Cost of Funds = Discount Rate?

numnum:

aempirei:

I think OP is talking about the WACC. The discount rate ("hurdle rate") is the required return a firm needs to earn to have the NPV of a project = 0. Cost of equity is more expensive than debt financing and generally has a higher required return. So if you fund Project A with 100% debt, it will have a lower discount rate / required return than Project B if B was funded with 100% equity.

I recently read a varying technique on how to calculate the discount rate by only using CAPM to get the cost of equity, and then using that cost of equity as the discount rate. Everywhere else I've seen people using WACC as the discount rate, taking into account the cost of debt in addition to the cost of equity.

Are there any good arguments for just using the cost of equity alone as the discount rate? Btw I read this in "Security Analysis and Business Valuation on Wall Street" by Jeffrey Hooke. He prefaces an entire chapter by saying this:

"The credibility of the discounted cash flow approach is dependent on an accurate projection and an appropriate discount rate. The discount rate is a representation of what a reasonable investor would expect from the subject investment, in terms of an annual rate of return. This book emphasizes the equity rate of return on a publicly traded common stock, rather than the weighted average cost of capital (WACC), which incorporates both a firm’s debt and equity returns."

We are talking about two different things here. I am referencing from the perspective of the firm's discount rate on its own projects while you are discussing an outside investor's required return on shares of stock.

WACC is appropriate from the capital budgeting perspective (adjusted for riskiness of the project) while the cost of equity is appropriate for an outside investor simply buying shares of stock.