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Kroll Lowers Its Recommended U.S. Equity Risk
Premium to 5.5%
Executive Summary
Kroll regularly reviews fluctuations in global economic and financial market conditions that may warrantchanges to our equity risk premium (ERP) and accompanying risk-free rate recommendations. The riskfree rate and ERP are key inputs used to calculate the cost of equity capital in the context of the Capital
Asset Pricing Model (CAPM) and other models used to develop discount rates. We also update country
risk data on a quarterly basis for 175+ countries using various models.
The Kroll Recommended U.S. ERP is decreasing from 6.0% to 5.5% when developing USD-denominateddiscount rates as of June 8, 2023 and thereafter, until further notice. The Kroll Recommended Eurozone
ERP is being reaffirmed in the range of 5.5% to 6.0% until further notice.

Background
According to our last update “Impact of High Inflation and Market Volatility on Cost of Capital
Assumptions” (dated October 18, 2022), the Kroll Recommended U.S. ERP was increased to 6.0% (from5.5%) when developing USD-denominated discount rates as of October 18, 2022 and thereafter, until
further guidance was issued.
In March 2023, we reaffirmed our 6.0% U.S. ERP guidance, largely due to the emerging banking crisis that
led to a number of banks declaring bankruptcy or being bailed out (through acquisitions).
More recently, we observed that the factors we monitor suggested (on the whole) that equity risks had
diminished relative to our previous March 2023 analysis, but the stalemate in the U.S. debt ceilingnegotiations was the factor preventing us from lowering the recommendation to 5.5%. In early May, U.S.
Treasury Secretary Janet Yellen warned that the country could breach the debt ceiling as early as June 1(later changed to June 5), which could have led to the first-ever debt default by the United States.
The stalemate over the debt ceiling has been resolved with the passage of the “Fiscal Responsibility Actof 2023” (signed into law by the U.S. President on June 3). In addition, the factors we normally monitor
continue to suggest that equity risks have diminished relative to when we issued our October 2022
guidance, as well as relative to the turmoil observed during the March 2023 banking crisis:•The Federal Reserve (Fed) hinted at a pause of its recent interest-rate hiking cycle, taking a wait-andsee approach. Although some Fed officials still think that additional rate hikes could be in the cards,
this pause has removed some of the uncertainty from financial markets.

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•At the end of May 2023, the S&P 500 index was up about 17% from its October 12, 2022 local low (inprice terms). The NASDAQ index, a barometer of the tech sector, was up by 27% since its December 28,
2022 local low. The S&P 500 and NASDAQ improvements since the beginning of this year do notcompensate for their overall 2022 losses of 19% and 33%, respectively. However, it does reflect the factthat markets have generally been more optimistic in 2023.

•The VIX (the volatility index on the S&P 500), known informally as the “fear index”, has generally beenaround or below its long-term average of approximately 20 since the beginning of the year (except during
the March banking crisis, when it reached a local high of 26.5 on March 13).

•U.S. corporate credit spreads (i.e., the difference between yields of speculative-grade bonds andinvestment-grade bonds) are still low on a historical basis, even though the underlying corporate yields
have increased significantly since early 2022. Similar to the VIX, corporate credit spreads are generally
considered a barometer of investors’ “fear”.

•Forward-looking ERP models have been lower relative to their September/October 2022 highs when welast increased our U.S. ERP recommendation to 6.0%.

•

While there is a chance the U.S. economy will tip into recession later in 2023 or in early 2024, many
economists do not expect it to be a deep or prolonged one.

•

While the U.S. unemployment rate increased to from 3.4% in April to 3.7% in May, this is still very low byhistorical standards. The labor market is still tight and unemployment rate projections are relatively tamewhen compared to past recessionary periods.

•Inflation, as measured by the Consumer Price Index (CPI), is still far above the Fed’s 2.0% target, but it
seems to be on a steady downward path. In the 12 months ending in April 2023, CPI inflation (beforeseasonal adjustments) increased 4.9%, down from its 41-year high of 9.1% for the 12 month-period
ending June 2022. Nevertheless, risks do remain. The Fed’s preferred gauge for inflation, the PersonalConsumer Expenditures (PCE) Price Index has actually accelerated in April to 4.4%. Likewise, the core PCEindex (i.e., excluding food and energy) accelerated to 4.7% in April, demonstrating the challenge the Fed
is facing in bringing down inflation.

•For now, the world economy appears to have avoided the worst-case scenarios from the Russia-Ukrainewar.
Meanwhile, a period of “stagflation”—where the economy experiences sluggish or no growth—accompanied by high inflation is still a realistic scenario for some economies within the eurozone. For
example, according to recent data, Germany—Europe’s largest economy—entered a technical recession in
Q1 2023, after two consecutive quarters of negative real economic growth. There was some optimism inearly 2023 that a contraction could be avoided, as an unseasonably warm winter in Europe contributed tolower energy prices. However, high prices continued to erode German consumer purchasing power.

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Inflation in Germany remained at an elevated level of 6.3% (estimated) in May and is expected to remain akey challenge for the rest of the year.
In the broader eurozone, inflation has been slowly coming down from 25-year highs, standing at an
estimated 6.1% at the end of May. However, core inflation (excluding volatile energy and food prices)
remained stubbornly high at an estimated 5.3%, and far from the European Central Bank’s (ECB) 2.0%
inflation target. The ECB slowed down the pace of interest rate hikes at its May 2023 meeting, but signaled
more tightening is still coming. The revision in Germany’s real GDP growth for Q1 2023 helped tip theeurozone economy into a technical recession, after also having contracted in Q4 2022. This will make
ECB’s job in 2023 even more challenging.

Cost of Capital Recommendations•United States: With the aforementioned factors suggesting that equity risks in the U.S. havediminished, and the immediate risks associated with the debt ceiling debate resolved with the passageof the “Fiscal Responsibility Act of 2023”, Kroll is lowering its Recommended U.S. ERP from 6.0% to5.5% when developing USD-denominated discount rates as of June 8, 2023 and thereafter, until
further notice. This is matched with the higher of a normalized risk-free rate of 3.5% or the spot 20year U.S. Treasury yield as of the valuation date.

•Eurozone (from a German investor perspective): The current Kroll Recommended Eurozone ERP
remains in the range of 5.5% to 6.0%. Based on current economic and financial market conditions, wecontinue to believe that an ERP towards the higher end of the range (i.e., 6.0%), used in conjunction
with a German normalized risk-free rate of 3.0%, is more appropriate when developing EURdenominated discount rates as of June 8, 2023 and thereafter, until further guidance is issued.
Incremental country risk adjustments for other eurozone countries with a sovereign debt rating below
AAA may be appropriate. Please note that this information does not supersede Germany’s IDW(Institut der Wirtschaftsprüfer) guidance for projects that will be reviewed by German auditors orregulators.
However, we are monitoring markets and the geo-political and economic environment closely todetermine whether indications point to an ERP closer to the lower end of our recommended range.

We will continue to closely monitor the situation and publish new guidance when appropriate.
Please contact our support team with any questions: costofcapital.support@kroll.com

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