The Impact of the Maturity and Source of the Risk-Free Rate in Equity Estimation Under the CAPM
Journal of Law and Financial Management, Vol. 13, No. 1, June 2014, pp. 30-37
13 Pages Posted: 5 Aug 2014
Date Written: August 3, 2014
There is divergence of opinion among academics and practitioners on the appropriate maturity and source of the risk-free rate when applying the Capital Asset Pricing Model (CAPM). For projects with betas near one, this divergence should be immaterial. What is not clear is how far project betas can diverge from one before these differences become significant. This cannot be readily ascertained perusing risk-free rate and market risk premium values published in textbooks and research since different data sets are used. Using standardised, readily available data sets and employing the methodologies proposed by three popular corporate finance textbooks, the results of this paper indicate that, except for a very narrow set of circumstances for betas near one, different risk-free rate maturity and source choices can significantly impact project selection via expected equity returns. However, even though statistically significant, for a given data source (current/historical) the maturity choice is well within cost of capital estimation variation expected by practitioners. For a given term, more variation occurs across source selection. Since the practitioner may have to justify the input parameters used for estimating equity costs for capital budgeting projects, this study focuses on the empirical consequences of choosing a particular set of CAPM input parameters over alternatives.
Keywords: Capital Asset Pricing Model, risk-free rate, equity costs
JEL Classification: M40, M41
Suggested Citation: Suggested Citation