Question

Discuss the term Opportunity Cost and its role in the reasons that a firm must retain cash.

Answer 1

Opportunity cost is the benefit that is lost when a resource is put to use for a particular purpose. The benefit lost is the benefit that would have been derived if, the resouce had been put to use for the next best alternative.  

While retaining cash, the opportunity cost is the income or interest that is lost if it had been invested in the assets in which surplus cash is usually parked.

Ordinarily short term surplus would be parked in marketable securities. Hence, when deciding the optimal cash balance the interest lost by not investing in marketable securities, is the opportunity cost for holding cash.