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Cost of Capital vs. Discount Rate: What’s the Difference?

The bring in of capital and the discount rate are two very similar terms and can often be confused with one another. They have portentous distinctions that make them both necessary in deciding on whether a new investment or project will be profitable.

Expenditure of Capital vs. Discount Rate: An Overview

The cost of capital refers to the required return necessary to make a project or investment rewarding. 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 disinterestedness. 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 up to date value of future cash flows in a discounted cash flow (DCF) analysis. This helps determine if the future money flows from a project or investment will be worth more than the capital outlay needed to fund the cast 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 assess is the number that needs to meet or exceed the cost of capital.

Many companies calculate their weighted usual 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 instructed return needed on a project or investment to make it worthwhile.
  • The discount rate is the interest rate used to calculate the now value of future cash flows from a project or investment.
  • Many companies calculate their WACC and use it as their mark down 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 reach financing for free; they want to be paid for delaying their own consumption and assuming investment risk. The cost of foremost helps establish a benchmark return that the company must achieve to satisfy its debt and equity investors.

The sundry widely used method of calculating capital costs is the relative weight of all capital investment sources and then adjusting the made return accordingly.

If a firm were financed entirely by bonds or other loans, its cost of capital would be alike to its cost of debt. Conversely, if the firm were financed entirely through common or preferred stock issues, then the cost of top would be equal to its cost of equity. Since most firms combine debt and equity financing, the WACC boosts turn the cost of debt and cost of equity into one meaningful figure.

Discount Rate

It only makes wisdom 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 utilitarian. The discount rate makes it possible to estimate how much the project’s future cash flows would be worth in the close.

An appropriate discount rate can only be determined after the firm has approximated the project’s free cash flow. Decidedly the firm has arrived at a free cash flow figure, this can be discounted to determine the net present value (NPV).

Setting the lessen rate isn’t always straightforward. Even though many companies use WACC as a proxy for the discount rate, other methods are old as well. In situations where the new project is considerably more or less risky than the company’s normal operation, it may be foremost 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 demanded.

Adding a risk premium to the cost of capital and using the sum as the discount rate takes into consideration the risk of put ining. For this reason, the discount rate is usually always higher than the cost of capital.

The Bottom Line

The expenditure of capital and the discount rate work hand in hand to determine whether a prospective investment or project will be money-making. The cost of capital refers to the minimum rate of return needed from an investment to make it worthwhile, whereas the deduction rate is the rate used to discount the future cash flows from an investment to the present value to determine if an investment intention be profitable. The discount rate usually takes into consideration a risk premium and therefore is usually higher than the sell for of capital.

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