Estimating the Risk-Free Rate

by Maestro

The starting point for the CAPM cost of equity estimate is rRF, the risk-free rate. There is really no such thing as a truly riskless asset in the U.S. economy. Treasury securities are essentially free of default risk, but nonindexed long-term T-bonds will suffer capital losses if interest rates rise, and a portfolio of short-term T-bills will provide a volatile earnings stream because the rate earned on T-bills varies over time. Since we cannot in practice find a truly riskless rate upon which to base the CAPM, what rate should we use? A recent survey of highly regarded companies shows that about two-thirds of the companies use the rate on long-term Treasury bonds.7

We agree with their choice, and here are our reasons:

1. Common stocks are long-term securities, and although a particular stockholdermay not have a long investment horizon, most stockholders do invest on a longtermbasis. Therefore, it is reasonable to think that stock returns embody longterminflation expectations similar to those reflected in bonds rather than theshort-term expectations in bills.

2. Treasury bill rates are more volatile than are Treasury bond rates and, most experts agree, more volatile than rs.

3. In theory, the CAPM is supposed to measure the expected return over a particular holding period. When it is used to estimate the cost of equity for a project, the theoretically correct holding period is the life of the project. Since many projects have long lives, the holding period for the CAPM also should be long. Therefore, the rate on a long-term T-bond is a logical choice for the risk-free rate.
In light of the preceding discussion, we believe that the cost of common equity is more closely related to Treasury bond rates than to T-bill rates. This leads us to favor T-bonds as the base rate, or rRF, in a CAPM cost of equity analysis. T-bond rates can be found in The Wall Street Journal or the Federal Reserve Bulletin. Generally, we use the yield on a 10-year T-bond as the proxy for the risk-free rate.

Taken From : Credit Repair by Attorneys Robin Leonard and Deanne Loonin