Hi, What is the correct risk free rate to use when calculating the cost of debt of a European steel manufacturing company please? I want to use the following formula to forecast the cost of debt of a company in a model: risk free rate + spread. Is SONIA (currently at 5%) the correct risk free rate? Thank you
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First off your risk-free rate does not depend on the industry, it is the same whether you're a steel manufacturing company or a company producing waffle-makers with an in-built MP3 player.
Risk-free rate must be in the same currency as your valuation, so if you are doing it in Euros, make sure the rate is in Euros. For European risk-free rates, use the German 10-year government bond for your risk-free rate. But what if your company is in Greece, where the 10-year government bond is yielding 10%?! Well, this rate is not risk-free because the government bond in itself has a risk premium (of default) attached.
Now God forbid you're doing a valuation of a company in Afghanistan, what would be the risk-free rate? Suppose the Afghan government was issuing bonds at 30% on a 10-year bond. Assume that the sovereign default rating of Afghanistan is CCC and has a default spread of 23%, the risk-free rate in Afghan currency is: 30% - 23% = 7%
Why does the RFR need to be in the same currency as the valuation? If you converted the Afghan company to USD, why would the RFR drop to 4%? In this case of a German steel company, why not assume that you’d borrow in USD over Euro?
There is nothing magical about it, the difference is primarily inflation. In principle, you can value any company using any currency you want and will get identical valuations across the range of currencies but you have to make consistent assumptions, such as the risk-free rate.
Suppose you woke up and decided to value Microsft using Venezuelan bolívar, which has an inflation of 300% a year. If your valuation is in nominal terms (as is the risk-free rate), your revenue growth year on year is going to be 300%+ to account for the fact that there is huge inflation of the currency. If you used a risk-free rate of 4% (say, a 10-year yield on a US treasury bond), you're essentially saying that the risk-free rate will be losing 296% in real terms a year (which by definition is not 'risk-free').
You can think of the rf rate as: rf = expected real growth rate + expected inflation if that helps you visualise it better|
tldr: rf rate has nothing to do with borrowing, it's just to do with the growth rate of your cashflows
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