What is the Risk-Free Rate?
The Risk-Free Rate is the return on an investment with hypothetically no risk of default. It represents the minimum return an investor expects for any investment since it compensates only for the time value of money.
Typically, the yields of highly rated government bonds are used as a proxy for the risk-free rate, such as:
U.S. Treasury Bonds for USD-denominated valuations.
German Bunds for Euro-denominated valuations.
How is the Risk-Free Rate Used in WACC?
The risk-free rate is a foundational component of the Cost of Equity and Cost of Debt and influences the overall WACC.
In the Cost of Equity:
Using the Capital Asset Pricing Model (CAPM):
rₓ: Risk-free rate, serves as the baseline return in CAPM, to which premiums for risk (Market Risk Premium, Beta, Company or Country specific risk premium) are added.
In the Cost of Debt:
The risk-free rate can also serve as a benchmark for determining the Cost of Debt:
Incorporation into WACC:
Once the Cost of Equity (rₑ) and Cost of Debt (rₖ) are determined, the WACC formula integrates them:
Why is the Risk-Free Rate Important in WACC?
Establishes the Base for Returns:
It anchors the Cost of Equity and Cost of Debt calculations, serving as the benchmark for all other risk premiums.
Reflects Macroeconomic Conditions:
The RFR is influenced by factors such as inflation, central bank policies, and economic growth, making it a proxy for the broader economic environment.
Direct Impact on WACC:
A higher RFR increases the Cost of Equity and Debt, raising WACC and reducing project valuations.
A lower RFR decreases WACC, encouraging investments and higher project valuations.