The Death of the Risk-Free Rate?

The risk-free rate is at the core of much that concerns the profession of business valuation. It is one of the variables in the Capital Asset Pricing Model (“CAPM”), the finance model that revolutionized the calculation of the required return on equity, a key component of the weighted average cost of capital. The CAPM has been one of academic finance’s great success stories, travelling from academic papers to near universal use in business, and earning a Nobel Prize in Economics for William Sharpe in the process. 

In the hands of business valuation practitioners, the CAPM morphed into the Build-Up Model, which is essentially the CAPM with the beta set equal to one. This model is popular in situations where a privately-held company does not have good publicly-traded comparable companies from which a beta could be calculated. 
 
The beauty of any good model is its explanatory power. A good model cuts like Occam’s razor, simplifying down to the essence of the issue (which is something that judge’s appreciate from testifying BV experts). Before the arrival of the CAPM and the Build-Up Model, valuation experts had to determine the cost of equity more qualitatively, based on their experience and the business’ characteristics.  In a litigation setting, one BV expert might say that the cost of equity should be 18%, while another might say it should be 25%, resulting in a huge difference in value. This made life difficult for judges, who had no financial training to decide who was right. 
 
The advent of the CAPM and Build-Up Models allowed a BV expert to explain how she came up with her cost of equity, by working from the foundation of the risk free rate (usually a long-term US Treasury Bond rate), adding the stock market risk premium (from sources such as Ibbotson or Duff & Phelps) and making adjustments for industry (beta or industry risk factors), size (also from Ibbotson or Duff & Phelps) and specific risk. The models essentially narrowed the playing field, as a judge had hard data to rely on for a large component of the cost of equity (the company-specific risk being the major exception). Judges could understand the progression of risk factors, and another valuation expert could reproduce most of the cost of equity with little variance.
 
As mentioned, these models were built on the foundation of the risk-free rate. A good, solid foundation, since the 20 year U.S. Treasury bond carried the full faith and credit of the United States of America, and more important a Triple A rating from Moody’s and Standard & Poor’s. Nothing could be more rock solid than bonds from the sole remaining global superpower, right? Well, maybe not. Moody’s Investor Services has already downgraded the USA within the Triple A category. Germany, France and Canada are classified as “resistant” Triple A, which means they are on a path to stay Triple A. The USA and UK are classified “resilient” Triple A, which means that their current recessions and exploding debts are stress testing their credit worthiness, but Moody’s believes there is still the capability to recover. Countries such as Ireland are considered “vulnerable”, which means they are on the path to a downgrade unless major changes occur. Spain has already been downgraded by Standard and Poor’s to AA+.
 
So what would be the effect on the BV profession if the USA’s debt were downgraded to Double A? First, the selection of a risk-free rate becomes more complicated, as Treasury bonds would now carry credit risk. Second, the equity risk premium time series calculated by Ibbotson and Duff & Phelps would have to be adjusted, as just calculating the premium over a 20 year Treasury might understate the performance of equities relative to bonds carrying a credit risk premium. So the entire cost of equity universe would be shaken. Not to mention the option pricing models, which also use risk-free rates to calculate option values. A downgrade would be an event for the BV profession, requiring a rethink of equity risk.
 
That said, the USA has an advantage that many countries lack, its debt is denominated in its own currency. As long as the dollar printing presses continue to run, a true default is not in the cards. Back during my B-school days, the question came up in finance class whether the Treasury rate was truly risk-free. Moody’s has formally stated that Triple A is not risk free. I like my professor’s answer better. He said it is not totally risk-free, but if the government defaults,  you are going to have bigger problems to worry about than not getting an interest payment.
 
Next column we will wade into the controversy over the Butler Pinkerton model.  See you then.

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Raymond J. ("RJ") Dragon MBA, MS, ASA, CFFA is a Principal in Citrin Cooperman's Valuation & Forensic Services practice in the New Jersey / New York City area.  His work encompasses valuations for litigation support, marital dissolution, shareholder disputes, estate and gift tax, intangible asset valuation, purchase price allocation and financial reporting.

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