Get Active in Our Amazing Community of Over 448,000 Peers!

Schedule mock interviews on the Meeting Board, join the latest community discussions in our Consulting Q&A and find like-minded Case Partners to connect and practice with!

Return on investment

Opportunity cost
New answer on Aug 16, 2019
3 Answers
1.3 k Views
Anonymous A asked on Aug 15, 2019

Hi,

For a real estate case, purchase with mortgage, basic P=R-C structure;

Revenues: Rent revenue & increase in the estate value

Costs: Downpayment & cost of the invested capital.

Here, don't we need to calculate the opportunity cost too in the cost bucket? Since if you didn't invest this money but instead land it to a bank you'd have received an interest which you can't get when you buy the house. So should the opportunity cost be added to the costs?

Overview of answers

Upvotes
  • Upvotes
  • Date ascending
  • Date descending
Best answer
Prateek replied on Aug 16, 2019

Opportunity cost is an Economic Cost (used in an economic perspective to arrive at decisions)
Economic costs differ from Accounting Costs (which are reported on PnL and Balance Sheet statements)

Thus, for a real estate project, you calculate the accounting costs and accounting revenues and calculate NPV(or IRR) for the project. The risk and time value of the project is captured in the discount rates and the income from the the project is converted to cash flow for the project.

Thereafter, you look at alternate projects (where you could have allocated your capital) and calculate their NPVs and IRRs. Its best to choose projects with the highest NPV unless there some very strategic considerations or constraints (issues not captured by your numerical analysis) that preventing you from doing so.

Was this answer helpful?
2
Ivan updated an answer on Aug 16, 2019

It would say it depends on your problem statement:

Scenario 1: given your financial position and mortgage agreement, is buying a house a financially viable solution? --> calculate ROI. Positive ROI is good, negative ROI is bad. Forget about opportunity cost.

Scenario 2: you consider whether to buy or rent a house and have 200k in your bank account at 3% p.a. you will need additional 300k to buy a house or you can rent it for 1.5k a month. --> calculate financials for both alternatives and compare ROI. Here: when buying a house you need to clear your bank account and basically lose 6k p.a. (=3%)which constitutes your opportunity cost from buying a house.

(edited)

Was this answer helpful?
2
Sidi
Expert
replied on Aug 16, 2019
McKinsey Senior EM & BCG Consultant | Interviewer at McK & BCG for 7 years | Coached 350+ candidates secure MBB offers

Yes, you can also subtract the opportunity cost and check whether you are still positive. But a more natural way would be to take the above profit and the resulting RoI, and then compare it to the RoI of the best alternative (e.g., lending the money to the bank).

Cheers, Sidi

Was this answer helpful?
How likely are you to recommend us to a friend or fellow student?
0
1
2
3
4
5
6
7
8
9
10
0 = Not likely
10 = Very likely