Risk-Free Rate +100bp: What Moves in Your Valuation and by How Much

"What happens if the risk-free rate goes up 100 basis points?" sounds like a one-line question. In an interview, it's a test of whether you can trace one input through an entire valuation and put numbers on it.

The short answer: cost of equity rises about 100bp, cost of debt rises up to 100bp pre-tax, WACC rises somewhat less than 100bp, and valuation falls, often by double digits for long-duration assets. Below, we walk through each step with a worked example, so you can answer quickly and confidently.

Why This Question Comes Up So Often

The risk-free rate sits at the base of almost every discount rate. Change it, and you touch:

• Cost of equity (through CAPM)
• Cost of debt (through the base rate under the credit spread)
• WACC, and therefore DCF value
• Bond prices, LBO interest costs and trading multiples

Interviewers like it because a strong answer shows you understand how the pieces connect, not just the formulas in isolation.

Step 1: Cost of Equity Rises by About 100bp

CAPM says:

Cost of equity = Risk-free rate + Beta × Equity risk premium

The risk-free rate is added on its own, not multiplied by beta. So if beta and the equity risk premium stay the same, cost of equity rises by exactly 100bp, whatever the beta.

Quick example:

• Risk-free rate: 4.0%
• Beta: 1.2
• Equity risk premium: 5.5%
• Cost of equity = 4.0% + 1.2 × 5.5% = 10.6%

Now bump the risk-free rate to 5.0%:

• Cost of equity = 5.0% + 6.6% = 11.6%

Up 100bp. A beta of 0.8 or 1.8 would give the same 100bp increase.

A common trap

Some candidates say "a high-beta stock's cost of equity rises more." Not in CAPM. Beta scales the premium, not the risk-free rate. Say this clearly and you'll stand out.

Step 2: Cost of Debt Rises, but Tax Softens the Blow

A company's pre-tax cost of debt is roughly the base rate plus a credit spread. If the spread doesn't change, pre-tax cost of debt also rises 100bp.

Continuing the example:

• Pre-tax cost of debt: 6.0% (4.0% base + 2.0% spread)
• Tax rate: 25%
• After-tax cost of debt = 6.0% × (1 − 25%) = 4.5%

After the shock:

• Pre-tax cost of debt: 7.0%
• After-tax cost of debt = 7.0% × 0.75 = 5.25%

So after-tax cost of debt rises only 75bp, because interest is tax-deductible.

"If the spread doesn't change" matters

In real life, spreads can move too. Higher rates can squeeze a weak borrower's interest coverage, which may widen its spread. Mentioning this shows you're thinking beyond the textbook.

Step 3: WACC Rises by Less Than 100bp

WACC blends the two costs by capital structure. Assume 70% equity, 30% debt.

Before:

• Equity: 70% × 10.6% = 7.42%
• Debt: 30% × 4.5% = 1.35%
• WACC = 8.77%

After:

• Equity: 70% × 11.6% = 8.12%
• Debt: 30% × 5.25% = 1.575%
• WACC = 9.695%, call it 9.70%

WACC rises by about 92.5bp. Here's the shortcut to remember:

ΔWACC ≈ 100bp × [E/V + D/V × (1 − t)]

= 100bp × [0.70 + 0.30 × 0.75] = 100bp × 0.925 = 92.5bp

The more debt in the capital structure, the smaller the WACC increase, thanks to the tax shield. An all-equity company sees the full 100bp.

Step 4: DCF Value Falls, Often a Lot

This is where small changes in the discount rate turn into big changes in value.

Take a mature company and value it as a growing perpetuity:

• Next year's unlevered free cash flow: $100m
• Long-term growth rate: 2.5%

Before: EV = 100 / (8.77% − 2.5%) = 100 / 6.27% ≈ $1,595m

After: EV = 100 / (9.70% − 2.5%) = 100 / 7.195% ≈ $1,390m

That's a drop of about 12.9% from a rate move of under 1 percentage point.

Why the impact is so large

The denominator (WACC − g) was only 6.27%. Adding 0.925% to it is a ~15% increase in the denominator, so value falls sharply. The smaller the spread between WACC and growth, the more sensitive the value.

That's also why the terminal value, which often makes up the majority of a DCF, does most of the damage.

What does NOT move in a standard DCF

• Unlevered free cash flow. It's calculated before interest, so a rate change doesn't touch it directly.
• Beta and the equity risk premium, unless you choose to change them.

Interviewers love candidates who say what stays fixed, not just what moves.

The growth rate caveat

If rates rose because of higher expected inflation, nominal growth expectations might rise too. If your terminal growth rate goes up alongside WACC, the value hit is smaller. A strong answer flags this assumption.

Step 5: Bonds Lose Value, Measured by Duration

For fixed-rate bonds, the rule of thumb is:

% price change ≈ − Modified duration × Change in yield

Take a 10-year bond with a 4% annual coupon, priced at par (yield 4%). Its modified duration is about 8.1.

• Duration estimate: −8.1 × 1.00% ≈ −8.1%
• Actual repricing at a 5% yield: price falls from 100 to about 92.28, or −7.7%

The actual drop is smaller than the estimate because of convexity: bond prices fall less than duration predicts when yields rise. Longer maturities and lower coupons mean higher duration and bigger losses.

Step 6: LBOs Feel It Through Interest Costs

Leveraged buyouts usually rely heavily on floating-rate debt, priced as a base rate plus a spread. A 100bp rise in the base rate flows straight into interest expense.

Example:

• EBITDA: $100m
• Debt: 5.0x EBITDA = $500m
• All-in rate: 8% → interest of $40m

After +100bp:

• All-in rate: 9% → interest of $45m
• After tax at 25%, that's about $3.75m less cash each year
• Interest coverage (EBITDA / interest) falls from 2.5x to about 2.2x

The knock-on effects:

• Less cash to pay down debt, so less deleveraging over the hold period
• Lower returns (IRR and money multiple) for the sponsor, all else equal
• Lower debt capacity, since lenders cap leverage based on coverage, which means more equity is needed or a lower purchase price

This is a big reason buyout activity tends to slow when rates climb.

Step 7: Trading Multiples Tend to Compress

Higher discount rates mean future cash flows are worth less today, so investors pay lower multiples for the same earnings.

The effect isn't uniform:

• Long-duration equities (high-growth companies whose cash flows sit far in the future) get hit hardest, for the same reason long bonds do.
• Mature, cash-generative businesses with near-term cash flows are less sensitive.
• Some sectors can benefit. Banks, for example, may earn more on their assets when rates rise, depending on how their deposits and loans reprice.

Don't give a precise multiple change here unless you've calculated it. Explaining the direction and why is what the interviewer is looking for.

A Bonus Point for Strong Candidates

In practice, the risk-free rate and the equity risk premium aren't fully independent. Some practitioners argue that when rates rise, the implied equity risk premium can shrink, partially offsetting the increase in cost of equity.

You don't need to go deep. A single sentence like "this assumes the equity risk premium stays constant, which may not hold in reality" signals real judgment.

How to Answer in an Interview (30-Second Version)

Here's a structure you can adapt:

1. Cost of equity: "In CAPM, cost of equity rises by the full 100bp regardless of beta, assuming the equity risk premium doesn't change."
2. Cost of debt: "Pre-tax cost of debt rises about 100bp if spreads hold, so after-tax it rises 100bp times one minus the tax rate."
3. WACC: "WACC rises by less than 100bp, roughly the equity weight plus the debt weight times one minus tax."
4. Valuation: "Free cash flows don't change, but the higher discount rate lowers DCF value, and the terminal value makes the impact significant, often 10% or more for a mature business."
5. Caveats: "If the move reflects higher inflation, terminal growth could rise too, and credit spreads might widen for weaker borrowers."

Key Takeaways

• Cost of equity: +100bp, independent of beta
• After-tax cost of debt: +100bp × (1 − t), so +75bp at a 25% tax rate
• WACC: rises by 100bp × [E/V + D/V × (1 − t)], less than 100bp for any levered company
• DCF value: falls, with sensitivity driven by how small WACC − g is
• Bonds: fall by roughly modified duration × 1%, slightly less due to convexity
• LBOs: higher interest, weaker coverage, lower returns and less debt capacity

Practice running these numbers once on paper. When the question comes up, you'll be able to walk through the whole chain in under a minute, and that's exactly what turns a decent answer into a memorable one.