Cathie Cameron
Cathie Cameron

Risk-Free or Not Risk-Free, That Is the Question

How does S&P's downgrade of long-term U.S. securities affect CPAs' methodology in calculating discount rates?

November 3, 2011
by Cathie Cameron CPA, ABV

Forensic accountants and business appraisers routinely discount future earnings at the weighted average cost of capital (WACC). WACC’s cost of equity component is usually calculated using the capital asset pricing model (CAPM) or the build-up method, both of which add premiums to a risk-free rate of return. Traditionally U.S. treasury rates have been used as proxies for a risk-free rate of return. That said, how does Standard & Poor’s (S&P) downgrading of the U.S. long-term sovereign credit rating from AAA to AA+ affect analyses performed?

Economists and research professionals alike have discussed the economic theory on this point at length in academia. Many will point out that no investment is truly risk-free, but rather wonder whether this downgrade means that long-term U.S. Treasuries have now become so risky that their returns can no longer be used as proxies for risk-free rates. They consider whether AAA rated U.S. corporate bond rates should be used instead of U.S. treasury securities. Usually they discount this notion because S&P’s short-term rate for U.S. Treasuries was not downgraded and corporate bonds generally have relatively shorter maturity rates than U.S. long-term debt. They also mull over whether AAA-rated foreign sovereign long-term debt rates should be used instead of U.S. Treasury securities. Again they discount the notion because of the added currency exchange rate risk . . . and the debate continues (see “The ‘Risky’ Risk-Free Rate: Does the Downgrade of U.S. Sovereign Debt Change Commonly-Used Valuation Approaches?” by Dr. Cindy Ma and Dr. Terence Tchen of Houlihan Lokey published in Financier Worldwide 2011).

While researchers have the time and resources to debate the theoretical implications of S&P’s downgrade, CPAs are not so blessed and are more concerned with how our everyday damage analyses and business valuations are affected by the downgrade. Should we adjust the risk-free rate we use and if so, how?

In practice, most CPAs rely on the annual publications of Ibbotson Associates (Ibbotson) and Duff & Phelps as the source for premium data. In particular, we use the equity risk premium data that they publish annually. Although individuals, including some highly esteemed individuals such as Dr. Aswath Damodaran, professor of finance at the Stern School of Business at New York University are great sources and calculate monthly equity risk premiums, we CPAs usually rely on the Ibbotson and Duff & Phelps rates that are published annually. That being the case, the equity risk premium rates that we are using to calculate discount rates during 2011 are based on data published many months before any downgrade (although some researchers anticipated the possibility of default in 2010 — see “Into the Abyss: What If Nothing Is Risk Free?” by Dr. Damodaran dated July 2010).


According to the 2011 Ibbotson SBBI Valuation Yearbook and Duff & Phelps Risk Premium Report 2011, equity risk premiums are based on the long-term return on equities less the return on long-term U.S. Treasuries. If we replaced the U.S. Treasury rates in our calculations by what we consider to be a better proxy for a risk-free rate, the equity risk premium would also require recalculation. This is because the revised basis for the risk-free rate of return may result in a different long-term equity premium over this substitute risk-free rate. Furthermore, as the equity risk premium calculated by Ibbotson and Duff & Phelps is based on data from 1926, it includes previous periods of volatility and should not be adjusted for another blip. For these reasons, CPA practitioners can sleep easy using the rates of long-term treasury securities and the equity risk premiums issued by Ibbotson and Duff & Phelps as a reliable source of data in their discount rate calculations.

However, S&P in their Special Report on the US Rating Downgrade and its Global Effects (published on August 17, 2011) has stated that it could lower the long-term U.S. Treasury rating to AA within the next two years under certain circumstances. S&P also stated that even without an additional downgrade, it does not anticipate returning the long-term U.S. Treasury rating to AAA very quickly. I am sure that the researchers at Ibbotson and Duff & Phelps are considering the implications of a prolonged downgrade on the data they publish annually, and it is interesting to consider what effect, if any, it will have.


This article has concentrated on one issue: whether S&P’s downgrade of long-term U.S. securities affects how practitioners calculate discount rates. There is another issue that has not been addressed, but is somewhat connected. That is, whether U.S. Treasury rates are artificially low, thus resulting in artificially low discount rates and overvalued companies and cash flows. It is interesting to note that Treasury securities appreciated in value after S&P’s downgrade. However, that is a different debate that I will leave for another time.

When I worked overseas, I used the rates of government securities of the local country as proxies for risk-free rates. Luckily, I workedcountries where the government securities were rated AAA. Spare a thought for practitioners in countries where their government securities are not highly rated and have unique currencies. Practitioners in those countries must have a much more difficult task than ours.

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Cathie Cameron, CPA, CA, CMA, ABV, CFF, is the president of Ness Consulting, LLC, which provides forensic accounting, damages analysis, business valuation and management consulting.