Final answer:
The appropriate risk-free rate for calculating a firm's cost of equity is typically the long-term Treasury rate. It is chosen because it matches the duration of expected cash flows from the firm's equity similar to that of long-term Treasury securities.
Step-by-step explanation:
The appropriate risk-free rate to use when calculating the cost of equity for a firm is typically the rate on long-term Treasury securities. This is because the cash flows that a firm's equity generates are expected to be received over a long period, just like the paybacks of long-term Treasury securities. Short-term rates, like those on Treasury bills, are more reflective of short-term borrowing and are less appropriate for this purpose.
Furthermore, Treasuries are considered risk-free because they are backed by the full faith and credit of the U.S. government, making them an ideal benchmark for gauging the cost of equity capital which is the return required by an investor to compensate for the risks of holding a company's equity. In practice, the duration of the Treasury security chosen should match the expected duration of the investment's cash flows. Hence, for most equity investments, the long-term Treasury rate is considered the appropriate risk-free rate.