Difference Between Cost of Capital and Discount Rate (With Table)

Running a business, whether small or big, might look easy to run and maintain; only the people associated with it and working day in and out know how much time and patience it takes. Keeping everything such as accounting, sales, purchases, discounts, handling customers and employees in balance is important to have a smooth flow in business and work.

Keeping track of everything and being up to date is vital to run a business. You can’t just keep hoping for profits without prior and proper planning. Calculating stats, revenue, cost of capital, discount rates, etc., is a part of a business. The owners’ shareholders, investors, are all involved in it. These systems help us keep track of the investment opportunities and helps maximize profits.

Cost of Capital vs Discount Rate

The difference between the cost of capital and discount rate is that cost of capital is the required return needed to make any new project successful, whereas the discount rate is the interest rate used to calculate the present value of cash flows that may be acquired by a project in future.

The cost of capital is an important factor to make an investment or a project worthwhile. It is the required return to make it possible. If the return is not more or equal to the required amount, then you won’t be able to justify the cost of your project. This depends on the type of funding used to pay for the project. It is called cost of equity if the finance is internal, and it is called cost of debt if it is financed externally.

Discount rate uses the discounted cash flow analysis (DFC) to determine the present value of cash flow that will be gained or acquired in the future. The discount rate is the interest rate. This helps to determine if the cash flow in the future will be a profit (more than capital outlay) or no. There is no use to start a new project or invest in it if the costs are higher than the expected revenue.

Comparison Table Between Cost of Capital and Discount Rate

 Parameters of Comparison  Cost of Capital Discount Rate
 Definition The required return a company accepts to justify the investment of a project. The estimated value of the present cash flow that we can gain in the future.
 Calculation It can be calculated by three methods, only cost of debt or equity or by combining both in WACC. Calculated by two methods WACC and APV (adjusted present value).
 Importance  Maximize potential investments, helps the investors make the right decisions, etc. Time value of money, calculate the NVP, determine the risks, etc.
 Types Explicit cost of capital, implicit, specific, weighted average, etc. The risk-free rate, WACC, etc
 Relation It cannot totally be a discount rate. The discount rate can be used as the cost of capital in WACC when the company is assessing a potential project.

What is Cost of Capital?

The cost of capital is a very important factor in making a project successful and worthwhile. It is the required return to justify the costs of the project and gain profits. When the investment done is internal, it is known as the cost of equity, and when it is external, it is called as cost of debt.

So when the investors calculate the cost of capital, they mean the average of both the costs, internal and external. The costs should be forward-looking and show risks and returns in the future. The weighted average cost of capital (WACC) is the blend of both costs of equity and cost of debt.

Formula of cost of debt = total debt/ interest expenses X (1- T).

Formula of cost of equity = Es = Rf + Beta ( Rm – Rf)

Formula of WACC = (E/V + Re) + ((D/V) X Rd) X 1-Tc

There is a lot of competition in the market, and hence to get maximum returns can be a task. The rate of return earned by the investment decides the value of the firm compared to the others in the market. The investors have to give in their hundred per cent to get the required return which has to be more than the cost of capital.

The cost of capital is an important economic and accounting tool. There are several reasons for it to be important. It can help to maximize potential investments, helps the investors take the right decisions, helps to assist capital budgeting, designing the right capital structure, and also evaluate performance for future use. Market opportunity, risks, inflation, capital providers are a few factors that affect the cost of capital.

What is Discount Rate?

The discount rate is calculated to see whether the future cash flow will be profitable or no. it is the interest rate that gives the estimate of the present value of the cash flow that will be gained later (future). They use the discounted cash flow analysis (DFC). It is the number that needs to meet or be more than the cost of capital.

The DFC analysis is a method that is used to figure out the value of the present investment, based on the estimate of how much value it will generate in the future. It tests whether a project is financially worth it or no. If the net value of the present cash flow is positive, only then a project can be considered worthwhile.

If the company is investing in standard assets, a risk-free rate of return is used as a discount rate, and if the company is assessing the potential project, they can use the WACC as the discounted rate. To calculate the discounted cash flow of the company, first, it has to predict the expected cash flow, then choose an appropriate discount rate, and lastly deduct the predicted flow from the present-day cash.

The discount rate is used to calculate the time value of money, calculate the NVP, determine the risks of the investments and the opportunity cost, comparison of the future worth of the investments, etc.

Main Differences Between Cost of Capital and Discount Rate

  1. Cost of capital is the required return a company accepts to justify the investment of a project, whereas the discount rate is the estimated value of the present cash flow that we can gain in the future.
  2. Cost of capital can be calculated by three methods, only cost of debt or equity or by combining both in the WACC method, whereas the discount rate is calculated by two methods WACC and APV (adjusted present value).
  3. The cost of capital cannot be a discount rate, whereas the discount rate can be used as the cost of capital in WACC when the company is assessing a potential project.
  4. Explicit cost of capital, implicit, specific, weighted average, etc., is the types of cost of capital, whereas risk-free rate, WACC, etc., are a few types of the discount rate.
  5. Cost of capital is used to maximize potential investments, help the investors take the right decisions, etc., whereas the discount rate is used to the time value of money, calculate the NVP, determine the risks, etc.

Conclusion

Understanding the Cost of capital and discount rate can be a little difficult at times as they are two very similar words, but knowing both the terms is important. Many investors suffer losses and then have to stop that project or the business itself. This is primarily because they did not do proper planning and estimate the value right.

Each industry or company will have its own cost of capital; it is up to them on how they manage to gain profits and give it back to the investors and shareholders. They should always have a cost of capital based on their opponents in the dame industry to avoid loss.

References

  1. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.2004.00672.x
  2. https://heinonline.org/hol-cgi-bin/get_pdf.cgi?handle=hein.journals/emlj68&section=12
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