Impact of High Inflation and Market Volatility on Cost of Capital
Assumptions – October 2022 Update
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.
In December 2021, despite some uncertainty regarding the impact of the omicron variant of COVID-19,
the global economy appeared to be on a strong path to recovery, although with some unevenness acrossregions. Major central banks were considering some level of normalization of monetary policy, both byslowing down (or stopping altogether) quantitative easing (QE) measures and by raising policy interest
rates, particularly as inflationary pressures proved to be more than transitory in many countries. OnJanuary 3, 2022, the S&P 500 index achieved a new record high, while two days later the STOXX Europe
600 index reached its own record high. At that time, Kroll began evaluating when and under which
circumstances it might be appropriate to lower our recommended ERPs for the U.S. and the Eurozone.
Starting in mid-January, as inflation continued to surprise with increasingly higher-than-expected readings
reaching levels not seen in 30 to 40 years in some countries, global equity markets became more volatile.
Investors have tried to ascertain the magnitude and speed at which central banks will raise interest rates,
leading to a potential decrease in the value of companies in various industries due to an increase indiscount rates.
Factors such as increased consumer demand for goods and services (driven in part by pent-up demand
and unprecedented levels of monetary and government fiscal stimulus to fight the pandemic), labor
shortages and global supply chain bottlenecks stemming from COVID-19 have all contributed to upward
inflationary pressures. In addition, rising tensions between Russia and Ukraine culminated in Russia’s
invasion of Ukraine on February 24, 2022. The Russia-Ukraine war has now surpassed the 7-month markand has placed further pressure on already-strained global supply chains, contributing to significant
increases in food and certain commodity prices across the world.
Economists have continued to downgrade global real economic growth projections for 2022 and 2023,
with Europe being particularly impacted due to its higher exposure to Russia and Ukraine, and especiallysince it was already suffering from an energy crisis prior to these events. The big question for investors iswhether central banks will manage to control inflation by slowing down economic activity, without creatinga major recession.
This increased level of uncertainty has precipitated a repricing of equity securities in stock markets
around the globe. At the end of September 2022, the S&P 500 index had declined by 25% since thebeginning of the year, while the NASDAQ Composite index had lost 32% (in price terms); both indices are
considered to be in “bear market” territory. The VIX (the volatility index on the S&P 500 index) is now
higher than in December 2020, when Kroll last changed its Recommended U.S. ERP. In the case ofEurope, the VSTOXX (the volatility index on the EURO STOXX 50 index) remains elevated, but it is downfrom the levels observed back in March 2022, immediately after Russia’s invasion of Ukraine. TheSTOXX Europe 600 index has decreased by 20% (in price terms) for year-to-date September 2022.

As major central banks continue to signal rate hikes (the Bank of Japan being an exception), significant
volatility has been observed in government bond yields. This has been exacerbated by the ongoing lackof confidence in the UK’s new government after its September 23, 2022 announcement of significant tax
cuts, to be funded by issuance of new government debt. In the near term, it is possible that even higher
levels of volatility will be observed in spot yields before they stabilize. Notwithstanding the references
below to spot yields as of a given valuation date, if government bonds yields continue to fluctuateconsiderably, valuation professionals may wish to consider using a moving average of spot yields tomitigate the impact of this volatility (e.g., weekly average, monthly average).
More broadly, this heightened uncertainty will have a negative impact on the valuation of investments
globally. The uncertainty generated by these events warrants a reevaluation of cost of capitalassumptions. While the following recommendations are effective as of October 18, 2022, many of theconditions and risk factors supporting the new guidance were already present in late September 2022.
Cost of Capital Recommendations•United States: The Kroll Recommended U.S. ERP is increasing from 5.5% to 6.0% whendeveloping USD-denominated discount rates as of October 18, 2022, until further notice. Thisis matched with the higher of a normalized risk-free rate of 3.5% or the spot 20-year U.S. Treasury
yield as of the valuation date. We are aware of lack of liquidity issues in the U.S. Treasury market forthe 20-year maturity, which is causing some distortion in the 20-year yield relative to that observed for
10 and 30 maturities. We will continue to closely monitor the situation and publish new guidance ifand when appropriate.

•Canada: The Kroll normalized risk-free rate remains at 3.5%. However, we recommend using thespot Government of Canada Benchmark Long-Term Bond yield as the proxy for the risk-freerate if the prevailing yield as of the valuation date is higher than our normalized Canadian riskfree rate of 3.5%. This guidance is effective when developing CAD-denominated discount rates as ofOctober 18, 2022 and thereafter, until further guidance is issued.

•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,
we continue to believe that a 6.0% ERP is more appropriate when developing EUR-denominateddiscount rates as of March 14, 2022 and thereafter, until further guidance is issued. However, we are
increasing the Kroll normalized risk-free rate for Germany from 2.0% to 3.0%, as of October 18,
2022 when developing EUR-denominated discount rates, until further notice. In addition, werecommend using the spot 15-year German government bond yield as the proxy for the risk-free rate
if the prevailing yield as of the valuation date is higher than our normalized German risk-free rate of3.0%. 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.

•United Kingdom: The Kroll normalized risk-free rate for the UK is increased from 3.5% to 4.0%
as of October 18, 2022 when developing GBP-denominated discount rates, until further notice.
We continue to recommend using the spot 20-year UK government bond yield as the proxy for therisk-free rate if the prevailing yield as of the valuation date is higher than our normalized UK risk-freerate of 4.0%.

For selected underlying data supporting the latest guidance for these countries, click here.

Please contact the costofcapital.support@kroll.com with any questions.