‘The “Normalized” Risk-Free Rate: Fiction or Science Fiction?’

BVWireIssue #217-3
October 21, 2020

cost of capital
cost of capital, discount rate, private company valuation, risk analysis, cost of equity

That’s the title of a new paper from Pablo Fernandez, a professor in the department of financial management at the University of Navarra—IESE Business School in Spain. The concept of normalizing the risk-free rate emerged around the time of the 2008 financial crisis and is a rate that should exist in a world that certain analysts and consultants call “normal,” but “it is not the world in which we live,” writes Fernandez. For example, he points out that no one can invest in any financial instrument and earn the normalized risk-free rate with little or no risk. The paper shows other inconsistencies in the use of a normalized risk-free rate that results in “important valuation errors.” Fernandez also includes a case study of a hypothetical consulting firm advising a client to use a normalized rate with some interesting comments from his MBA students that back up the notion that such a rate is an “unacceptable invention.” You can download his new paper if you click here.

As with many aspects of business valuation, there are different camps of thought—some analysts use a normalized rate and others do not. In a BVWire survey from last year, two-thirds of respondents said they use the spot yield on Treasury bonds. Most (58%) use the 20-year spot yield, and the rest (9%) use the 10-year spot yield. A quarter of respondents use a normalized rate, and the remainder use something different (e.g., a 30-year spot yield) or a custom rate. Most respondents who use the spot yields said they get their information right from the U.S. Treasury website.

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