- Valuation Basics
- Enterprise Value
- Enterprise Value Formula
- Equity Value
- Equity Value Formula
- Market Capitalization
- Market Capitalization Formula
- Internal Growth Rate Formula
- Intrinsic Value Formula
- Absolute Valuation Formula
- Assessed Value vs Market Value
- Required Rate of Return Formula
- Historical Cost vs Fair Value
- Large Cap vs Small Cap
- Free Float Market Capitalization
- Market Cap vs Enterprise Value
- Book Value Vs Market Value
- Value vs Growth Stocks
- Book Value Per share
- Fair value vs Market value
- Discounted Cash Flows
- Going Concern concept
- Dividend Discount Model (DDM)
- Gordon Growth Model
- Gordon Growth Model Formula
- Discounted Cash Flow Analysis (DCF)
- DCF Formula (Discounted Cash Flow)
- Free Cash Flow Formula (FCF)
- Free Cash Flow to Firm (FCFF)
- Free Cash Flow to Equity (FCFE)
- Terminal Value
- Terminal Value Formula
- Cost of Equity
- Cost of Equity Formula
- Risk-Free Rate
- Sustainable Growth Rate Formula
- Beta in Finance
- Beta Formula
- CAPM Beta
- Stock Beta
- Calculate Beta Coefficient
- Unlevered Beta
- Market Risk Premium
- Market Risk Premium Formula
- Equity Risk Premium
- Risk Premium formula
- Weighted Average Cost of Capital (WACC)
- Cost of Capital Formula
- WACC Formula
- Security Market Line (SML)
- Systematic Risk vs Unsystematic risk
- Free Cash Flow (FCF)
- Free Cash Flow Yield (FCFY)
- Mistakes in DCF
- Treasury Stock Method
- CAPM Formula
- Cash Flow vs Free Cash Flow
- Business Risk vs Financial risk
- Business Risk
- Financial Risk
- Valuation Multiples
- Equity Value vs Enterprise Value
- Trading Multiples
- Comparable Company Analysis
- Transaction Multiples
- (Price Earning Ratio (P/E)
- PE Ratio formula
- PEG Ratio Formula
- Price to Cash Flow (P/CF)
- Price to Book Value Ratio (P/B)
- Price To Book Value formula
- Price Earning Growth Ratio (PEG)
- Trailing PE vs Forward PE
- Forward PE
- EV to EBITDA Multiple
- EV to EBIT Ratio
- EV to Sales Ratio
- EV to Assets
- Other Valuation Tools
- Valuation Interview Prep
What is Risk-Free Rate of Return?
The Risk-Free rate is a rate of return of an investment with zero risks or it is the rate of return that investors expect to receive from an investment which is having zero risks. It is the hypothetical rate of return, in practice, it does not exist because every investment has a certain amount of risk.
At the time of business valuation, usually, US treasury bills consider as the risk-free asset or investment as they are fully backed by US government.
Risk-Free Rate of Return Reflects 3 Components
- Inflation:- The expected rate of inflation over the term of the risk-free investment.
- Rental Rate:- It is the real return over the investment period for lending the funds.
- Maturity risk or Investment risk: It is the risk which is related to the investment’s principal market value i.e., it can be rise or fall during the period to maturity as a function of changes in the general level of interest rates.
US Treasury Bills
T bills are the short term obligation issued by the US Government. These are issued for one year or less than a year. These are the safest investment as they are backed by US government. T bills carry a zero default risk as they are fully guaranteed and credit by US government and the Department of the treasury.
Funds generated from selling Treasury bill, the government uses those funds for various public projects such as highway & schools. There are so many factors which influence treasury bills price like monetary policy, macroeconomic conditions and supply& demand for the treasury. Longer treasury bills tend to have higher returns but normally T bill’s maturity lies between few days to 12 months.
Calculation of Risk-Free Rate
- Most of the time the calculation of the risk-free rate of return depends on the time period that is under evaluation. If the time period is for one year or less than one year than one should go for the most comparable government security i.e., Treasury Bills. For example, if the treasury bill quote is .389 then the risk-free rate is .39%.
- If the time duration is in between one year to 10 years than one should look for Treasury Note. For Example: If the Treasury note quote is .704 than the calculation of risk-free rate will be 0.7%
- If the time period is more than one year than one should go for Treasury Bond For example if the current quote is 7.09 than the calculation of risk-free rate of return would be 7.09%.
Risk-Free Rate in CAPM
While calculating the cost of Equity using CAPM, Risk-free rate is used, which influences a business weighted average cost of capital. Calculation of cost of capital takes place by using the Capital Asset Pricing Model (CAPM).
CAPM Formula & Risk Free Return
ra = rrf + Ba (rm-rrf)
- rrf = the rate of return for a risk-free security
- rm = the broad market’s expected rate of return
CAPM Formula Example
If the risk-free rate is 7%, the market return is 12%, and the stock’s beta is 2, then the expected return on the stock would be:
Re = 7% + 2 (12% – 7%) = 17%
In the above CAPM example, the risk-free rate is 7% and the market return is 12%, so the risk premium is 5% (12%-7%) and the expected return is 17%. Capital asset pricing model helps in getting a required rate of return on equity based on how risky that investment is when compared to a totally risk-free.
- Risk free rate is a rate of return of an investment with zero risks.
- It is the hypothetical rate of return, in practical, it does not exist because every investment having a certain amount of risk.
- US treasury bills consider as the risk free asset or investment as they are fully backed by US government.
- In the cost of Equity, Risk-free rate is used for CAPM calculation.
- Calculation of cost of capital takes place by using the Capital Asset Pricing Model (CAPM).
- CAPM describes the relationship between systematic risk and expected return
This has been a guide to Risk-Free Rate. Here we discuss its meaning, calculation of Risk-Free Rate with Example. Here we also see how risk-free rate affects CAPM cost of equity. You may also take a look at our suggested articles –