The risk-free interest rate corresponds to the return on a capital investment that is not subject to default risk. In addition to the default risk, the term and the currency are further characteristics that determine the level of this so-called riskfree base rate.
The risk-free interest rate corresponds to the return on a capital investment that is not subject to default risk. In addition to the default risk, the term and the currency are further characteristics that determine the level of this so-called riskfree base rate. Read the following article to find out what you need to consider when determining the riskfree base rate.
In capital market theory, a risk premium model is used almost universally to explain the expected cost of capital. The basis is a risk-free interest rate. A risk premium is added to reflect the characteristics of the financing. Together, these components make up the cost of capital of the form of financing. This applies both to equity instruments, which are generally valued on the basis of the CAPM, and to debt instruments.
In the context of a forward-looking business valuation, this means finding an opportunity interest rate for discounting that allows an adequate comparison. Comparability in terms of risk naturally does not apply to the riskfree base rate. At least the two components of matching maturities and matching currencies remain.
Future cash surpluses must be measured at an interest rate with a matching maturity. This applies to both the riskfree base rate and the risk premium. If a single cash flow is to be measured, the riskfree base rate that corresponds exactly to this term must be used. In the case of several or an infinite number of cash flows, either the corresponding interest rate can be charged for each cash flow or a so-called present value equivalent interest rate can be used, which reflects the entire interest rate structure with a suitable weighting.
The maturity-equivalent interest rates mentioned are not readily available on the capital markets. The majority of traded government bonds are coupon bonds. So-called "strips" have the character of a zero-coupon instrument, but are not available for the entire maturity band. The Bundesbank publishes prime rates daily, which are calculated using the Svensson method. Alternatively, the valuer can convert available current yields into a zero coupon curve.
Interest rates contain compensation for inflation expectations. As different inflation expectations prevail in different currency areas, the base interest rates also differ. Matching the currency of the cash surpluses and the currency of the riskfree base rate is therefore crucial. Determining the riskfree base rate can be difficult if the valuation is carried out in a less liquid currency such as the Mexican peso. A surcharge model can help here, in which the interest rate structure of a default-proof state is corrected by the expected inflation delta.
Valuation practice in Germany is closely linked to the recommendations of the IDW. The IDW has published various statements on the determination of a present value equivalent interest rate and its rounding.
The risk-free interest rate is a central component in business valuation and forms the basis for calculating the cost of capital. The precise determination and application of this interest rate, taking into account maturity and currency congruence, is crucial for an accurate valuation. smartZebra's tools and expertise can help to make these complex processes efficient and ensure accurate valuations.
