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
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.
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.
Is the discount rate the same as 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 discount rate and cap rate? ›
A discount rate is used to convert a series or stream of future income to an indicated present value, while a capitalization rate is used to convert only a single-period expected level of income to an indicated present value.
What is the difference between cost of capital and rate of return? ›
RoR: This is typically from the investor's perspective, focusing on the return they can expect from their investment. Cost of Capital: This is from the company's perspective, representing the cost of raising funds to finance its operations and investments.
Should discount rate be higher than 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 a good discount rate? ›
An equity discount rate range of 12% to 20%, give or take, is likely to be considered reasonable in a business valuation. This is about in line with the long-term anticipated returns quoted to private equity investors, which makes sense, because a business valuation is an equity interest in a privately held company.
What does 10% discount rate mean? ›
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.
Why not use WACC as discount rate? ›
Using WACC As A Discount Rate Might Be Dangerous
First, the assumption behind using the WACC is that you should demand the same rate of return for investing in the company that other investors would. That's sort of like saying you should set your standards based on what other investors were willing to accept.
What is the difference between WACC and cost of capital? ›
The cost of capital is computed through the weighted average cost of capital (WACC) formula. The cost of capital includes both the cost of equity and the cost of debt.
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.
What is the Fed discount rate today? ›
Basic Info. US Discount Rate is at 5.50%, compared to 5.50% the previous market day and 5.25% last year.
How to calculate discount rate? ›
How to Calculate Discount Rate
- First, the value of a future cash flow (FV) is divided by the present value (PV)
- Next, the resulting amount from the prior step is raised to the reciprocal of the number of years (n)
- Finally, one is subtracted from the value to calculate the 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.
Should ROI be higher than cost of capital? ›
In all cases the ROI must be greater than the cost of capital to calculate a positive NPV. Comparing ROI to the cost of capital is a direct way to assess this situation, rather than trying to interpret the NPV result.
Is cost of capital the same as ROI? ›
The cost of capital refers to the expected returns on the securities issued by a company. The required rate of return is the return premium required on investments to justify the risk taken by the investor.
What is the formula for calculating the discount rate? ›
The formula to calculate the discount rate is: Discount % = (Discount/List Price) × 100. For example, if the list price of an item is $80, and a $10 discount is offered on the item, then the discount percent will be (10/80) × 100, which is equal to 12.5%.
Does CAPM calculate discount rate? ›
The discount rate in CAPM is calculated by adding a risk premium to the risk-free rate. Therefore, any changes in the risk-free rate will directly impact the discount rate. For example, if the risk-free rate increases, the discount rate will also increase, making the investment less attractive.
What is the formula for the rate of discount? ›
There are a few other ways to calculate the discount percentage when the percentage is given: Rate of Discount = Discount% = (Discount/Listed Price) ×100. Listed Price = (Selling Price × 100)/ (100−discount %) Discount = Listed Price × Discount Rate.
What is the cost price formula for discount? ›
This is basically labelled by shopkeepers to offer a discount to the customers in such a way that, Discount = Marked Price – Selling Price. And Discount Percentage = (Discount/Marked price) x 100.
