Are cost of capital and discount rate the same thing?
Cost of capital and discount rate are two different concepts in a business. This article will profoundly illustrate the difference between the two concepts.
Cost of Capital
The cost of capital is the total worthwhile of a project. It refers to the total actual amount of cash both in debt and equity capital that can be used to finance the intended project cost. The lenders and owners to the company do not provide their money at a free will but with an intention of getting it back after a while. Therefore the cost of capital represents the company’s total return on a particular project.
Company’s use the cost of capital to determine whether the intended capital project will give a worth return to the company owners investment. Similarly, the investors use the cost of capital to decide whether or not they will invest in the project or not invest. Cost of capital hence helps the investor to determine whether the project is risky or worth investing. Cost of capital help in the reduction of investment risk to the investors.
The cost of capital always depends on the form of financing the company uses on its project. When the business uses only equity as their means of funding of then, the cost of capital to their project is the total cost of the equity. Likewise, if the owner’s money financed the business, the cost of capital would be as well being the total amount of the equity capital. A choice made concerning the means of financing makes the cost of capital very crucial since it dictates the business capital structure. Most businesses tend to minimize the cost of capital to maximize the profit outcome. The only approach used in the calculation the cost of money is the weighted average of cost of capital (WACC).
The Discount Rate
The discount rate is defined as the amount of interest rates used in determining the current value of prospected cash flow in standard discounted cash flow analysis. It is always a concern for a company to proceed with its projects when it is only profitable. The discount rate is, therefore, responsible for indicating the future profitability of a project. It determines how the future cash flow of the project will be of value in the present. The higher the discount rate, the smaller the investment requirement. The discount rate of a business is therefore used to determine both future and present profitability.
After a firm has determined the cash flow, the discount rate can then be easily identified. The approximated cash flow figures when discounted, the projects future cash flow value can be determined too. Coming up with a project discount rate usually is not a straightforward calculation. Some particular companies use the weighted average to determine the discount rates. Other approaches, such as the capital asset pricing model are used. It is efficient to use capital asset pricing to determine the discount rate only when the project is considered to be less risky. The discounted rate for a project is always calculated in percentage.