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why the adjusted risk free rate is used??
user-21492 - 01/13/2020, 5:39 pm

Why is the adjusted risk free rate used??

user-37188 - 08/2/2020, 8:14 pm

Ames, Inc. has an expected 81M payment in 20 years. IF Ames had an investment that payed 8%, Ames only needs to set aside 21.87M today to cover expected 81M payment in 20 years.

Credit adjusted risk free interest rate in this question is the minimum expected return of the power plant that justifies power plants existence.

So it is reasonable for Ames management to expect a 21.87M set aside and invest in the power plant to grow into 81M in 20 years.

Of course management can instead set aside and invest 32.4M today in government securities that return 5%. Not optimal. Hence 8%.

Leelah-18085 - 06/4/2020, 11:55 am

Because loaning money (Buying Bond) to a company (Ames) is more risky than loaning money (Buying Bond) to the U.S. government.

U.S. government can print money = risk-free interest rate

Companies have to do work to earn money = more (adjusted) risk