Thursday, May 6th, 2010
risk free rate and cost of debt and cost of equity?
Just Wondering asked:
If the risk-free rate increases what kind of impact would this have on the cost of
debt? What impact would it have on the cost of equity?
If the risk-free rate increases what kind of impact would this have on the cost of
debt? What impact would it have on the cost of equity?
May 7th, 2010 at 8:09 pm
Risk free rate and cost of debt :
The risk free rate is the interest rate paid by investments that offer no risk to the investor. If the risk free rate increases would indirectly affect the cost of debt of a company. In other words, increasing the risk-free, it would indirectly increase the cost of a company to borrow funds.
Risk-free and cost of equity.
The cost of equity of a company is determined by the SML, Security Market Line or CAPM , the capital asset pricing model.
CAPM express the cost of equity as a function of the risk free rate and the systematic risk.
Re =Rf + B(Rm-Rf) where,
Re = Cost of Equity
B = beta, measurement for systematic risk
(Rm -Rf) = Risk of the Market in general
So, from the formula, if the risk free increases, the cost of equity may increase , decrease or remain the same, because its dependent on the risk of market and beta of the company