The cost of capital and the discount rate are two very similar terms and can often be confused with one another. They have important distinctions that make them both necessary in deciding on whether a new investment or project will be profitable.
Cost of Capital vs. Discount Rate: An Overview
The cost of capital refers to the required return necessary to make a project or investment worthwhile. This is specifically attributed to the type of funding used to pay for the investment or project. If it is financed internally, it refers to the cost of equity. If it is financed externally, it is used to refer to the cost of debt.
The discount rate is the interest rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis. This helps determine if the future cash flows from a project or investment will be worth more than the capital outlay needed to fund the project or investment in the present. The cost of capital is the minimum rate needed to justify the cost of a new venture, where the discount rate is the number that needs to meet or exceed the cost of capital.
Many companies calculate their weighted average cost of capital(WACC) and use it as their discount rate when budgeting for a new project.
Key Takeaways
- The cost of capital refers to the required return needed on a project or investment to make it worthwhile.
- The discount rate is the interest rate used to calculate the present value of future cash flows from a project or investment.
- Many companies calculate their WACC and use it as their discount rate when budgeting for a new project.
Cost of Capital
The cost of capital is the company's required return. The company's lenders and owners don't extend financing for free; they want to be paid for delaying their own consumption and assuming investment risk. The cost of capital helps establish a benchmark return that the company must achieve to satisfy its debt and equity investors.
The most widely used method of calculating capital costs is the relative weight of all capital investment sources and then adjusting the required return accordingly.
If a firm were financed entirely by bonds or other loans, its cost of capital would be equal to its cost of debt. Conversely, if the firm were financed entirely through common or preferred stock issues, then the cost of capital would be equal to its cost of equity. Since most firms combine debt and equity financing, the WACC helps turn the cost of debt and cost of equity into one meaningful figure.
Discount Rate
It only makes sense for a company to proceed with a new project if its expected revenues are larger than its expected costs—in other words, it needs to be profitable. The discount rate makes it possible to estimate how much the project's future cash flows would be worth in the present.
An appropriate discount rate can only be determined after the firm has approximated the project's free cash flow. Once the firm has arrived at a free cash flow figure, this can be discounted to determine the net present value (NPV).
Setting the discount rate isn't always straightforward. Even though many companies use WACC as a proxy for the discount rate, other methods are used as well. In situations where the new project is considerably more or less risky than the company's normal operation, it may be best to add in a risk premium in case the cost of capital is undervalued or the project does not generate as much cash flow as expected.
Adding a risk premium to the cost of capital and using the sum as the discount rate takes into consideration the risk of investing. For this reason, the discount rate is usually always higher than the cost of capital.
The Bottom Line
The cost of capital and the discount rate work hand in hand to determine whether a prospective investment or project will be profitable. The cost of capital refers to the minimum rate of return needed from an investment to make it worthwhile, whereas the discount rate is the rate used to discount the future cash flows from an investment to the present value to determine if an investment will be profitable. The discount rate usually takes into consideration a risk premium and therefore is usually higher than the cost of capital.
FAQs
The cost of capital is a measure of both expected return, which takes us from the present to the future, and the discount rate, which takes us from the future to the present. Expected returns come with varying degrees of certainty, but in all cases a single number reflects a distribution of potential outcomes.
What is the difference between cost of capital and discount rate? ›
The cost of capital refers to the minimum rate of return needed from an investment to make it worthwhile, whereas the discount rate is the rate used to discount the future cash flows from an investment to the present value to determine if an investment will be profitable.
What is the difference between the discount rate and the WACC? ›
The discount rate is an investor's desired rate of return, generally considered to be the investor's opportunity cost of capital. The Weighted Average Cost of Capital (WACC) represents the average cost of financing a company debt and equity, weighted to its respective use.
What is the difference between interest rate and cost of capital? ›
interest rate is the rate at which the borrowing is availed by the company i.e the interest rate of the debt taken whereas co's cost of capital is the weighted average rate of interest rate , cost of equity, cost of preference shares, etc. In other words co's cost of capital includes interest rate.
How to convert cost of capital to discount rate? ›
How to calculate discount rate. There are two primary discount rate formulas - the weighted average cost of capital (WACC) and adjusted present value (APV). The WACC discount formula is: WACC = E/V x Ce + D/V x Cd x (1-T), and the APV discount formula is: APV = NPV + PV of the impact of financing.
Does discount rate equal cost of capital? ›
In many businesses, the cost of capital is lower than the discount rate or the required rate of return. For example, a company's cost of capital may be 10% but the finance department will pad that some and use 10.5% or 11% as the discount rate.
What is an example of a discount rate? ›
For example, $100 invested today in a savings scheme with a 10% interest rate will grow to $110. In other words, $110, which is the future value (FV), when discounted by the rate of 10%, is worth $100 (present value) as of today.
What is the difference between WACC and cost of capital? ›
The cost of capital is the total cost of debt and equity that a company incurs to run its operations. This method doesn't consider the relative proportion of each source of financing. WACC, on the other hand, goes a step further by considering the proportion of each financing source used by the company.
How to define discount rate? ›
In corporate finance, a discount rate is the rate of return used to discount future cash flows back to their present value. This rate is often a company's Weighted Average Cost of Capital (WACC), required rate of return, or the hurdle rate that investors expect to earn relative to the risk of the investment.
Why is cost of capital the same as discount rate? ›
The cost of capital and discount rate are somewhat similar and the terms are often used interchangeably. Cost of capital is often calculated by a company's finance department and used by management to set a discount rate (or hurdle rate) that must be beaten to justify an investment.
The cost of capital is a measure of both expected return, which takes us from the present to the future, and the discount rate, which takes us from the future to the present. Expected returns come with varying degrees of certainty, but in all cases a single number reflects a distribution of potential outcomes.
What is the formula for the cost of capital? ›
One common method is adding your company's total interest expense for each debt for the year, then dividing it by the total amount of debt.
What does a high discount rate mean? ›
A high discount rate mean that it is more costly for banks and other financial institutions to borrow money from the Federal Reserve. When discount rates are high, banks may lend less to consumers. As a monetary tool, the Federal Reserve may raise discount rates to encourage people to borrow less and save more.
What happens when the discount rate increases? ›
An increase in the discount rate makes it less profitable for banks to borrow from the Federal Reserve. As banks reduce their borrowing, the total reserves of the banking system are reduced and the quantity of money supplied by the banking system declines.
What is the difference between WACC and CAPM discount rate? ›
In other words, WACC is the average rate a company expects to pay to finance its assets.” “CAPM is a tried-and-true methodology for estimating the cost of shareholder equity. The model quantifies the relationship between systematic risk and expected return for assets.”
What is the difference between cost of capital and CAPM? ›
How Are CAPM and WACC Related? WACC is the total cost of all capital. CAPM is used to determine the estimated cost of shareholder equity. The cost of equity calculated from the CAPM can be added to the cost of debt to calculate the WACC.
