Risk free Rate

 

Let’s learn about the simplest topic – Risk free rate, students read that risk free is Bank FD rate or govt bond rate. However, that’s not correct.

Here today we will learn, what is risk free rate, why we use it, where we use it, what books says about risk free rate, what is best practices in corporates, corporate reality vs Theory in the books, Myths About Risk-Free Rate

Let’s start with what is risk free rate.

The risk-free rate is the Return on investment when any investor invests with zero risk of non-payment & most certainty of ROI & capital invested.

Eye opener for investors – there is nothing like risk free investment in the world, now people say any bank FD rate is safe, secured & risk free by Reserve bank of India. However, the risk is still there. Also, people believe that govt bonds are risk free but the risk is still there. So, nothing is risk free.  

it is myth that Government bonds are truly risk-free. Inflation, political, or currency risks remain. “Risk-free” is relative, not absolute.

What are academic books say: -

Damodaran (Valuation guru) - Mr. Ashwath Damodaran says risk free rate should be without default risk and no reinvestment risk.

Corporate Finance books – Government bonds are closest proxies for risk free rate. And generally, school and college teachers and professors teach that take bank FD rate or 10 year’s government bond rates as a risk-free rate.

Best Practice in Corporates

Currency match with valuation: while doing valuation, the cash flows and government bond yield (10 Year) should be in same currency for example: if cash flows are in USD then government bond yield INR then convert either cash flows in INR or convert government bond yield in USD

Match time horizon of cash flow and project maturity: For long-term projects, use long-term bond yields (10–30 year).

Adjust for country risk: If valuing any company in a country where the default risk is higher, add a sovereign risk premium. For example, currently Russia Ukraine war is going on than Russia and Ukrainian companies have some extra risk.

Consistency: Risk free rate, Equity risk premium, & beta must be from the same market and currency.

Where we use Risk free rate:

Risk free rates are used to: -

CAPM model – for calculation of cost of equity there is a model CAPM model (capital asset pricing model). The formula of CAPM model is

                    Cost of Equity=Rf+β(Rm−Rf)

Rf = Risk free rate

β= Beta

Rm = Return on Market

DCF Valuation: - while doing valuation risk free rate is used to discount the cash flows.

WACC calculation: - As cost of equity is depends on Risk free rate, weighted average cost of capital is also depends on Rf.

Baseline benchmark: - Pension funds, insurance companies use Risk free rate as baseline standard. Also, it is used to project financial models.

Smart Analysts do for risk free rate (Best Practices)

ü  Match currency of Risk-free rate and cash flows.

ü  Match maturity of Rf and project horizon.

ü  If country has sovereign risk, then adjust properly.

ü  Use current yield curve, not averages.

ü  Use Rf, ERP, and beta consistent.

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