Term
Risk-free rate
The return on an investment assumed to carry no default risk, in practice usually the yield on long-term government bonds of creditworthy countries. It is the starting point for calculating the cost of capital and discount rates.
Updated
What it means
The risk-free rate is the return on an investment where the investor is assumed to get the money back with certainty. In practice the yield on long-term government bonds of the highest-rated countries, such as Germany for the euro, is used.
It is the foundation of financial calculations. Any riskier investment must deliver the risk-free rate plus a risk premium, or it is not worth it to the investor.
In the CAPM the risk-free rate is the first component of the cost of equity. It moves with monetary policy and market expectations, which is why company valuations change over time even with unchanged results.
How it works in practice
When valuing a company or project, the risk-free rate is chosen to match the currency and length of the cash flows. For euro cash flows over decades, yields on long-term German or comparable government bonds are used.
A rising risk-free rate raises the discount rate and the WACC, lowering the present value of future profits. That is why valuations of growth companies in particular fall when rates rise.
For an entrepreneur the risk-free rate is also a practical benchmark: if a term deposit or government bond yields about as much as a risky project, the project is not worth it.
What to watch out for
Slovak government bonds are not entirely risk-free, as their rating is lower than Germany's. If their yield is used, part of the country risk is already in the rate and must not be counted again in a premium.
The risk-free rate must match the currency of the cash flows. Combining euro cash flows with a dollar rate, or vice versa, leads to a wrong valuation.
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