Cost of Capital vs. Discount Rate: An Overview
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.
Thecost of capitalrefers to the required return by the equity holders and the debtholders, to make a project or an investment worthwhile. This is specifically attributed to the type of funding used to pay for the investment or project. If it is funded via equity, the required return is called the cost of equity. If it is financed via debt, the interest associated with debt is called the cost of debt.
Thediscount rateis the rate used to determine the present value of future cash flows in adiscounted 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 given the perceived risk of the project. The cost of capital is the required rate to justify the cost and the risk of a new venture, whereas the discount rate is the return needed to meet the cost of capital required for the investment.
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, 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 take into consideration the risk of investing. For this reason, the discount rate is usually always higher than the cost of capital.
What Is Cost of Capital?
The cost of capital is a company’s required return. It helps establish a benchmark return that the company must achieve to satisfy its debt and equity investors.
What Is Discount Rate?
The discount rate is the interest rate used to calculate the present value of future cash flows from a project or investment. It makes it possible to estimate how much the project’s future cash flows would be worth in the present.
How Can Cost of Capital Be Calculated?
To calculate cost of capital, three factors must be considered: cost of debt, cost of equity, and weighted average cost of capital (WACC). The formula is cost of debt + cost of equity = cost of capital.
How Can Discount Rate Be Calculated?
Two primary formulas are used to determine discount rate: the weighted average cost of capital (WACC) and the adjusted present value (APV).
The WACC discount formula isWACC = E/V × Ce × D/V × Cd × (1-T), where:
- E = Value of equity
- D = Value of debt
- Ce = Cost of equity
- Cd = Cost of debt
- V = D + E
- T = Tax rate
The APV discount formula is APV = NPV + PV of the impact of financing, where:
- NPV = Net present value
- PV = Present value
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 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.
What is the difference between discount rate and capitalization rate? ›
The main difference between the two is that a discount rate is applied when the discounted future income method is used for valuation purposes, whereas a capitalization rate is used when the capitalization-of-income method is applied.
What is the difference between opportunity cost of capital and discount rate? ›
Investors determine the cost of capital based on their opportunity cost, or the value of the next best alternative. 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.
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.
Are WACC and discount rate the same thing? ›
WACC is often used as a discount rate because it encapsulates the risk associated with a specific company's operations. The WACC indicates the expected cost of new capital, which aligns with future cash flows—a primary factor that should match with the discount rate in a discounted cash flow (DCF) analysis.
Should discount rate be higher than cost of capital? ›
The Bottom Line
The discount rate usually takes into consideration a risk premium and therefore is usually higher than the cost of capital.
What are the two types of discount rates? ›
There are typically two types of discount rates used in business valuation. The equity discount rate and the weighted average cost of capital (“WACC”).
What is the relationship between cost of capital and discount rate? ›
The cost of capital and discount rate are somewhat similar and the terms are often used interchangeably. The 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.
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 discount rate today? ›
US Discount Rate is at 5.50%, compared to 5.50% the previous market day and 5.25% last year. This is higher than the long term average of 2.15%.
The discount rate is determined by the Fed's board of governors, as opposed to the federal funds rate, which is set by the market between member banks.
Is the discount rate which should be used in capital? ›
The discount rate is the interest rate used to determine the present value of future cash flows in standard discounted cash flow analysis. Many companies calculate their weighted average cost of capital and use it as their discount rate when budgeting for a new project.
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.
Why do we use a discount rate? ›
A discount rate is used to calculate the Net Present Value (NPV) of a business as part of a Discounted Cash Flow (DCF) analysis. It is also utilized to: Account for the time value of money. Account for the riskiness of an investment.
Why is the discount rate higher than the cap rate? ›
The discount rate is then used to discount the yearly cash flows and the terminal value of the property, which is determined by applying the cap rate to the next year's cash flow. The discount rate will always be higher than the cap rate, as long as income growth is positive.
What is the meaning of capitalization rate? ›
The capitalization rate is a profitability metric used to determine the return on investment of a real estate property. The formula for the capitalization rate is calculated as net operating income divided by the current market value of the asset.
What is the difference between valuation cap and discount rate safe? ›
The lower the valuation cap, the less advantageous the deal is for founders because investors can convert their notes into more equity in the company. Discount rate. The discount rate of a SAFE outlines the 'discount' that investors will receive on the priced round when it converts.
What is the difference between cap rate and DCF? ›
The critical difference is that in the discounted cash flow model, the business valuer builds growth into the expected cash flows (not the discount rate). Under the capitalisation of income method, the business valuer build growth (providing it is minimal) into the capitalisation rate.
Why is the discount rate a cap on the federal funds rate? ›
The discount rate is the interest rate charged by the Fed for loans it makes through the Fed's discount window. Because banks will not likely borrow at a higher rate than they can borrow from the Fed, the discount rate acts as a ceiling for the federal funds rate.
