1 Thought on risk free rate and cost of debt and cost of equity?
  1. Reply
    Tom C
    August 1, 2011 at 12:15 am

    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

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