Return on Investment vs Cost of Capital: Difference and Comparison

Corporate Finance is the branch which deals with the company, and organization, to help them with the right knowledge of where and how to invest their funds and capital structuring, and mainly helps in taking investment-related decisions.

The branch of Corporate Finance has many critical terminologies which are quite difficult to understand, but it is essential to be known before making any investments.

Key Takeaways

1. Return on Investment (ROI) and Cost of Capital (COC) are financial metrics used to evaluate investment opportunities and the cost of capital for a business.
2. ROI is the percentage of profit generated from an investment compared to the initial investment, while COC is the minimum return investors require to fund a project.
3. A high ROI and a low COC indicate a profitable investment, while a low ROI and a high COC suggest a risky or unprofitable investment.

Return on Investment vs Cost of Capital

The difference between Return on Investment and Cost of Capital is that Return on Investment is the relative measure of the return after the investment to the actual cost of the investment. At the same time, the Cost of Capital is the return a company must need while moving on with a new project, construction, etc.

Return on Investment (ROI) measures the profit the company or organization gains after investing in a new project or construction. It is simple to calculate and is measured as a percentage. It can also be used to compare two or more investments.

Cost of Capital (COC) is the amount of money a company or an organization is needed after investing in a project or construction to be done in the future. Also, it is said that a company should make a profit or generate a return larger than the expected cost of capital of the project. Otherwise, the project would not yield the return to be generated to the investors.

Comparison Table

Parameters of Comparison	Return on Investment	Cost of Capital
Definition	It is the relative measure of the return an individual will get to the actual cost of the investment.	It can be defined as the return a company requires while moving on with a new project.
Formula	Net Profit/Investment Cost × 100	Cost of Debt + Cost of Equity
Types	Interest, Dividends, Capital Gains.	Cost of Equity Capital, Cost of Debt Capital, Cost of Preference Share, Cost of Retained Earnings.
Also Known As	Required Rate of Return	Weighted Average Cost of Capital
Components	Dividend Yield, Earnings Growth, and change in valuation level, i.e. (P/E) ratio.	Debt, Preferred, Common Equity.

What is Return on Investment?

Return on Investment (ROI) can be defined as the relative measure of the amount of money of return an individual expects to get to the actual amount of the investment.

Return on Investment (ROI) is also known as the “Required Rate of Return”. It is based on its three major components, which are as follows – Dividend Yield, Earnings Growth, and P/E ratio.

Return on Investment (ROI) is of three known types: Interest, Earnings Growth, and changes in the P/E ratio.

The formula for calculating Return on Investment (ROI) is as follows –

Return on Investment = Net Profit / Investment Cost × 100

The result of the expression is expressed in percentage. Because of this, it can be compared to two or more investments at a time.

What is the Cost of Capital?

Cost of Capital (COC) can be defined as the amount of return an individual or an investor will get when investing in new projects or any construction or can be stated as the minimum return, which is said to be expected by the investors from a new running project.

Also referred to as “Weighted Average Cost of Capital”. 

The Cost of Capital is based on its three components Debt, Preferred, and Common Equity.

It can also be distinguished into four types – Cost of Capital Equity, Cost of Debt Equity, Cost of Preference Share, and Cost of Retained Earnings.

The cost of Capital (COC) can be calculated by the simple formula given below – 

Cost of Capital (COC) = Cost of Equity + Cost of Debt

Main Differences Between Return on Investment and Cost of Capital

1. Return on Investment (ROI) can be defined as the relative measure of the sum of money that is to be gained by the investor to the actual cost of the investment. It is expressed in percentage. On the other hand, Cost of Capital (COC) can be defined as the return required by the company after investing in a certain project.
2. Return on Investment (ROI) is also known as the “required rate of return”, while the other name for Cost of Capital (COC) is “weighted average cost of capital”. This word is sometimes used interchangeably.
3. Return on Investment (ROI) is of three types, i.e. Interest, Dividends, Capital Gains, while Cost of Capital (COC) is of four types, i.e. Cost of Equity Capital, Cost of Debt Capital, Cost of Preference Share, and Cost of Retained Earnings.
4. Return on investment has three major components, i.e. Dividend Yield, Earnings Growth, and the change in the valuation (P/E) ratio. In comparison, Cost of Capital (COC) also has three components: Debt, Preferred, and Common Equity.
5. Return on Investment (ROI) is the expected return getting by an individual, while Cost of Capital (COC) is the return the company requires to invest in a project.     

References

1. https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.2004.00672.x
2. https://books.google.co.in/books?hl=en&lr=&id=WROeaDUXOpkC&oi=fnd&pg=PA1&dq=difference+between+return+on+investment+and+cost+of+capital&ots=YjS4K-qfXb&sig=MNuSvTXZhcfYKn5yyda6bNZkBCU&redir_esc=y#v=onepage&q=difference%20between%20return%20on%20investment%20and%20cost%20of%20capital&f=false

Last Updated : 11 June, 2023