DISCOUNT RATES AND RATES OF RETURN

Time value of money calculations are often referred to as calculations using "interest rates", "discount rates", or "rates of return".  From a mathematical point of view, the calculations are the same regardless of the terminology used to refer to the interest rate or the specific notation used to reflect the interest rate.  The terminology is confusing at times, however, so the following notes might help.

The term "interest rate" is sometimes used when calculating future values on investments that pay interest such as savings accounts and savings deposits or on investments in annuities that are made over time.  The term is always used when calculating compound or simple interest.  For most time value calculations, the term "rate of return" is more appropriate to use because it is a more general term.

"Rate of return" is a more general term than "interest rate" and can refer to returns that come either in the form of interest income or in the form of capital gains.

"Discount rate" is a term often used when calculating present values from future value amounts or streams of future payments.

"Required rate of return" is a term that usually refers to the lowest compound annual return an investor will be satisfied with given a certain level of investment risk.  We often talk of an investor's required rate of return for a specific type of financial investment.

"Cost of capital" is a term used to refer to the firm's annual compound % cost of raising funds through the issuance of financial securities such as common stock, preferred stock and bonds.  Related terms include the firm's cost of equity, the firm's cost of debt, and the firm's cost of preferred financing.  An additional term, "weighted average cost of capital" refers to the average annual cost of all forms of long term financing used by the firm.