The cost of capital refers to the actual cost of financing business activity through either debt or equity capital. The discount rate is the interest rate used to determine the present value of future cash flows in standard discounted cash flow analysis.
Many companies calculate their weighted average cost of capital (WACC) and use it as their discount rate when budgeting for a new project. This figure is crucial in generating a fair value for the company's equity.
What Is Cost of Capital?
Another way to look at the cost of capital is as the company's required return. The company's lenders and owners don't extend financing for free; they want to be paid for delaying their own consumption and assuming investment risk. The cost of capital helps establish a benchmark return that the company must achieve to satisfy its debt and equity investors.
The most widely used method of calculating capital costs is the relative weight of all capital investment sources and then adjusting the required return accordingly.
If a firm were financed entirely by bonds or other loans, its cost of capital would be equal to its cost of debt. Conversely, if the firm were financed entirely through common or preferred stock issues, then the cost of capital would be equal to its cost of equity. Since most firms combine debt and equity financing, the WACC helps turn cost of debt and cost of equity into one meaningful figure.
Early-stage companies usually do not have sizable assets to use as collateral for debt financing. Therefore, equity financing becomes the default mode of funding for most of these companies.
Debt financing has the advantage of being more tax-efficient than equity financing, since interest expenses are tax-deductible and dividends on common shares have to be paid with after-tax dollars. However, too much debt can result in dangerously high leverage, resulting in higher interest rates sought by lenders to offset the higher default risk.
What Is the Discount Rate?
It only makes sense 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 profitable. The discount rate makes it possible to estimate how much the project's future cash flows would be worth in the present. The higher the discount rate, the smaller the present investment needs to be to achieve the revenue required for the project to succeed.
An appropriate discount rate can only be determined after the firm has approximated the project's free cash flow. Once the firm has arrived at a free cash flow figure, this can be discounted to determine net present value.
Setting the discount rate isn't always straightforward. Even though many companies use WACC as a proxy for the discount rate, other methods are used as well. In situations where the new project is considerably more or less risky than the company's normal operation, it may be best to use the capital asset pricing model to calculate a project-specific discount rate. The normal cost of capital won't act as an effective substitute for risk premium for such a project.