what to do with $1 million. Let’s say you invest in a fast food restaurant your brother-in-law is starting. He promises you a return of 3 % annually. But, your advisor tells you have the ‘opportunity’ to make 7% annually in the market. Since you have just the $1M, if you invest in the restaurant, you lose the opportunity to make possibly 7%. In most cases, if you do not have an alternative and you want to compare the restaurant investment to something else, you would take for example the Treasury rate as the alternative. The OC is the basis for ‘discounted cash flow analysis.’ DCF analysis is when you assign appropriate values to cash flows that occur at different points in time in the future and then summarize it to a single present value. This allows you to take a promised future return and ‘discount’ it to present dollars or present value. The opposite of discounting is compounding, where you take a present sum and calculate, based on a given interest rate, the future value. The OC (or also known as the discount rate) applicable to investment cash flows is the rate that could be earned on an alternative investment with similar risk. The last phrase is important. You cannot compare investment opportunities fairly unless you factor in the risk. Got it?