Aswath Damodaran

ESTIMATING HURDLE RATES II: RISK

FREE RATE
Nothing in life is guaranteed, right?

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

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36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

Inputs required to use the CAPM -

The capital asset pricing model yields the following

expected return:
Expected Return = Riskfree Rate+ Beta * (Expected Return

on the Market PorRolio - Riskfree Rate)

To use the model we need three inputs:

a.
b.

c.

The current risk-free rate

The expected market risk premium (the premium
expected for invesWng in risky assets (market porRolio)
over the riskless asset)
The beta of the asset being analyzed.

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The Riskfree Rate and Time Horizon

On a riskfree asset, the actual return is always equal to the expected return. For an
investment to be riskfree, i.e., to have an actual return be equal to the expected return, two
condiWons have to be met

There has to be no default risk, which generally implies that the security has to be issued by the
government. Note, however, that not all governments can be viewed as default free.
There can be no uncertainty about reinvestment rates, which implies that it is a zero coupon security
with the same maturity as the cash ow being analyzed.

TheoreWcally, this translates into using dierent riskfree rates for each cash ow - the 1 year
zero coupon rate for the cash ow in year 1, the 2-year zero coupon rate for the cash ow
in year 2 ...
PracWcally speaking, if there is substanWal uncertainty about expected cash ows, the
present value eect of using Wme varying riskfree rates is small enough that it may not be
worth it.

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The Bo_om Line on Riskfree Rates

Using a long term government rate (even on a coupon bond) as the

riskfree rate on all of the cash ows in a long term analysis will yield a
close approximaWon of the true value. For short term analysis, it is
enWrely appropriate to use a short term government security rate as the
riskfree rate.
The riskfree rate that you use in an analysis should be in the same
currency that your cashows are esWmated in.

In other words, if your cashows are in U.S. dollars, your riskfree rate has to be in
U.S. dollars as well.
If your cash ows are in Euros, your riskfree rate should be a Euro riskfree rate.

The convenWonal pracWce of esWmaWng riskfree rates is to use the

government bond rate, with the government being the one that is in
control of issuing that currency. In November 2013, for instance, the rate
on a ten-year US treasury bond (2.75%) is used as the risk free rate in US
dollars.

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What is the Euro riskfree rate? An exercise in

November 2013
Rate on 10-year Euro Government Bonds: November 2013
9.00%

8.30%

8.00%
7.00%

6.42%
5.90%

6.00%
5.00%
3.90%
4.00%

3.30%

3.00%
2.00%

3.95%

2.10%

1.75%

2.15%

2.35%

1.00%
0.00%
Germany

Austria

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France

Belgium

Ireland

Italy

Spain

Portugal

Slovenia

Greece

When the government is default free: Risk free rates

in November 2013

!
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What if there is no default-free enWty?

Risk free rates in November 2013

If the government is perceived to have default risk, the government bond rate will have a default
spread component in it and not be riskfree. There are three choices we have, when this is the case.

Adjust the local currency government borrowing rate for default risk to get a riskless local currency rate.
n In November 2013, the Indian government rupee bond rate was 8.82%. the local currency raWng from
Moodys was Baa3 and the default spread for a Baa3 rated country bond was 2.25%.
Riskfree rate in Rupees = 8.82% - 2.25% = 6.57%
n In November 2013, the Chinese Renmimbi government bond rate was 4.30% and the local currency
raWng was Aa3, with a default spread of 0.8%.
Riskfree rate in Chinese Renmimbi = 4.30% - 0.8% = 3.5%
Do the analysis in an alternate currency, where gekng the riskfree rate is easier. With Vale in 2013, we could
chose to do the analysis in US dollars (rather than esWmate a riskfree rate in R$). The riskfree rate is then the
US treasury bond rate.
Do your analysis in real terms, in which case the riskfree rate has to be a real riskfree rate. The inaWon-
indexed treasury rate is a measure of a real riskfree rate.

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EsWmaWng a sovereign default spread

Estimating a default spread for a country
or sovereign entity
Market Based estimates
Sovereign Bond spread
1. Find a bond issued by the
country, denominated in US$ or
Euros.
2. Compute the default spread
by comparing to US treasury
bond (if US $) or German Euro
bond (if Euros).

Country
Brazil
China
India
Poland

CDS Market
1. Find a 10-year CDS
for the country (if one
exists)
2. Net out US CDS
2. This is your default
spread.

SovereignBond-Yield Currency Risk-free-rate

4.50%
US$
3.04%
NA
NA
NA
NA
NA
NA
2.50%
Euro
1.80%

Default- CDS-Spread-(netSpread
of-US)
1.46%
2.07%
NA
0.87%
NA
3.05%
0.70%
0.82%

Rating/Risk score based estimates

Step 1: Find a sovereign rating (local
currency) for the country (on Moody's or S&P)
Step 2: Look up the default spread for that
rating in the lookup table below:
Moody's rating Sovereign Bonds/CDS
Aaa/AAA
0.00%
Aa1/AA+
0.40%
Aa2/AA
0.50%
Aa3/AA(
0.60%
A1/A+
0.70%
A2/A
0.85%
A3/A(
1.20%
Baa1/BBB+
1.60%
Baa2/BBB
1.90%
Baa3/BBB(
2.20%
Ba1/BB+
2.50%
Ba2/BB
3.00%
Ba3/BB(
3.60%
B1/B+
4.50%
B2/B
5.50%
B3/B(
6.50%
Caa1/ CCC+
7.50%
Caa2/CCC
9.00%
Caa3/ CCC10.00%
Country Moody's,Rating Default,Spread
Brazil
Baa2
1.90%
China
Aa3
0.60%
India
Baa3
2.20%
Poland
A2
0.85%

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0.00%
Japanese Yen
Taiwanese $
Swiss Franc
icelandic Krona
Czech Koruna
Phillipine Peso
Bulgarian Lev
Euro
Danish Krone
Hong Kong $
Lithuanian Litas
Thai Baht
Dutch Guilder
CroaWan Kuna
Swedish Krona
Singapore $
Israeli Shekel
BriWsh Pound
Canadian dollar
Malaysian Ringgit
Hungarian Forint
Norwegian Krone
US $
Romanian Leu
Polish Zloty
Vietnamese Dong
Pakistani Rupee
Chinese Remimbi
Australian Dollar
Chilean Peso
Colombian Peso
Mexican Peso
Peruvian Sul
New Zealand $
ArgenWne Peso
Russian Rouble
Venezuelan Bolivar
Indonesian Rupiah
South African Rand
Indian Rupee
Turkish Lira
Kenyan Shilling
Nigerian Naira
Brazilian Reais

Risk free rates will vary across currencies:

January 2014
Risk free rate by Currency: January 2014

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

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10

Task
EsWmate the
risk free rate
in the
currency of
your choice

11

Read
Chapter 4