Let us imagine a hypothetical company. "Company" makes candy bars. Or guns. Or butter. It does not matter. What does matter is that they cannot do so profitably. So, eventually, they file for reorganization under bankruptcy law.
Along comes a person who loaned Company money. "Creditor" wants their money. Company wants to pay them, but proposes that they do that over time. Sensing that something is better than nothing, Creditor says OK, but you have to pay me interest.
Company agrees in principle that Creditor is due interest. Trouble is, Company wants to use the risk-free rate of return as their interest rate.
What is the risk-free rate of return?
Let's begin by stating that interest is proportionate to risk, and we establish that the United States Government is the only one getting the risk-free rate of return. After all, if interest is a measure of risk, is not the "full faith and credit" of the US Govt. about the best bet there is?
All risk is measured relative to the full faith and credit of the US Govt. 3-mo T-bills, for example, may be deemed a "risk-free rate." Anyone who has applied for a mortgage or a car loan understands this next point intuitively. Your credit rating impacts the rate which you can borrow money. The lower your credit score, the riskier a borrower you are. And a higher rate you get from the bank. Make sense? This is "credit risk" or "risk premium". That is, how likely are you to repay your debt? The bank making the loan must be compensated for this risk.
There are other factors (e.g., 30 year notes are higher than 15 year notes due to a concept called "duration; rates vary by country; etc.) but let's keep this blog entry tidy.
What would you say if Company, recently reorganized in bankruptcy court, came to you and said, "Hey, loan me money. Yes, I know had some hard times, but things are looking up...blah blah blah."
Your thought process might go something like, "Hmmm. You just filed for bankruptcy, so you seem pretty risky a place to park my money. I'm going to need a high interest rate to account for this risk..."
The point being: you would not loan money at the risk-free rate. That says that there is NO RISK associated with receiving your payments from the Company. That says that Company is on par with the US Govt in terms of risk. Receiving your payments in full and on time is a LOCK. No sweat, sleep easy. Company would not do something like...go...bankrupt. Ever.
Surely, you see that is bollocks. So, you call up your friendly neighborhood finance wonk, who starts throwing alphabet soup in your math:
r = rf + beta*(market premium)
But the equation is simple and she helps you understand. The interest rate, r, which you would charge is something above the risk-free rate, rf. For purposes of this blog entry, that's all you need to know.
Good people, think of the finest company you can imagine. Take GE. Everyone knows GE. Most everybody loves GE. Big, stable, long-running, profitable. Fine. Even GE, the "best of the best", does NOT get the risk-free rate of return on money it borrows. So, how do you think a company which has filed bankruptcy compares to GE?
Please do not let anyone ever tell you that such a Company gets the risk-free rate. I will cry myself to sleep tonight if you believe that.
(Oh, and lest I be accused of not offering solutions... My proposed solution for anyone trying to establish an appropriate rate for such a company as Company? Look at comparables, see what rate they have borrowed money (comparables analysis). Look at Company's position in the marketplace to get a feel for their competitive advantage, their balance sheet, their processes and products (company analysis). Look at Company's competitors (competitor analysis). And look at Company's industry (industry analysis). Use all of this information to estimate the appropriate rate to lend money to Company.)
