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Kroll Cost of Capital Summary - March 2025 Update

Core Content Overview

Kroll provides updated cost of capital recommendations, particularly focusing on the equity risk premium (ERP) and risk-free rates, for the U.S., Eurozone, and U.K. These recommendations are essential for calculating the cost of equity capital in models like CAPM and are subject to quarterly updates based on global economic and financial conditions. The report highlights potential upcoming changes in ERP due to various uncertainties and risks.

Key ERP and Risk-Free Rate Recommendations

United States

• Recommended ERP: 5.0% as of February 28, 2025.
• Risk-Free Rate: The higher of a normalized rate of 3.5% or the spot 20-year U.S. Treasury yield.
• Last Change: Lowered from 5.5% to 5.0% on June 5, 2024.
• Potential Increase: Possible increase in ERP due to trade policy uncertainty, fiscal policies, and geopolitical risks.

Eurozone (From a German Investor Perspective)

• Recommended ERP: 5.5% to 6.0%, with a preference for 5.5% when developing EUR-denominated discount rates.
• Risk-Free Rate: The higher of a normalized rate of 2.5% or the spot 15-year German government bond yield.
• Last Change: Reaffirmed at 5.5% as of February 5, 2024.

United Kingdom

• ERP Status: No official recommendation is currently published, though historical data is available.
• Inflation Trends: Inflation has decreased from a peak but remains above target, with a recent increase to 3.0% in January 2025.
• Interest Rates: The Bank of England has cut rates from 5.25% to 4.5% by February 2025, but further cuts are expected to be cautious.

Major Potential Sources of Uncertainty

1. U.S. Trade Policy Uncertainty

• President Trump has threatened high tariffs on U.S. trading partners, including the EU.
• Tariffs could disrupt global trade, lead to retaliation, and potentially cause stagflation or recession.
• The uncertainty is affecting M&A and capital expenditure plans, increasing market volatility.
• The Fed may be forced to maintain higher interest rates due to inflationary pressures.

2. Fiscal Policy and Budget Deficits

• Extension of the Tax Cut and Job Act (TCJA) could increase the U.S. budget deficit by up to $5.1 trillion over 10 years.
• The GAO warns that current fiscal policies are unsustainable, with public debt projected to reach 106% of GDP in 2027.
• The administration is pursuing pro-growth policies, but restrictive immigration policies may hinder labor force growth and economic activity.

3. Geopolitical Risks

• Shifts in U.S. foreign policy, including potential withdrawal from NATO and reduced support for Ukraine, are increasing geopolitical risks.
• These actions are causing European governments to rearm and increase defense spending.
• Escalation of conflicts in the Middle East and potential U.S. annexation of Greenland or Canada are also sources of concern.

Economic and Market Indicators

U.S. Economy

• Resilient growth with real GDP of 2.8% in 2024.
• Inflation has decreased from 9.1% in 2022 to 2.9% in December 2024, but recent signs indicate a potential resurgence.
• The VIX index has risen to levels near its long-term average, indicating growing market uncertainty.
• Credit spreads have been historically low, suggesting investor confidence in economic stability.

Eurozone Economy

• Real GDP growth in 2024 was 0.9%, with Germany contracting in both 2023 and 2024.
• The ECB has cut rates significantly, but inflation remains a concern.
• The "ReArm Europe" plan aims to boost defense spending and reduce reliance on U.S. support.

U.K. Economy

• Experienced a technical recession in 2023 and lagged behind other G7 countries post-Russia-Ukraine war.
• Inflation has fluctuated but remains above target, with recent increases to 3.0%.
• The Bank of England has started a rate-cutting cycle, but it is expected to be more cautious compared to the ECB.
• The FTSE-100 has performed well in 2024, while the FTSE-250 has struggled.

Recommendations for Valuation Professionals

• Use Moving Averages: Given the volatility in spot yields, valuation professionals are advised to consider using moving averages (e.g., weekly or monthly) of government bond yields to stabilize their analyses.
• Monitor Uncertainty: The combination of trade policy, fiscal policy, and geopolitical risks could lead to a "risk-off" sentiment and higher ERPs in certain regions.
• Regional Variability: ERP recommendations may vary by region, with the U.S. and Eurozone being more affected than the U.K. due to their exposure to global uncertainties.

Conclusion

Kroll remains cautious about potential changes in ERP recommendations, especially in the U.S. and Eurozone, due to the increasing uncertainties in trade, fiscal, and geopolitical environments. The U.K. remains a unique case with no official ERP recommendation but continues to face its own set of challenges. Valuation professionals are advised to stay informed and consider the evolving landscape when making financial decisions.