Fluctuations in global economic and financial conditions warrant periodic reassessments of the selected equity risk premium (ERP) and accompanying risk-free rate. Based on current market conditions, Duff & Phelps has reaffirmed its U.S. ERP recommendation of 5.5% to be used in conjunction with a normalized risk-free rate. However, based on declining real interest rates and long-term growth estimates for the U.S. economy, D&P is lowering the U.S. normalized risk-free rate from 4.0% to 3.5%. This lower rate should be used when developing discount rates as of Nov. 15, 2016, and thereafter, until further guidance is issued, D&P says. Using the lower rate, the “base U.S. cost of equity capital” is 9.0% (5.5% + 3.5%).
A normalized risk-free rate is based upon a long-term average rate, and it is used when it is believed that the risk-free rate is abnormally low. This is an “ex post” approach (historical information) and D&P explains the rationale for using normalized risk-free rates in its 2017 Valuation Handbook - U.S. Guide to Cost of Capital. On the other hand, some experts are proponents of an “ex ante” approach, which uses forward-looking estimates that are extracted by examining stock prices today and expected cash flows in the future.
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