Cost of Capital vs. Discount Rate: What’s the Difference?

Cost of Capital vs. Discount Rate: An Overview

The cost of capital and the discount rate are two related terms that are sometimes confused with each other. But they have important distinctions that make them both useful in deciding whether a new investment or project will be profitable enough to be worth pursuing.

The cost of capital refers to the return required by equity holders and debt holders to make a project or an investment worthwhile. If the investment or project is funded by equity, the required return is called the cost of equity.

If it is financed by debt, the interest associated with that debt is called the cost of debt. Because many projects are funded in multiple ways, companies will often calculate a weighted average cost of capital (WACC) in budgeting for a potential new initiative.

The discount rate is the rate used to determine the present value of future cash flows in a discounted cash flow (DCF) analysis, which takes into account the time value of money. This helps assess whether the future cash flows from a project or investment will be worth more than the capital outlay needed to fund it in the present given the perceived risk of the project.

Key Takeaways

• The cost of capital refers to the required return needed on a project or investment to make it worthwhile.
• Because companies may have a variety of funding sources, they often use a weighted average cost of capital (WACC) in their calculations.
• The discount rate is the interest rate used to calculate the present value of future cash flows from a project or investment.

The Cost of Capital

The cost of capital is the company’s required return. The company’s lenders and owners, including shareholders, don’t extend financing for free; they want to be paid for delaying their own consumption and assuming the 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 determines the relative weight of all capital investment sources and then sets the required return accordingly. This is the weighted average cost of capital, or WACC.

If a company was financed entirely by bonds or other loans, its cost of capital would be equal to its cost of debt. Conversely, if the company was financed entirely through common or preferred stock issues, then the cost of capital would be equal to its cost of equity.

Note

Since many companies rely on both debt and equity financing, WACC helps turn their cost of debt and cost of equity into one meaningful figure.

The 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, the project 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 company has approximated the project’s free cash flow. Once it 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 may be used as well.

In situations where the new project is considerably more or less risky than the company’s normal operations, it may be best to factor 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 will take into consideration the risk of investing. For this reason, the discount rate is usually higher than the cost of capital.

Special Considerations

Depending on the specific project or situation, the cost of capital and the discount rate can vary. Projects in stable industries, like utilities, generally have lower costs of capital because their cash flows are predictable, making them less risky for investors.

On the other hand, projects in more volatile industries, such as tech, have higher costs of capital because of uncertain cash flows, which increases the risk for investors.

Additionally, external factors like inflation and rising interest rates can make debt more expensive, making future cash flows less valuable, and impacting these metrics. Businesses must incorporate these into their assessments in order to not underestimate the cost of financing or overstate the value of future returns.

What Is the Cost of Capital?

The cost of capital is a company’s required return on a potential project or investment. It helps establish a benchmark return that the company must achieve to satisfy its debt and equity investors. Many companies use a weighted average cost of capital in their calculations, which takes into account both their cost of equity and cost of debt, each weighted according to their percentage of the whole.

What Is the 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.

What Is the Hurdle Rate?

The hurdle rate is a term for the lowest rate of return that a project or investment must be expected to achieve in order to be acceptable to a company’s managers or investors.

How Can the Discount Rate Be Calculated?

Two primary formulas are used to determine the discount rate: the weighted average cost of capital (WACC) and the adjusted present value (APV).

The WACC discount formula is WACC = 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 assess whether a prospective investment or project will be profitable.

The cost of capital refers to the minimum rate of return needed from a project or investment to make it worthwhile, whereas the discount rate is used to discount the future cash flows from that project or investment back to its present value.

Used together, they can help businesses and investors compare different opportunities and choose the ones that are likely to be most worth pursuing from a financial standpoint.