What are the new considerations for cost of capital determinations, given the recent S&P downgrade of U.S. debt? Should analysts add a default premium—or even a “country risk” premium?” Four Houlihan Lokey professionals (Cindy Ma, Terence Tchen, Tim Smith and Andrew MacNamara) provide some current options in their new article, “The ‘risky’ risk rate: does the downgrade of US sovereign debt change commonly-used valuation principles?” published in Financier Worldwide (subscription required):
One alternative risk-free asset is the ‘AAA’-rated (or equivalent) sovereign debt of other countries.
Another alternative might be to use ‘AAA’-rated U.S. corporate bonds as risk-free proxies.
Perhaps analysts might derive a risk-free rate by removing the portion of yield attributable to credit risk from U.S. Treasury yields; or,
They could remove credit risk from U.S. Treasury yields by estimating the additional required rate of return for a non-‘AAA’ rated security compared to an ‘AAA’-rated security.
Each of these scenarios has its problems as well as its merits, the authors caution—warranting a carefully supported analysis of any cost of capital adjustments.