Question

When do we use the Risk free rate instead of the Discount rate

Answer 1

It only makes sense for a company to proceed with a new project if its expected revenues are larger than its expected costs—in other words, it needs to be profitable. The discount rate makes it possible to estimate how much the project's future cash flows would be worth in the present.

An appropriate discount rate can only be determined after the firm has approximated the project's free cash flow. Once the firm has arrived at a free cash flow figure, this can be discounted to determine the net present value (NPV).

Setting the discount rate isn't always straightforward. Even though many companies use WACC as a proxy for the discount rate, other methods are used as well. In situations where the new project is considerably more or less risky than the company's normal operation, it may be best to add in a risk premium in case the cost of capital is undervalued or the project does not generate as much cash flow as expected.

Adding a risk premium to the cost of capital and using the sum as the discount rate takes into consideration the risk of investing. For this reason, the discount rate is usually always higher than the cost of capital.

Hence, we can use Risk free rate instead of the Discount rate only when there is no risk involved in the project. In other words, the risk premium of the project is zero and the beta is equal to one (simultaneously).