What is the Riskfree Rate? A Search for the Basic Building Block
33 Pages Posted: 18 Dec 2008 Last revised: 1 Jul 2009
Date Written: December 14, 2008
In corporate finance and valuation, we start off with the presumption that the riskfree rate is given and easy to obtain and focus the bulk of our attention on estimating the risk parameters of individuals firms and risk premiums. But is the riskfree rate that simple to obtain? Both academics and practitioners have long used government security rates as riskfree rates, though there have been differences on whether to use short term or long-term rates. In this paper, we not only provide a framework for deciding whether to use short or long term rates in analysis but also a roadmap for what to do when there is no government bond rate available or when there is default risk in the government bond. We look at common errors that creep into valuations as a consequence of getting the riskfree rate wrong and suggest a way in which we can preserve consistency in both valuation and capital budgeting.
Keywords: riskfree rate, cost of equity, discount rate, valuation
JEL Classification: G11. G12, G31
Suggested Citation: Suggested Citation