Using a short-term rate, such as the 3-month bill, can lead to an inaccurate discount rate because it does not account for the long-term risk profile of the cash flows. Key Components of CAPM Risk-Free Rate (Rf): Typically based on the yield of long-term government bonds, this rate represents the theoretical return of an investment with zero risk.
Understanding Discount Rate Sensitivity in DCF Analysis
Market Risk Premium (MRP): The expected return of the market minus the risk-free rate, representing the compensation investors demand for taking on market risk. The formula establishes a linear relationship between risk and expected return, using the risk-free rate as the baseline.
This metric is crucial because it reflects the opportunity cost for both debt holders and equity investors. A beta of 1.
Discount Rate Sensitivity DCF Testing: Understanding Risk and Time Horizon Mismatch
Beta (β): This measures the volatility of the asset relative to the overall market. Choosing the Appropriate Risk-Free Rate Selecting the risk-free rate is often more complex than it appears, primarily due to the mismatch between the duration of the DCF projection and the available government securities.
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