Difference Between Return on Investment and Cost of Capital (With Table)

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

Return on Investment vs Cost of Capital

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

Return on Investment (ROI) is used to measure the profit gain by the company or organization after investing in a new project or construction. It is simple to calculate and is measured in the form of a percentage. It can also be used to make a comparison between 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 Between Return on Investment and Cost of Capital

Parameters of ComparisonReturn on InvestmentCost of Capital
DefinitionIt is the relative measure of the amount of return an individual will get to the actual cost of the investment.It can be defined as the amount of return required by a company while moving on with a new project.
FormulaNet Profit/Investment Cost × 100Cost of Debt + Cost of Equity
TypesInterest, 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 ReturnWeighted 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 types that are known – 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 which it can be compared to two or more investments at a time.

What is Cost of Capital?

Cost of Capital (COC) can be defined as the amount of return an individual or an investor will get who invested it in the 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 in four types – Cost of Capital Equity, Cost of Debt Equity, Cost of Preference Share, and Cost of Retained Earnings. 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 which is 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 also 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 level of valuation (P/E) ratio, while Cost of Capital (COC) also has three components that are – Debt, Preferred, and Common Equity.
  5. Return on Investment (ROI) is the expected return getting by an induvial while Cost of Capital (COC) is the return required by the company to invest in a project.     

Conclusion

The advancement of the corporate finance area has led everyone to know the basic terminologies related to the branch. The knowledge of these terms can only help in selecting and comparing the best future investment possible in the future. Some of the terms related to the branch are – Cost of Capital, Cost of Equity, Require Rate of Return, Debt, Discounted Cash Flow, and many more.

Return on investment depends on the three components that are – Dividend Yield, Earnings Growth, and the change in the level of valuation. It has three major types – Interest, Dividends, Capital Gains.

In contrast, the Cost of Capital (ROI) depends on its three components are Debt, Preferred, and Common Equity. Also, like Return on Investment (ROI), it has four types which are – Cost of Equity Capital, Cost of Debt Capital, Cost of Preference Share, and Cost of Retained Earnings.
Return on Investment (ROI) or Required Rate of Return and Cost of Capital are the two terms related to the interest rates before and after the investment.

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