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Hope my last post on cost of capital helps you in understanding
its fundamentals and various factors affecting it. As discussed in the last
post, the cost of Equity is given as
Ke = Rf + Beta* ( Rm-Rf)
Where
Rf = Risk free rate
Rm= Expected return from the market
Here, Risk Free rate is rate at which there lies no variance
around the expected return rate. It means that on a risk free asset, the actual
return is equal to the expected return. For any investment to become risk free
it must satisfy two conditions which are as follows:-
1) No Default risks
2) No Reinvestment risks
The first condition states that it shouldn’t carry unwanted
risks i.e. Business risks, financial risks or any other risks whereas second
one states that there should not be any risk associated with the reinvestment
of the money in the same assets.
Besides these the other
two things that one must keep in his mind while taking assumptions for risk
free rate is that time horizon matters , which means it is always better to
take risk free rate of that assets for the current period rather than from any
historical data. It also states that it is always better to take risk free rate
for that asset whose time period of maturity matches with the time period of
your valuation. Suppose you want to do valuation for a company by taking cash
flow for 10 periods, then it is better to take 10 years Treasury bond rate as
Rf rather than 6 months treasury bill rate because reinvestment risk is
attached with 6 months treasury bill. Secondly, not all government securities
are risk free.so, before using any Government securities rate as
risk free rate kindly check the risk associated with it. For example, most of
the analysts in the world uses U.S. Treasury bond as risk free rate but after
2008 crisis Moody has downgraded U.S. bond ratings from Aaa grade. So, we can’t
take it as risk free rate rather we must subtract its credit spread associated
with its bond ratings to get Rf.
One can calculate risk free rates in three ways
Ø Risk free rates when valuation is done in local currency:-When
we want to do valuation for a company in local currency then the best way to
calculate the risk free rate is to subtract the Credit spread from the local
government bond rate. Now, the question arises, why we subtract the credit
spread? And the answer to this question is that as discussed above not all
Government securities are risk free rather they have some inherent risks which
is calculated by Credit Rating agencies and is given in the form of Credit
spread. Hence, once we subtract that credit spread we will get the Rf. The
credit spread arises because of various economic, social, political, legal etc.
risks associated with a country. Hence, as an investor I will invest in those
bonds when I will be getting the premium and that premium is calculated in the
form of credit spread by the rating agencies.
Ø Risk Free rate in Real term:-When you are doing
valuation in real term then take the government inflation indexed bond as risk
free rate or if such rate is not available then take the normalized value of
the growth rate of country as risk-free rate.
Ø Stable currency denominated bond can be used as
risk free rate but it must be issued by the country whose currency you think is
stable. For ex- Dollar ( Though Moody has downgraded the rating of U.S. bond
but still people all over the world uses it), Euros.
One thing that we must keep in mind that the risk free rate
varies across currencies, therefore we use stable currency denominated bond as
risk free rate. The reason behind difference in the risk free rate for
different currencies is that every currency is associated with the economy of
its host country and hence any downslides in the economy affect its stability.
Hence, risk free rate varies across the currency depending upon the stability
of its host country. (Please note that there are many other issues attached
with the stability of the currency)
Hope this blog helps you in understanding the way one will take
risk free rate. Be ready to explore the world of Risk premium in my next post.
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