Risk Premium Assumption Projection Calculation

In terms of financing a project through debt, risk premium refers to the difference between the risk-free rate and the rate that you are charged to borrow money.

Risk-Free Rate

• The risk-free rate is generally the rate at which the American government can borrow. Currently in America, the risk-free rate for borrowing over a 10-year term is 2.62 percent. Theoretically, this is the lowest rate at which anyone can expect to borrow money.

Risk Premium

• The risk premium is based on how risky the individual or company who is borrowing money is perceived to be. It is a combination of credit risk, market risk, inflation risk, operational risk and liquidity risk.

Calculating the Risk Premium

• The most simple way to calculate the risk premium is to take the interest rate at which you are borrowing money and subtract the risk-free rate from this rate. It is important to match the time horizon that you are borrowing for with the time horizon of the government note you are using as the risk-free rate. The difference between the two rates is the risk premium that you are being charged.