**Risk free Rates in a Static World**

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**Risk free Rates in a Dynamic World**

*Risk free Rates and Growth (Real and Nominal)*

*Dynamic Implication: As the risk free rate changes, your estimates of nominal growth will have to be stepped down, not because you have changed your beliefs about a specific company, but because you should be lowering the base growth rate for the economy (global or domestic).*

*Risk free Rates and ERP*

*Dynamic Implication: As the risk free rate changes, the equity risk premiums you use will also have to change to reflect the market's updated expectations. A crisis that causes rates to plummet will also make risk premiums rise. If you stick with historical risk premiums, while using current risk free rates, you will misvalue companies.*

*Risk free Rates and Default Spreads*

*Dynamic Implication: As the risk free rate changes, the default spread used to estimate the cost of debt should also change, thus ensuring that the cost of debt will not move in lock step with the risk free rate.*

*Risk free Rates and Debt Ratios*

*Dynamic Implication: As the risk free rate changes, the debt ratios for companies will also change as they reevaluate the trade off of using debt as opposed to equity. That change, in conjunction with tax and default risk assessments, will lead to a change in the cost of capital.*

*Risk free Rates and Value: The Full Picture*

- The nominal growth rate in the economy will be equal to the risk free rate, reflecting how closely the T.Bond rate has tracked the nominal GDP growth rate.
- The company will grow at a rate 6% higher than the nominal growth rate of the economy for the next five years. Thus, with a 4% riskfree rate, the growth rate is 10%, matching the original assumption, but at a 2% riskfree rate, the nominal growth in cash flows will be 8%. In perpetuity, the company will now grow at the riskfree rate = nominal growth rate of the economy,
- The equity risk premium is the trickiest component, but if the market's behavior over the last decade is any indication, the expected return on stocks will stay at 8%, with the equity risk premium adjusting to the new risk free rate. Thus, if the riskfree rate drops to 2%, the equity risk premium will be 6%.

**Playing Devil's Advocate**

If you are skeptical about my arguments, I don't blame you! In fact, I will preempt you and bring up some counter arguments that you can make against my thesis.

__Mean Reversion__: The essence of mean reversion is that when something looks unusually low or high, it will be revert back to historic norms. Using this argument on risk free rates, there are some who use "normalized" risk free rates (with the extent of normalization varying across users) in valuation. There are two problems with this argument. The first, and I referenced it in adifferent context in my post on CAPE , is that assuming things will revert back to the way they used to be can be dangerous, if there has been a structural shift in the process. The second, and perhaps even stronger, argument is that you cannot selectively mean revert some numbers and not mean revert others. Thus, if you decide to replace today's risk free rate with a normalized risk free rate of 4%, reflecting 2007 levels, you have to also adjust your growth rates and risk premiums to reflect 2007 levels. In effect, you will be valuing your company in 2016, as if your were back in 2007. Good luck with that!__Central Bank as Master Manipulators__: The conventional wisdom is that the Fed (and central banks) are all-powerful and that the low rates of today have little to do with fundamentals and more to do with central banking policy. If you believe that and you also believe that markets are being led by the nose, you do have the basis for a "bubble" argument, where "artificially" low interest rates are leading all financial assets into bubble territory. The problem, though, is that if this were the case, the cost of equity should be tracking down, in step with the risk free rate, and as the figure on equity risk premiums (in the section above) notes, that does not seem to be the case.

**Conclusion**

**YouTube Video**

**Attachments**

Risk free rates, Inflation and GDP Growth Risk free rates and ERP Risk free rates and the Baa Default Spread Risk free rates and Debt Ratios over time Static and Dynamic Valuation Spreadsheet

**DCF Myth Posts**

If you have a D(discount rate) and a CF (cash flow), you have a DCF. A DCF is an exercise in modeling & number crunching. You cannot do a DCF when there is too much uncertainty. - It's all about D in the DCF (Myths
4.1 ,4.2 ,4.3 ,4.4 &4.5 ) - If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF.
- A DCF requires too many assumptions and can be manipulated to yield any value you want.
- A DCF cannot value brand name or other intangibles.
*A*DCF yields a conservative estimate of value.- If your DCF value changes significantly over time, there is something wrong with your valuation.
- A DCF is an academic exercise.