Roger Grabowski, Carla Nunes, and James Harrington
We discuss the cost of capital in terms of its two major components, a risk-free rate and a risk premium, in earlier chapters. This chapter examines the risk-free rate.
The risk-free rate serves as a building block for many of the cost-of-equity capital models (e.g., the build-up method, the capital asset pricing model [CAPM], the Fama-French three-factor model, etc.). For example, the basics of the build-up method begin with adding the general expected equity risk premium for the market (ERP or notationally, RPm) to the selected risk-free rate (see Chapter 8). The basics of the CAPM begin with adding the ERP multiplied by a risk factor to the selected risk-free rate (see Chapter 9). The Fama-French three-factor model also begins by adding a series of factors reflecting several risks to the selected risk-free rate (see Chapter 18).
A risk-free rate is the return available, as of the valuation date, on a security that the market generally regards as free of the risk of default.
When estimating the cost of equity capital by using one of the commonly applied methods, the risk-free rate serves as an inflation ...