Why Do Risk-Free Rates Matter?
The risk-free rate is the building block for estimating both the cost of equity and capital. The cost of equity is computed by adding a risk premium to the risk-free rate, with the magnitude of the premium being determined by the risk in an investment and the overall equity risk premium (for investing in the average risk investment). The cost of debt is estimated by adding a default spread to the risk-free rate, with the magnitude of the spread depending on the credit risk in the company. Thus, using a higher risk-free rate, holding all else constant, increases discount rates and reduces present value in a discounted cash flow valuation.
The level of the risk-free rate matters for other reasons as well. As the ...
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