Risk-free vs. risk-adjusted rates: Reconciling FASB requirements

BVWireIssue #52-1
January 3, 2007

In one of our best-attended telephone conferences of 2006 (Discount and Capitalization Rates, Part II), the panelists were presented with the question: “Do you encounter FASB Concept Statement No. 7 in your work and how do you reconcile it?” 

That is, FASB Statement 7 (Using Cash Flow Information and Present Value in Accounting Measurements) indicates using a risk-free (or close to risk-free) discount rate for discounting a stream of cash flows calculated using expected value. But, the questioner adds, “I thought that using a risk-adjusted discount rate, such as calculated from the Duff & Phelps [study] was the proper level?”

Jim Alerding responds, “If you look at Statement 7 in a vacuum, it’s probably not a very good document, and I’m trying to be kind…It was written by someone with no valuation training.”

Co-panelist Jim Hitchner concurs, describing a presentation he made to the FASB when they were deliberating FSAS 141 and 142. “We did a traditional discounted cash flow using CAPM, and then we said: ‘Here's what it would look like if we used a risk-free rate as the discount rate.’ What we found is that you had to have such a high probability of total loss or a crash or something to make that model fit (what I call) the more traditional model.”

For a transcript and/or CD of the “Discount and Cap Rates” telephone conference, which included in-depth discussions of all your most frequently asked questions, click here.

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