Difference between Cost of Capital and Rate of Return
In financial management, cost of capital and rate of return are two of the most commonly used terms which are often used synonymously, but there is a significant difference between them. The former term refers to the overall cost of the funds which the company has incorporated for a specific project or projects. On the other hand, rate of return is the return which the company attain by making investment of its capital resources in a business activity or a project. The project is considered as feasible if rate of return exceeds the cost of capital.
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Cost of Capital
In finance, it is a term which is used to refer to company’s overall cost of funds (debt and equity). It is a benchmark which the company must meet so as to keep its shareholders and creditors satisfied. Moreover, it is extremely for the companies to evaluate the feasibility of their new projects on the basis of cost of capital.
It consists on the cost of debt and the cost of equity. The cost of debt is quite easy to calculate as compared to equity. Debt includes all the funds which the company have taken from other financial institutions like banks on an agreement to give them fixed amount of money in return. It is to be noted that interest expense on the debt is tax deductible so the company can use it to limit its expenses. Furthermore, it can be used to avail financial leverage.
In contrast, cost of equity is a little bit difficult to calculate as it involves more complex calculations. It is equal to the risk free rate of return plus premium expected for risk i.e. risk multiplied with market rate of return after deducting risk free rate of return. In addition, the equity can be divided into preferred stock and ordinary stocks. The return is fixed on preferred stock and it is paid before the payment is made to the common or ordinary stock holders.
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Rate of return
It is rate which is obtained after making the capital investment in any project. The companies calculate both cost of capital and rate of return before making an investment. If the rate of return is larger than the cost of capital, it means that the project is feasible, otherwise it is not. Generally, the rate of return is higher if more risk is taken. But, it is not a fixed rule.
