The “risk-free rate” can be estimated by reference to U.S. government securities, loans investors make to the U.S. Treasury.
The U.S. Treasury is seen as the purest credit risk in the world, committed to paying its debts when due without fail. Hence, yields on U.S. Treasury debt are considered the benchmark for valuing all other assets, including corporate debt and equities.
Corporate debt bears greater risk than U.S. Treasury debt. In corporate bankruptcy, debt is paid before common stock, so the common stock of a company carrying debt bears a greater risk than that debt.
Selecting a risk-free rate requires judgment based on various factors. Such factors include:
- bond maturity,
- reference date or time frame, and
- reference source.
Other customs include using 30-year bonds to reflect the long-term character of the investment in a corporation.
When valuing a business as a going concern, following the daily, weekly, or monthly movements in the U.S. Treasury market introduces distorting valuation volatility into the exercise. Business value does not move in tandem with daily or even monthly fluctuations in Treasury rates. Avoiding the sensitivity to short-term fluctuations in treasury rates can be done by averaging rates over the preceding year or so.
To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset. For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC).
Also read:
No comments:
Post a Comment