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Question: Your direct manager has asked you to explain why the cost of debt is different from the cost of equity and to differentiate between the real risk-free rate and the nominal risk-free rate of interest.

22 Oct 2022,9:56 PM

 

Your direct manager has asked you to explain why the cost of debt is different from the cost of equity and to differentiate between the real risk-free rate and the nominal risk-free rate of interest. Describe which interest rate is used to assign value to an asset.

Expert answer

 

The cost of debt is the effective rate that a company pays on its outstanding debt, including interest, fees, and other charges. The cost of equity is the return that shareholders expect to earn on their investment in a company.

 

The real risk-free rate of interest is the interest rate on a loan that is not subject to default risk. The nominal risk-free rate of interest is the interest rate on a loan that includes a premium for default risk.

 

The real risk-free rate of interest is used to assign value to an asset because it represents the true cost of borrowing money. The nominal risk-free rate of interest includes a premium for default risk, which means that it overstates the true cost of borrowing money. As a result, using the nominal risk-free rate of interest to assign value to an asset would lead to an overestimation of the asset's value.

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