What is a Risk-Free Rate?
A Risk-Free Rate of return is the interest rate an investor can expect to earn on an investment that carries zero risk. In practice, the Risk-Free rate is considered to equal a 3-month government Treasury bill, since this is generally the safest investment an investor can make. A risk-free rate is a theoretical number since technically all investments carry some form of risk, as explained here. Nonetheless, it is common practice to refer to the T-bill as the risk-free rate. While it is possible for the governments to default on their securities, the probability of this happening is very low; hence the investment is considered “Risk-Free.”
The risk-free rate may differ from investor to investor. The general rule of thumb is to consider the most stable government body offering t-bills in a certain currency. For example, an investor investing in securities that trade in USD should use the U.S. T-bill rate, whereas an investor investing in securities traded in Euros or Francs should use a Swiss or German T-bill.
How does risk-free rate affect the cost of capital?
The Risk-Free rate is used in the calculation of the cost of equity (as calculated using the CAPM), which influences a business’ weighted average cost of capital. The graphic below illustrates how changes in the Risk-Free rate would affect a business’ cost of equity:
CAPM (Re) – Cost of Equity
Rf – Risk-Free Rate
β – Beta
Rm – Market Risk Premium
In our example, a rise in Rf will pressure the market risk premium to increase. It is because as investors are able to get a higher risk-free return, risky assets will need to perform better than before in order to meet the investors’ new standard for required returns. In other terms, investors will perceive other securities as riskier than before and thus will demand a higher rate of return to compensate them for the increased risk.
Assuming the market risk premium rises by the same amount as the risk-free rate does, the second term in the CAPM equation will remain the same. However, the first term will increase, thus increasing CAPM. The chain reaction would also occur in the opposite direction if risk-free rates were to decrease (i.e., a lower risk-free rate would result in lower cost of equity).
Here’s how the increase in Re would increase WACC:
Holding the business’ cost of debt, capital structure, and tax rate the same, we see that WACC would increase. The opposite is also true (i.e., a decreasing Re would cause WACC to decrease).
From a business’ perspective, rising risk-free rates can be stressful. The company is under pressure to meet higher required returns from investors. Thus, driving stock prices up and meeting profitability projections become a high priority.
From an investor’s perspective, rising risk-free rates are a good sign since it signals a confident treasury and the ability to demand higher returns.
Historical U.S 3-month T-bill Rates
Below is a chart of historical U.S. 3-month T-bill rates:
T-bills fell as low as 0.01% during the 1940s and 2010s and rose as high as 16% during the 1980s. High T-bill rates usually signal prosperous economic times where private sector companies are performing well; meeting earnings targets and increasing stock prices over time.
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