The document discusses risk-free rates and issues in estimating them. It begins by defining the risk-free rate as having zero risk of loss and no reinvestment risk. It notes that risk-free rates are used to estimate the cost of equity and debt. However, directly measuring the risk-free rate can be challenging due to factors like currency effects, lack of long-term government bonds, and government default risk. The document examines approaches for estimating risk-free rates in different market conditions and currencies.

1. REPORT ON FINANCIAL RESEARCH PAPER
RESEARCH PAPERS ON:
A) What is the riskfree rate? A Search for the Basic Building Block
B) Valuing Companies with intangible assets
C) Measuring Company Exposure to Country Risk: Theory and Practice
Submitted To: Dr. Satinder Bhatia
By: Nilesh A. Mashru
Roll no. 28, Student id: S12MMMMM01593
PGDIBS, BKC - Mumbai

2. What is the riskfree rate? A Search for the Basic Building Block
Risk free rate is basically the rate of return of an investment with zero risk of financial loss. It is
interpreted as the return or interest that an investor would expect from an absolutely risk-free
investment. For instance the most commonly used benchmark for risk free rate is bank interest on fixed
deposits. As fixed deposits with bank have zero risk of financial loss, interest income expected out of the
same is interpreted as risk free income and the rate of such interest as risk free rate.
Since the risk free rate can be obtained with no risk, it is implied that any additional risk taken by an
investor should be rewarded with an interest rate higher than the risk-free rate.
The risk free rate means different things to different people and there is no such consensus on how to
go about a direct measurement of the same. However, perhaps the most common interpretation is
aligned to Fisher's concept of inflationary expectations, described in his treatise 'The Theory of Interest'
(1930) which is based on the theoretical costs and benefits of holding currency. In Fisher’s model these
are described by two potentially offsetting movements: i) Expected increases in the money supply
should result in investors preferring current consumption to future income. ii) Expected increases in
productivity should result in investors preferring future income to current consumption.
The correct interpretation is that the risk free rate could be either positive or negative and in practice
the sign of the expected risk free rate is an institutional convention - this is analogous to the argument
that Tobin makes on page 17 of his book, Money, Credit and Capital. In a system with endogenous
money creation and where production decisions and outcomes are decentralized and potentially
intractable to forecasting, this analysis provides support to the concept that the risk free rate may not
be directly observable.
However, it is commonly observed that for people applying this interpretation, the value of holding
currency is normally perceived as being positive. It is not clear what is the true basis for this perception,
but it may be related to the practical necessity of some form of currency to support the specialization of
labour, the perceived benefits of which were detailed by Adam Smith in The Wealth of Nations.
However it should be observed that Adam Smith did not provide an 'upper limit' to the desirable level of
the specialization of labour and did not fully address issues of how this should be organised at the
national or international level.
An alternative (less well developed) interpretation is that the risk free rate represents the time
preference of a representative worker for a representative basket of consumption. Again, there are
reasons to believe that in this situation the risk free rate may not be directly observable.
Usually the return on domestically held short-dated government bonds is normally perceived as a good
proxy to the risk free rate provided there is no perceived risk of default associated with the bond (e.g.
Eurozone crisis).
The risk-free interest rate is highly significant in the context of the general application of Modern
Portfolio Theory which is based on the Capital Asset Pricing Model. There are numerous issues with this

3. model, the most basic of which is the reduction of the description of utility of stock holding to the
expected mean and variance of the returns of the portfolio. The risk free rate is also a required input in
financial calculations, such as the Black–Scholes formula for pricing stock options and the Sharpe Ratio.
Note that some finance and economic theories assume that market participants can borrow at the risk
free rate; in practice, of course, very few (if any) borrowers have access to finance at the risk free rate.
In corporate finance and valuation, we start off with the presumption that the riskfree rate is given and
easy to obtain and focus the bulk of our attention on estimating the risk parameters of individuals firms
and risk premiums. But is the riskfree rate that simple to obtain? Both academics and practitioners have
long used government security rates as riskfree rates, though there have been differences on whether
to use short term or long term rates.
In this paper by Aswath Damodaran from Stern school of Business, New York University, not only does
he provide a framework for deciding whether to use short or long term rates in analysis but also a
roadmap for what to do when there is no government bond rate available or when there is default risk
in the government bond.
What is a risk free asset?
To understand what makes an asset risk free, let us go back to how risk is measured in investments.
Investors who buy assets have returns that they expect to make over the time horizon that they will
hold the asset. The actual returns that they make over this holding period may by very different from
the expected returns, and this is where the risk comes in. Risk in finance is viewed in terms of the
variance in actual returns around the expected return. For an investment to be risk free in this
environment, then, the actual returns should always be equal to the expected return.
Hence it can be concluded that when there is no variance between the expected & the actual rate of
returns on a particular investment, it is a risk free rate.
Why do riskfree rates matter?
The riskfree rate is the building block for estimating both the cost of equity and capital. The cost of
equity is computed by adding a risk premium to the riskfree rate, with the magnitude of the premium
being determined by the risk in an investment and the overall equity risk premium (for investing in the
average risk investment). The cost of debt is estimated by adding a default spread to the riskfree rate,
with the magnitude of the spread depending upon the credit risk in the company. Thus, using a higher
riskfree rate, holding all else constant, will increase discount rates and reduce present value in a
discounted cash flow valuation.
The level of the riskfree rate matters for other reasons as well. As the riskfree rate rises, and the
discount rates rise with it, the breakdown of a firm’s value into growth assets and assets in place will
also shift. Since growth assets deliver cash flows further into the future, the value of growth assets will
decrease more than the value of assets in place, as riskfree rates rise.

4. Requirements for an Investment to be called Risk-Free
1. There can be no default risk.
2. There is no re-investment risk.
Risk free rate will vary with time if both the above conditions have to be fulfilled which is a purist
solution. Hence a one year cash flow will use a one year risk free rate and a five year cash flow will used
a five year risk free rate.
A practical compromise is to comeup with one common risk free rate to use on all the cash flows.
Common use of this is by banks in terms of duration matching. In valuation and capital budgeting, we
could use a variation on this duration matching strategy, where we use one riskfree rate on all of the
cash flows, but set the duration of the default-free security used as the risk free asset to the duration2
of the cash flows in the analysis.
The currency effect: Even if we accept the proposition that the ten-year default free bond rate is the risk
free rate, the number we obtain at any point in time can vary, depending upon the currency that you
use for your analysis.
Risk free rate vary across currencies: Since the rates that we have specified as riskfree rates are all over
the same maturity (ten years) and are default-free, the only significant factor that can cause differences
is expected inflation. High inflation currencies will have higher riskfree rates than low inflation
currencies. If higher riskfree rates lead to higher discount rates, and holding all else constant, reduce
present value, using a yen riskfree rate seemingly should give a company a higher value than using a US
dollar riskfree rate.
Summarizing, the risk free rate used to come up with expected returns should be measured consistently
with the cash flows are measured. Thus, if cash flows are estimated in nominal US dollar terms, the risk
free rate will be the US Treasury bond rate.
Real VS Nominal Risk free rate: Done consistently, the value of a company should be the same whether
we discount real cash flows at a real discount rate or nominal cash flows, in any currency, at a nominal
discount rate in the same currency.
Issues in Estimating risk free rates:
a. There are no long term traded government bonds
b. In many countries (and their associated currencies), the biggest roadblock to finding a riskfree
rate is that the government does not issue long term bonds in the local currency.
c. When there are no long term government bonds in the local currency that are widely traded,
analysts valuing companies in that market often take the path of least resistance when
estimating both cash flows and discount rates, resulting in currency mismatches in their
valuations.

5. d. Choosing valuation Currency – mature currency or local currency
e. The government is not default free
f. Local currency bond rate would include a default spread.
g. Risk free rate may vary over time
h. What is considered a more normal rate could have potential problems – Experience on normal
rate would change with time period, using normal risk free rate against current risk free rate
could have valuation consequences and interest rates vary from time to time.
Conclusion:
The risk free rate is the starting point for all expected return models. For an investment to be risk free, it
has to meet two conditions. The first is that there can be no risk of default associated with its cash flows.
The second is that there can be no reinvestment risk in the investment. Using these criteria, the
appropriate risk free rate to use to obtain expected returns should be a default-free (government) zero
coupon rate that is matched up to when the cash flow or flows that are being discounted occur. In
practice, however, it is usually appropriate to match up the duration of the risk free asset to the
duration of the cash flows being analyzed. In corporate finance and valuation, this will lead us towards
long-term government bond rates as risk free rates. In this paper, we considered three problem
scenarios. The first is when there are no longterm, traded government bonds in a specific currency. We
suggested either doing the valuation in a different currency or estimating the riskfree rate from forward
markets or fundamentals. The second is when the long-term government bond rate has potential
default risk embedded in it, in which case we argued that the riskfree rate in that currency has to be net
of the default spread. The third is when the current long term riskfree rate seems too low or high,
relative to historic norms. Without passing judgments on the efficacy of this view, we noted that it is
better to separate our views about interest rates from our assessment of companies.

6. Valuing Companies with Intangilble Assets
As we move from manufacturing to service based economies, an increasing large proportion of the firms
that we value derive their value from intangible assets ranging from technological patents to human
capital. In this paper, we focus on a few variables that make valuing these service companies different
from conventional manufacturing firms. The first is that accountants routinely miscategorize operating
and capital expenses, when firms invest in intangible assets. Thus, R&D expenses, which are really
capital expenses, are treated as operating expenses, thus skewing both reported profit and capital
values. The second is that firms with intangible assets are more likely to use options and restricted stock
to compensate employees and the accounting treatment of this compensation can also affect earnings
and cash flows. This paper looks at how best to correct for the accounting errors and the consequences
for valuation.
Looking at publicly traded firms, it is obvious that many firms derive the bulk of their value from
intangible assets. From consumer product companies, dependent upon brand names, to pharmaceutical
companies, with blockbuster drugs protected by patent, to technology companies that draw on their
skilled technicians and know-how, these firms range the spectrum.
Characteristics of firms with intangible assets
1. Inconsistent accounting for investments made in intangible assets
2. Generally borrow less money
3. Equity options
Such companies have valuation consequences due to miscategorization of capital expenses, the sparing
use of debt and equity based compensation.
1. We generally draw on the current earnings and current book value of a firm to derive a value for
existing assets. The flawed accounting treatment of intangible assets renders both numbers
unreliable.
2. If growth is a function of how much firms reinvest and the quality of that reinvestment, the
accounting treatment of expenditures on intangible assets makes it difficult to gauge either
number. The reinvestment made by the firm is often buried in the operating expenses.
3. Additional risk as monitoring assets is difficult.
4. Intangible assets may or may not get steady in the short run.
Issues with the valuation:
1. Capital expenses treated as operating expenses leads to loss of a potent tool to estimate growth
& internal consistency.

7. 2. Effect of accounting miscategorization can vary widely across firms in the same sector thus
making it difficult to do a relative comparison.
3. Looking for simple alternative methods may lead to false sense of complacency.
Consequences for Valuation:
When we capitalize R&D, brand name advertising and training expenses, there are significant
consequences for both discounted cash flow and relative valuation. In discounted cash flow valuation,
our estimates of cash flows and growth can be dramatically altered by the use of the adjusted numbers.
In relative valuation, comparisons of firms within the same sector can be skewed by where they are in
the life cycle.
Discounted Cashflow Valuation:
When we capitalize the expenses associated with creating intangible assets, we are in effect redoing the
financial statements of the firm and restating numbers that are fundamental inputs into valuation –
earnings, reinvestment and measures of returns.
a. Earnings: The operating and net income of a firm will change as a consequence. Since the adjustment
involves adding back the current year’s expense and subtracting out the amortization of past expenses,
the effect on earnings will be non-existent if the expenses have been unchanged over time, and positive,
if expenses have risen over time.
b. Reinvestment: The effect on reinvestment is identical to the effect on earnings, with reinvestment
increasing or decreasing by exactly the same amount as earnings.
c. Free Cash flow to the equity(firm): Since free cash flow is computed by netting reinvestment from
earnings, and the two items change by the same magnitude, there will be no effect on free cash flows.
d. Reinvestment Rate: While the free cash flow is unaffected by capitalization of these expenses, the
reinvestment rate will change. In general, if earnings and reinvestment both increase as a consequence
of the capitalization of R&D or advertising expenses, the reinvestment rate will increase.
e. Capital Invested: Since the unamortized portion of prior year’s expenses is treated as an asset, it adds
to the estimated equity or capital invested in the firm. The effect will increase with the amortizable life
and should thererfore be higher for pharmaceutical firms (where amortizable lives tend to be longer)
than for software firms (where research pays off far more quickly as commercial products).
f. Return on equity (capital): Since both earnings and capital invested are both affected by
capitalization, the net effects on return on equity and capital are unpredictable. If the return on equity
(capital) increases after the recapitalization, it can be considered a rough indicator that the returns
earned by the firm on its R&D or advertising investments is greater than its returns on traditional
investments.

8. g. Expected growth rates: Since the expected growth rate is a function of the reinvestment rate and the
return on capital, and both change as a result of capitalization, the expected growth rate will also
change. While the higher reinvestment rate will work in favor of higher growth, it may be more than
offset by a drop in the return on equity or capital.
In summary, the variables that are most noticeably affected by capitalization are the return on
equity/capital and the reinvestment rate. Since the cost of equity/capital is unaffected by capitalization,
any change in the return on capital will translate into a change in excess returns at the firm, a key
variable determining the value of growth. In addition to providing us with more realistic estimates of
what these firms are investing in their growth assets and the quality of these assets, the capitalization
process also restores consistency to valuations by ensuring that growth rates are in line with
reinvestment and return on capital assumptions. Thus, technology or pharmaceutical firms that want to
continue to grow have to keep investing in R&D, while ensuring that these investments, at least
collectively, generate high returns for the firm.
Conclusion
This paper examines the two key issues that we face when valuing firms with substantial intangible
assets. The first is that the accounting treatment of what comprises capital expenditures at these firms
is inconsistent with the accounting treatment of capital expenditures at manufacturing firms. R&D
expenses, brand name advertising and employee recruitment and training expenses are treated as
operating, rather than capital expenses. As a result, both the earnings and book value numbers at these
firms are skewed and using them in valuation can lead to poor estimates of value. We examined ways of
correcting for this accounting inconsistency and the resulting effect on value. In general, firms that can
convert R&D expenditures more efficiently and profitably into commercial products will see their
estimated values increase, as a result of the correction, whereas firms that spend significant amounts on
acquiring intangible assets with little to show for it in terms of higher earnings will see their estimated
values decrease. The second issue that we consider is the use of equity options to compensate
employees. We look at two traditional approaches for dealing with these options – the diluted stock and
treasury stock approaches – and discard them. Instead, we argue for valuing these options using
modified option pricing models and adjusting the value of common shares today both for options that
have been granted in the past (the option overhang) and expected future option grants.

9. Measuring Company Exposure to Country Risk: Theory and Practice
The growth of financial markets in Asia and Latin America and the allure of globalization has made the
analysis and assessment of country risk a critical component of valuation in recent years. In this paper,
we consider two issues. The first is the whether country risk should be considered explicitly in valuation,
and if the answer is yes, how to do it. Generically, there are two ways of incorporating country risk; we
can either adjust the cash flows or change the discount rate and we will consider both approaches. The
second and equally important issue is how to assess a company’s exposure to country risk. Firstly not all
companies in an emerging market are equally exposed to country risk and that we need to differentiate
between firms. Secondly, a company’s exposure to country risk comes not from where it incorporates
and trades but from where it does its business. In other words, assessing and dealing with country risk
can be important even for companies that trade in developed markets, if they get a significant portion of
their revenues in emerging markets.
While evaluating country risk, there are 2 basic questions:
1. Whether there should be an additional premium when valuing equities in these markets
because of the country risk?
Yes depending upon the country of investment, the premium may or may not be considered
when valuing equities in these markets. While globally diversified investors are playing an
increasing role in the pricing of equities around the world, the resulting increase in correlation
across markets has resulted in a portion of country risk being nondiversifiable or market risk.
2. Estimation of such premium for emerging markets.
a. Historical risk premium approach
b. Implied Premium approach
Determinants of a company’s exposure to risk:
1. Revenue sources
2. Production facilities
3. Risk management
4. Data constraints
Conclusion:
As companies expand operations into emerging markets and investors search for investment
opportunities in Asia and Latin America, the assessment of country risk has become a central
component of valuation. In this paper, we considered two key questions. The first is whether there
should be an extra premium assessed for country risk, and if yes how to estimate it. While it is true that

10. globally diversified investors can eliminate some country risk by diversifying across equities in many
countries, the increasing correlation across markets suggests that country risk cannot be entirely
diversified away. To estimate the country risk premium, we consider three measures: the default spread
on a government bond issued by that country, a premium obtained by scaling up the equity risk
premium in the United States by the volatility of the country equity market relative to the US equity
market and a melded premium where the default spread on the country bond is adjusted for the higher
volatility of the equity market. We also estimated an implied equity premium from stock prices and
expected cashflows. The second question relates to how this country risk premium should be reflected
in the costs of equities of individual companies in that country. While the standard approaches add the
country risk premium as a constant to the cost of equity of every company in that market, we argue for
a more nuanced approach where a company’s exposure to country risk is measured with a lambda. This
lambda can be estimated either by looking at how much of a company’s revenues or earnings come
from the country – the greater the percentage, the greater the lambda – or by regressing a company’s
stock returns against country bond returns – the greater the sensitivity the higher the lambda. If we
accept this view of the world, the costs of equity for multinationals that have significant operations in
emerging markets will have to be adjusted to reflect their exposure to risk in these markets.