Risk and the Cost of Capital

Risk and the Cost of Capital

Risk is defined as a loss or negative return expected by the investors and is an occurrence that is caused by being vulnerable. Financial risk is a lower than expected return on an investment (business, n. d.), and is viewed in terms of the variance in the actual returns around the expected return.   In figuring out the risk factor, investors use the real risk-free interest rate and the nominal risk-free interest rate.   The real risk-free interest rate is the return required on a zero-risk interest with no inflation and is a theoretical concept.   This forms the basis of all expected returns and observed interest rates in the economy (Springer, n.d.). The real risk-free rate is not static but changes over time depending on the economic conditions. The precise measurement of the real risk-free rate is difficult for most experts to measure, but think that the rate has fluctuated in the range of 1% to 5% in recent years (Brigham & Houston, 2012, p. 190).   Over time, the real risk-free interest rate in a country is approximately equal to the economy’s long-run growth rate (Springer, n.d.).   The nominal risk-free interest rate is the interest rate before taking inflation into account and is quoted in loans and deposit agreements. This is the way that investors try to protect themselves from a loss of purchasing power (Springer n.d.). The nominal risk-free rate depends upon the real risk-free rate and the expected inflation rate. This is the interest rate that you are quoted (Adkins, n.d.). The nominal risk-free rate includes and inflation premium equal to the average expected inflation rate over the remaining life of the assets (Brigham & Houston, 2012, pp.190-191).   The relationship between the real risk-free interest rate and the nominal risk-free interest rate need to be understood so that the investor is able to assess the investment potential of the asset. In investments, the investors who buy the assets, have returns that they...