Running a small or big business 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 track of everything and being updated is vital to running a business. You can’t just keep hoping for profits without prior and proper planning.
Key Takeaways
- The cost of capital represents the expense of financing a company’s operations through equity or debt, while the discount rate determines the present value of future cash flows.
- The cost of capital is used to determine whether an investment will generate sufficient returns, whereas the discount rate is used to determine the value of an investment.
- The cost of capital is a component of the discount rate, risk-free rate and risk premium.
Cost of Capital vs. Discount Rate
The difference between the cost of capital and the discount rate is that cost of money is the required return needed to make any new project successful. In contrast, the discount rate is the interest rate used to calculate the present value of cash flows that a project may acquire.
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The cost of capital is essential in making an investment or a project worthwhile. It is the required return to make it possible.
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.
Comparison Table
| 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 current cash flow that we can gain in the future. |
| Calculation | Three methods can calculate it, only the cost of debt or equity or combining both in WACC. | It was calculated using 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 | The direct cost of capital, implicit, specific, weighted average, etc. | The risk-free rate, WACC, etc |
| Relation | It cannot 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 the Cost of Capital?
The cost of capital is a significant factor in making a project successful and worthwhile. The required return is to justify the project’s costs and gain profits.
So when the investors calculate the cost of capital, they mean the average of internal and external prices. The fees should be forward-looking and show risks and returns in the future.
The 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, so getting maximum returns can be a task. The rate of return earned by the investment decides the firm’s value compared to the others in the market.
There are several reasons for it to be necessary. It can help maximize potential investments, helps the investors make the right decisions, helps to assist capital budgeting, design the proper capital structure, and evaluate performance for future use.
What is Discount Rate?
The discount rate is calculated to determine whether future cash flow will be profitable. The interest rate estimates the present value of the cash flow that will be gained later (future).
The DFC analysis is a method used to determine the value of the present investment based on estimating how much weight it will generate in the future.
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, it can use the WACC as the discounted rate.
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 assets, etc.
Main Differences Between Cost of Capital and Discount Rate
- Direct cost of capital, implicit, specific, weighted average, etc., is the cost of capital, whereas risk-free rate, WACC, etc., are a few discount rate types.
- The cost of capital is used to maximize potential investments, help the investors make the right decisions, etc. In contrast, the discount rate is used to the time value of money, calculate the NVP, determine the risks, etc.
- https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.2004.00672.x
- https://heinonline.org/hol-cgi-bin/get_pdf.cgi?handle=hein.journals/emlj68§ion=12
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Chara Yadav holds MBA in Finance. Her goal is to simplify finance-related topics. She has worked in finance for about 25 years. She has held multiple finance and banking classes for business schools and communities. Read more at her bio page.
