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 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.
Can I use cost of capital instead of 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.
Is discount rate and opportunity cost of capital the same? ›
Hurdle rate, the opportunity cost of capital, and discounting rate are all same. It is that rate of return that can be earned from the next best alternative investment opportunity with a similar risk profile.
Should I use WACC or CAPM for discount rate? ›
Who uses WACC? WACC is used in financial modeling (it serves as the discount rate for calculating the net present value of a business). It's also the hurdle rate that companies use when analyzing new projects or acquisition targets.
Is the company cost of capital the correct discount rate only for investments? ›
The company cost of capital is the right discount rate only for investments that have the same risk as the company's overall business. For riskier projects the opportunity cost of capital is greater than the company cost of capital. For safer projects it is less.
Why not use WACC as discount rate? ›
WACC will not be suitable for assessing risky projects since the Discount rate (i.e., cost of capital) will also be very high to reflect the high risk.
What is the difference between WACC and discount rate? ›
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.
Which rate is also known as cost of capital? ›
Cost of capital is the minimum rate of return or profit a company must earn before generating value. It's calculated by a business's accounting department to determine financial risk and whether an investment is justified.
How do you calculate cost of capital? ›
Calculation of Cost of Capital (Step by Step)
The weight of the debt component is computed by dividing the outstanding debt by the total capital invested in the business, i.e., the sum of outstanding debt, preferred stock, and common equity.
Why should you use the opportunity cost of capital as the discount rate? ›
Why is this “opportunity cost of capital” always the right rate at which to discount cash flow? If you discount at a rate r < opportunity cost of capital then intuitively you would be willing to spend more to create the cash flow than you could just buy the same cash flow for in the market.
The main advantage of using the WACC is that it takes into account the different risks associated with equity and debt financing. The disadvantage of using the WACC is that it is a long-term average and may not be representative of the company's current cost of capital.
Should I use WACC for DCF? ›
If the DCF is higher than the current cost of the investment, the opportunity could result in positive returns and may be worthwhile. Companies typically use the weighted average cost of capital (WACC) for the discount rate because it accounts for the rate of return expected by shareholders.
Should discount rate be higher than cost of capital? ›
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.
Why is cost of capital taken as minimum acceptable? ›
Cost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to fund its operations.
Should I use WACC or cost of equity? ›
The cost of equity is a less relevant measure for companies in the current economic environment. The weighted average cost of capital is a more important measure for companies that are looking to raise capital. This is because it is a more accurate measure of a company's true cost of capital.
Why is WACC misleading? ›
The WACC is neither a cost nor a required return: it is a weighted average of a cost and a required return. To refer to the WACC as the “cost of capital” can be misleading because it is not a cost.
What is the WACC fallacy? ›
Such behavior is referred to as the WACC (weighted average cost of capital) fallacy. In the case of mergers and acquisitions, the stock price reaction of the acquiring firm tends to be lower when the target entity has a higher beta than the acquirer.
What mistakes are commonly made when estimating the WACC? ›
The seven errors mentioned in the article include the following:
- using the wrong tax rate.
- using the book value of debt and equity instead of the correct valuation.
- assuming a capital structure that is neither the current nor forecasted structure.
- failure to satisfy the “time consistency formulae” (see the paper)
When using the WACC as the discount rate, an entity may accept some negative net present value projects and reject some positive net present value projects. This is due to the WACC being different from the rate which is used for NPV calculations.
What are the two types of cost of capital? ›
The cost of capital of a firm can be analyzed as explicit cost and implicit cost of capital. The explicit cost of capital of a particular source may be defined in terms of the interest or dividend that the firm has to pay to the suppliers of funds.
The cost of capital can thus be thought of as the “hurdle” rate of return required on new investment projects. That is, the minimum rate of return a new project must yield to be undertaken profitably.
What is cost of capital in NPV? ›
The cost of capital represents the minimum desired rate of return (i.e., a weighted average cost of debt and equity capital). The net present value (NPV) is the difference between the present value of the expected cash inflows and the present value of the expected cash outflows.
What is the formula for the discount rate? ›
The formula to calculate the discount rate is: Discount % = (Discount/List Price) × 100.
Is the cost of capital 8 percent? ›
The weighted average cost of capital is simply 8%, the same as the cost of equity. This would normally be the most conservative, safe and flexible capital structure. The safety and flexibility enjoyed are being paid for by a relatively high WACC.
What is WACC for cost of capital? ›
The weighted average cost of capital (WACC) is the average rate that a business pays to finance its assets. It is calculated by averaging the rate of all of the company's sources of capital (both debt and equity), weighted by the proportion of each component.
What is an example of discount rate? ›
For example, $100 invested today in a savings scheme that offers 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 are the benefits of discount rate? ›
The discount rate is used to express future monetary value in today's terms. Using a higher discount rate reduces the value of the future stream of net benefits or costs compared with a lower rate. Therefore, a higher discount rate implies that we value benefits less the further they are in the future.
What are the advantages of the discount rate? ›
Advantages of discount rate include measuring the potential value of an investment, assessing the time value of money, comparison of different investments, investment yield, opportunity cost, and determining risks.
Is WACC the discount rate in NPV? ›
What is WACC used for? The Weighted Average Cost of Capital serves as the discount rate for calculating the Net Present Value (NPV) of a business. It is also used to evaluate investment opportunities, as it is considered to represent the firm's opportunity cost. Thus, it is used as a hurdle rate by companies.
Is WACC the most appropriate discount rate to use when applying a valuation model? ›
Answer and Explanation: The most appropriate discounting rate when applying the FCFF model would be the weighted average cost of capital (WACC) because it reflects the cost of capital of the firm on an average.
Securities analysts employ WACC when valuing and selecting investments. For instance, in discounted cash flow analysis, WACC is used as the discount rate applied to future cash flows for deriving a business's net present value. WACC can be used as a hurdle rate against which to assess ROIC performance.
How do I know if my WACC is reasonable? ›
As a rule of thumb, a good WACC is one that is in line with the sector average. When investors and lenders require a higher rate of return to finance a company it may indicate that they consider it riskier than the sector.
What discount rate should I use for DCF? ›
The right number to use is the marginal tax rate since you're trying to make a marginal decision, and that's typically 35% in the US. Ve = value of equity. Company market cap less cash plus debt. For a private company, best estimate – probably based on last round price.
What happens if the discount rate is too high? ›
If you are using a discount rate that is too high, you may be underestimating the value of future cash flows. This could lead you to make suboptimal investment decisions. Alternatively, if you are using a discount rate that is too low, you may be overestimating the value of future cash flows.
Why cost of capital is a risk? ›
The term “cost of capital” refers to the expected rate of return that the market requires to attract funds to a particular investment. The cost of capital is based on the perceived risk of the investment. Risky companies (or investments) warrant a higher discount rate and, therefore, a lower value (and vice versa).
Does cost of capital equal required rate of return? ›
Cost of Capital. Although the required rate of return is used in capital budgeting projects, RRR is not the same level of return that's needed to cover the cost of capital. The cost of capital is the minimum return needed to cover the cost of debt and equity issuance to raise funds for the project.
What is the minimum acceptable rate of return? ›
What is a minimum acceptable rate of return (MARR)? A minimum acceptable rate of return (MARR) is the minimum profit an investor expects to make from an investment, taking into account the risks of the investment and the opportunity cost of undertaking it instead of other investments.
What discount rate to use for NPV? ›
The 10% discount rate is the appropriate (and stable) rate to discount the expected cash flows from each project being considered. Each project is assumed equally speculative. The shareholders cannot get above a 10% return on their money if they were to directly assume an equivalent level of risk.
Is WACC better too high or too low? ›
Higher WACC ratios generally indicate that a business is a riskier investment, while a lower WACC tends to correlate with more stable business investments. With a good WACC, an investor can feel secure in their investment and satisfied with the rate at which they'll see a return.
Why cost of equity is higher than cost of capital? ›
This is because equity investors are rewarded more generously than debtholders, and take higher levels of risks. In addition, debt provides a guaranteed level of payments, and debtholders are given priority in the event of bankruptcy.
Because the cost of debt is usually lower than that of equity, a business's WACC will usually work out lower than just the cost of equity. Therefore, it is considered a discounted rate. It is used to calculate that business's net present value and by investors to determine the hurdle rate of a potential investment.
Is The cost of capital the same as the rate of return? ›
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.
Why is it important to calculate the cost of capital? ›
Companies use this method to determine rate of return, which indicates the return that shareholders demand to provide capital. It also helps investors gauge the risk of cash flows and desirability for company shares, projects, and potential acquisitions.
Why would a company choose to use weighted average costing? ›
One of the main reasons companies choose weighted average costing over other costing methods is because it radically simplifies cost calculations and record keeping.
Should ROI be higher than cost of capital? ›
If the ROIC is greater than the WACC, then value is being created as the firm invests in profitable projects. Conversely, if the ROIC is lower than the WACC, then value is being destroyed as the firm earns a return on its projects that is lower than the cost of funding the projects.
Is cost of capital and WACC the same? ›
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital.
Is cost of capital included in ROI? ›
What is Return on Investment (ROI)? Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will receive in relation to their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment.
