Strategic Corporate Finance: Applications in Valuation and Capital Structure

THE “RISKLESS RATE”

With the 10-year Treasury at abnormally low levels, we typically normalize the riskless rate. Ten-year Treasuries are near historic lows below 5 percent (and 30-year Treasuries near 5 percent); the 10-year historical average is closer about 5.5 percent. Though many companies use a trailing average to normalize the riskless rate for policy purposes, this will have the perverse effect of continuing lower even as spot rates climb and the forward curve steepens.

The forward curve for 10-year Treasuries is a market-derived estimate for the riskless rate. It tends to asymptote in the 5 percent range. The forward curve is less sensitive to the choice of historical averaging period and provides a stable and objective benchmark for a normalized riskless rate.

In practice, investors use any number of government bond rates as a proxy for the risk-free rate, each with its own strengths and weaknesses.8 Those who use T-bill rates argue that the shorter duration and lower correlation of the T-bill with the stock market make it truly riskless. However, because T-bill rates are more susceptible to supply/demand swings, central bank intervention, and yield curve inversions, T-bills provide a less reliable estimate of long-term inflation expectations and do not reflect the return required for holding a long-term asset.

For valuation, long-term forecasts, and capital budgeting decisions, the most appropriate risk-free rate is derived from longer-term government bonds. They capture ...