A:

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.

The discount rate might also refer to the interest rate charged by the Federal Reserve Bank to commercial banks through its discount window.

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.

RELATED FAQS
  1. How do you use discounted cash flow to calculate a capital budget?

    Learn how discounted cash flows are used in creating capital budgets as a part of the net present value and internal rate ... Read Answer >>
  2. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
  3. What's the formula for calculating WACC in Excel?

    Learn about the weighted average cost of capital (WACC) formula and how it is used to estimate the average cost of raising ... Read Answer >>
  4. determine the proper weights of costs of capital?

    Learn how to calculate the weights of the different costs of capital, as well as how this is used to determine the weighted ... Read Answer >>
  5. When and why should the terminal value be discounted?

    Find out why investors use the terminal value, why the terminal value is discounted to the present day, and how it's related ... Read Answer >>
Related Articles
  1. Small Business

    Capital Budgeting: Which is Better, IRR or NPV?

    Using internal rate of return and net present value for capital budgeting evaluations often end in the same result. But there are times when using NPV to discount cash flows makes more sense.
  2. Investing

    Methods used in valuing private companies

    There are a few methods for calculating the valuation of a private company. By using financial information from peer groups, we can estimate the valuation of a target firm.
  3. Investing

    How interest rates affect property values

    Interest rates have profound impact on the value of income-producing real estate property. Find out how the rise and fall of interest rate affects property value.
  4. Investing

    Cash flow statement: Analyzing cash flow from financing activities

    The financing activity in the cash flow statement measures the flow of cash between a firm and its owners and creditors.
  5. Small Business

    Is Equity Financing the Right Choice for Your Business?

    Discover the benefits and drawbacks of equity financing for a small business, and learn when equity financing should be used instead of debt financing.
  6. Financial Advisor

    How Federal Reserve Activity Impacts Investment Portfolios

    The Federal Reserve's monetary policies impact investments in a number of ways.
  7. Investing

    Learn to Value Real Estate Investment Property

    Make sure you know what your real estate investment is worth before you sign the ownership papers. Learn what capitalization rate means to your net operating income.
  8. Retirement

    Senior Discounts Alert: National Parks Pass Rises Aug. 28

    First, Social Security rose a measly 0.3%. Now, the national parks lifetime pass is going up 8 times. Yet another reason to save with senior discounts.
  9. Investing

    Discount Broker

    A discount broker is a stockbroker who carries out "buy" and "sell" orders at a reduced commission compared to a full-service broker, but provides no investment advice.
RELATED TERMS
  1. Cost of Capital

    Cost of capital is the required return necessary to make a capital ...
  2. Discounting

    Discounting is the process of determining the present value of ...
  3. 1%/10 net 30

    1%/10 net 30 is a way of providing cash discounts on purchases, ...
  4. Rate of Return

    A rate of return is the gain or loss on an investment over a ...
  5. Debt Financing

    Debt financing occurs when a firm raises money for working capital ...
  6. Incremental Cost of Capital

    Incremental cost of capital is a capital budgeting term that ...
Hot Definitions
  1. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  2. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  3. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  4. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  5. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  6. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
Trading Center