AIRA Journal

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WHAT’S INSIDE
Navigating the Uncertainty
Around Cost of Capital andValuation Assumptions
Modified Intercompany
Debt: Is It Still Recognized
as Debt?
The Brave New Worldof Sovereign Debt
Restructuring: The China
Conundrum and Other
Challenges
Venturing into the
Valuation of Venture Debt
Synergy Realization:
Maximizing Value in
Post-Merger Integration
Why U.S. Long-Term
Inflation May Be Higher
than Two Percent

2023 Bank Sector
Dislocation and the Impact
on the Financial Services
Sector39th Annual Conference"AC23" Awards andSponsors

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VOL 36: NO 32023
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V ALU A T I ON

NAVIGATING THE UNCERTAINTY AROUND COST
OF CAPITAL AND VALUATION ASSUMPTIONS
Carla Nunes
Kroll

What a difference a year can make. In 2021, the S&P 500 Index
increased by 27% while the NASDAQ Composite Index (a typicalbenchmark for tech stocks) gained 21%, in price terms. At thebeginning of 2022, new record highs were reached by the S&P
500 as optimism about the recovery from the COVID-19 pandemic
continued to fuel stock prices, despite some uncertainty on
inflationary expectations.
A year later, the picture changed dramatically. The S&P 500
dropped 19% in 2022 (in price terms), entering “bear market”
territory sometime during the year. The NASDAQ plunged,
settling at a loss of 33% for the year, with many companies seeing
their market value collapse by half or more. In fact, 2022 was
the worst performance year for the S&P 500 since 2008, at theheight of the global financial crisis.
The bleak performance for 2022 reflects volatile economic andgeopolitical conditions. Since mid-January of last year, inflation
continued to rise, reaching levels not seen in decades in somecountries. To make matters worse, when Russia’s war on Ukraine
began in late February 2022, there was a sustained spike in energy
and other commodity prices, which had a particularly negative
impact in Europe. This added uncertainty to what was alreadya complex environment. For businesses operating in and acrossthese economies, cost of capital and valuation assumptions wereimpacted, creating challenges for firms in terms of forecasting
cash flows and assessing future risks.

How Did We Get Here?
In October 2022, inflation surged in many developed andemerging economies, hitting a record 25-year high of 10.6%
in the eurozone.1 Since then, inflation has slowly been coming
down, standing at an estimated 6.1% at the time of writing (earlyJune 2023). However, core inflation (excluding volatile energy
1Monthly inflation readings are calculated on a year-on-year basis. Sourceof underlying data: Eurostat database, series “HICP - monthly data (annual rateof change),” https://ec.europa.eu/eurostat/databrowser/view/prc_hicp_manr/
default/table?lang=en. Accessed on June 1, 2023.

8Vol. 36 No. 3 - 2023and food prices) remains stubbornly high at an estimated 5.3%,
far from the European Central Banks’s (ECB) 2.0% target.2
In the U.S. and UK it is a similar story. The U.S. saw inflation surge toa 41-year high in June of 2022, which came down to 4.9% in April
2023,3 still more than double the U.S. Federal Reserve’s target of
2.0%. Moreover, the Personal Consumption Expenditures (PCE)
Price Index, the Fed’s preferred gauge for inflation, increased inApril to 4.4%.4 Likewise, the Core PCE index (i.e., excluding foodand energy) accelerated to 4.7% in April, demonstrating thechallenge the Fed is facing in bringing down inflation.

But How Did We Get Here?
The origins track back to COVID-19. Around the world,
governments implemented stimulus packages to support theireconomies, similar in magnitude to fighting a world war. At thesame time, central banks brought their policy interest rates tozero and launched unprecedented quantitative easing (QE)
measures, creating an environment of easy and cheap access tocredit.
This left consumers flush with cash, creating pent-up demand forgoods; however, lockdowns left manufacturers and businesses
struggling with global supply chain disruptions and labour
shortages (e.g., China’s zero-COVID policies which exacerbatedworldwide supply chain problems). All these factors led to a
disconnect between supply and demand, creating the perfectstorm for inflation to surge.
At first, lockdowns left businesses unable to keep up withdemand for consumer goods. When the economy reopened,inflation expanded to services as people were able to travel andgo to restaurants, for example. But industries like hospitality
and healthcare continued to struggle with staff shortages. All of
this contributed to inflation within “services”—a much harderproblem to tackle.
2
In the eurozone, core inflation also excludes alcohol and tobacco prices.
Source of underlying data: Eurostat database, series “Overall index excluding
energy, food, alcohol and tobacco.” Accessed on June 1, 2023.
3
Source of underlying data: U.S. Bureau of Labor Statistics (BLS), series“All items in U.S. city average, all urban consumers, not seasonally adjusted,”
12-Month Percent Change.
4
Source of underlying data: U.S. Bureau of Economic Analysis (BEA).

Reprinted with permission from AIRA Journal

The cost of other services such as rent and energy also
skyrocketed, with the price of energy particularly deepening
what many termed a “cost of living crisis.” Dramatic rises inenergy and agricultural commodity prices, triggered by Russia’s
war on Ukraine, placed renewed pressure on recovering global
supply chains, contributing to the knock-on effect of significant
inflation spikes in food and certain services across the world.

new investments need to generate to offset upfront costs andachieve profit, while also reflecting their potential risks.

Inflationary pressures are no longer limited to volatile energy
and food prices, creating the perfect breeding ground for“stagflation.”

Pressure on earnings may force companies to cut costs. For
example, we have begun to see layoffs despite continued
labour shortages9 and unemployment rates are expected torise, although projections are relatively tame compared to past
recessionary periods. While cost-cutting initiatives often startwith employee reductions, the next step is to cut back spending
on big ticket items like advertising and IT.

The Spectre of Stagflation
From the onset of the pandemic, monetary policies and fiscal
spending played a role in surging inflation across the globe.
In contrast, today, major central banks have embarked on aninterest rate hiking cycle to tame stubbornly high inflation, which
has reached levels not seen in 30 to 40 years in some countries.5
Amidst this perfect storm of inflationary pressures, major
central banks, including the Fed, were forced to increase policy
interest rates in 2022 at a much quicker pace than anticipated byinvestors. This has the potential to lead to a fall in the value ofcompanies due to an increase in their cost of capital assumptions.
In addition, it raises the risk of recession, a “double whammy” forbusiness outlook.
In early 2023, economists have significantly downgraded
real growth expectations, with several countries expected toexperience a recession later in 2023 or in early 2024. In April
2023, the Conference Board estimated there is a 99% likelihoodof a recession in the U.S. within the next 12 months, based on its
probability model.6 Meanwhile, a period of “stagflation”—wherethe economy experiences sluggish or no growth accompanied byhigh inflation—is still a realistic scenario for the UK and 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.7 Therewas some optimism in early 2023 that a contraction could beavoided as an unseasonably warm winter in Europe contributed
to lower energy prices. However, high overall prices continued toerode German consumer purchasing power. Inflation in Germany
remained at an elevated level of 6.3% (estimated) in May and is
expected to persist as a key challenge for the rest of the year.8In this highly volatile market, quantifying risk becomessignificantly difficult. For example, if a company’s earnings arevolatile or cost of capital is higher, share prices (and valuations ingeneral) may plummet. For investors and business leaders alike,dealing with this uncertainty is increasingly important.

From a cost of capital perspective, companies can expect anenvironment of higher interest rates and, as a result, a higher
cost of capital. Even if a mild recession is in the cards and the Fed
reduces policy interest rates in the latter half of the year, this will
not reduce long-term interest rates to pre-pandemic levels.

Where Are We Now?
Stock markets began recovering in 2023 despite the Fedcontinuing its policy tightening. Nevertheless, the rapid increasein U.S. interest rates (10 times in a little over a year) has begun
to cause anxiety in some pockets of the economy.10 The housing
sector is suffering from higher mortgage rates, while commercial
real estate is still struggling with low office occupancy rates but isnow facing higher funding rates.
The impact of credit tightening is also being felt in the banking
sector, with some spillovers felt in global markets. It began in early
March with the failure of Silicon Valley Bank (SVB). The bank’s
U.S. operations were seized by the FDIC, while its subsidiary,
SVB UK, was bought by HSBC for the symbolic amount of £1.11
Two days after taking control of SVB, the FDIC seized anotherinstitution, Signature Bank.12 This was followed by Switzerland’s
largest bank, UBS, agreeing to take over its smaller rival Credit
Suisse after ongoing negotiations with the country’s centralbank, Swiss National Bank (SNB). On March 19, the Fed, the Bankof England, the Bank of Japan, the ECB, and the SNB announced
a coordinated action to enhance liquidity via standing U.S. dollarliquidity swap lines, in an attempt to ease strains in global funding
conditions.13

Companies across the globe are now battling with higher cost ofcapital estimates, as they struggle to gauge how much money

In light of the banking turmoil, the Fed noted at its Marchmeeting that recent developments were likely to result in tighter
credit conditions for households and businesses while weighingon economic activity, hiring, and inflation, with the full extent of5
Release: Global inflation: 1970 to 2022, Figure 1, Office for National Statistics(ONS), November 22, 2022, https://www.gov.uk/government/statistics/globalinflation-1970-to-2022.
6“Probability of US Recession Remains Elevated,” The Conference Board,
April 12, 2023, https://www.conference-board.org/research/economy-strategyfinance-charts/CoW-Recession-Probability.
7“Gross domestic product: detailed economic performance results for the 1stquarter of 2023,” Statistisches Bundesamt (Destatis), Press release No. 203 of 25
May 2023, https://www.destatis.de/EN/Press/2023/05/PE23_203_811.html.
8Monthly inflation readings are calculated on a year-on-year basis. Sourceof underlying data: Eurostat database, series “HICP - monthly data (annual rateof change),” https://ec.europa.eu/eurostat/databrowser/view/prc_hicp_manr/
default/table?lang=en. Accessed on June 1, 2023.

9The U.S. unemployment rate reached a 54-year low of 3.4% in January andalthough it saw minor increases thereafter it reverted to 3.4% in April. Source:
Bureau of Labor Statistics, Labor Force Statistics from the Current Population
Survey, Series Id: LNS14000000. Accessed on June 1, 2023.
10See Federal Reserve, Policy Tools, Open Market Operations, https://www.
federalreserve.gov/monetarypolicy/openmarket.htm.
11
For more details on SVB’s U.S. operations, see: https://www.fdic.gov/news/press-releases/2023/pr23019.html. For more on the SVB UK acquisition, see:https://www.hsbc.com/news-and-media/media-releases/2023/hsbc-acquiressilicon-valley-bank-uk-limited.
12
See https://www.fdic.gov/news/press-releases/2023/pr23018.html.
13
See the Fed’s related press release here: https://www.federalreserve.gov/newsevents/pressreleases/monetary20230319a.htm.

But What Does This Mean for Businesses?

Reprinted with permission from AIRA Journal

Vol. 36 No. 3 - 2023 9

Con ti n ue d fr omp.9

these effects being uncertain. However, the Fed reiterated thatthe banking system remained sound and resilient.14 This did notlessen the pressure on U.S. regional bank stocks, culminatingwith First Republic Bank’s being seized by regulators andsubsequent sale to JP Morgan Chase in early May.15 This was thesecond largest bank failure in the U.S., after Washington Mutual’scollapse at the height of the 2008 global financial crisis.16
Throughout this mini-banking crisis, the Fed continued to raise
rates. There is a disconnect between what markets are pricing
and what Fed officials are saying will happen for the rest of theyear. Markets seemed to be anticipating a rate cut as early as
July;17 meanwhile, the Fed appeared to pause its interest-rate
hiking cycle at its May meeting, taking a wait-and-see approach.
Although some Fed officials were still thinking another rate hikecould be in the cards, this pause helped remove some uncertainty
from financial markets.
At the end of May, the S&P 500 was up approximately 17%
from its October 2022 low. Showing even greater recovery, theNASDAQ was up 27% from its December 2022 low and 25%
from its local low in October. The S&P 500’s improvement of
7–9% since the beginning of this year does not compensate
for its overall 19% loss in 2022; however, it does reflect greater
optimism by investors since the beginning of the year. Or, said
another way, perhaps investors are less pessimistic compared toprevailing sentiment during 2022.
In 2023, the Volatility Index (VIX)—known informally as the “fearindex”—has been consistently below its long-term average ofaround 20 (except for at the peak of the mini-banking crisis inMarch), implying a lower risk aversion. Corporate credit spreads(i.e., the difference in yields of junk-rated bonds and investmentgrade bonds) remain low on a historical basis, even though
underlying corporate debt yields have gone up significantly since
early 2022.
While there is a good chance the U.S. economy will tip into
recession later in 2023 or in early 2024, indicators suggest itwould not be a deep or prolonged slump. Inflation is still far fromthe Fed’s 2.0% target but is on a steadily downward path, while
the global economy appears to have avoided the worst-casescenarios from the Russia-Ukraine conflict.
The one wrinkle here is the potential for another U.S. debt
ceiling debacle, as happened in 2011 when acrimonious politicalwrangling over the debt ceiling led to S&P’s downgrading
the U.S. sovereign credit rating from AAA to AA+. The current
situation resembles 2011 in some respects—back then, financial
markets became significantly volatile and credit spreads spiked,with spillovers being felt in global financial markets. While a14
Board of Governors of the Federal Reserve, “Federal Reserve issues FOMC
statement,” Press Release, March 22, 2023, https://www.federalreserve.gov/
newsevents/pressreleases/monetary20230322a.htm.
15
FDIC, “JPMorgan Chase Bank, National Association, Columbus, Ohio
Assumes All the Deposits of First Republic Bank, San Francisco, California,”
Press Release, May 1, 2023, https://www.fdic.gov/news/press-releases/2023/
pr23034.html.
16
Ken Sweet, “First Republic Bank seized, sold in fire sale to JPMorgan,” AP
News, May 1, 2023, https://apnews.com/article/first-republic-bank-siliconvalley-fdic-5ab48702b7136d42f73ac13e0a20955d.
17CME FedWatch Tool, https://www.cmegroup.com/markets/interest-rates/
cme-fedwatch-tool.html, accessed June 1, 2023. Probabilities are based on 30Day Fed Funds futures pricing data and change every trading day.

10Vol. 36 No. 3 - 2023

current U.S. default has been averted as Congress approved abill to raise the debt limit, there could be residual ramifications
from the polarized negotiation process between Democrats andRepublicans. For one, Fitch Ratings placed its AAA rating for theU.S. on negative watch. Although Fitch acknowledged the U.S.
government debt ratio of 112.5% of GDP at year-end 2022 was
12% above its 2019 pre-pandemic levels, it also pointed out thiswas much higher than the indebtedness of other AAA-rated
countries (36.1% for the AAA median).18 A U.S. sovereign credit
rating downgrade could place further pressure on interest rates,with negative repercussions to corporate funding costs.

The Growing Spectre of BankruptcyViewing the overall economic environment from the perspectiveof risk, projected cash flows are subject to the pressures of
the current high inflation environment. Consumer demand isdecreasing for some industries; for example, the decline in carpurchases which shows there is less leeway for companies toincrease prices going forward. Many businesses are struggling
with stubbornly high inflation which is contributing tocompressed margins. Ultimately, these and other factors could
lead to more bankruptcies, especially in a “higher for longer”
interest rate environment. Moody’s and S&P expect defaultrates to rise between now and Q1 2024, as refinancing at higher
rates and lower cash flows restrict the ability to make interest
payments.19 Additionally, compressed margins will make itharder to refinance existing loans.
Cost of capital is a function of both the cost of equity and thecost of debt. Given the current level of uncertainty, the equity
risk premium remains high. Startup businesses planning toaccess liquidity via a near-term IPO have seen those prospects
shattered. Meanwhile, corporate debt, which is typically priced
as a spread over the risk-free rate, is also expected to command
higher yields. Because of the recent mini-banking crisis, lending
criteria has tightened, placing further upward pressure on therates at which companies can borrow. Access to credit is morechallenging, which—coupled with lower financial performance—is leading to defaults and debt restructuring activity.

The Outlook for Risk-Free Rates
When dealing with valuing investments or pricing deals, investors
and corporations care about long-term cost of capital estimates.
When considering risk-free rates (the building block of any costof capital estimate), they do not rely on the policy rates that
central banks set (which are short-term in nature), but rather onwhat would be the cost of financing debt and equity over the lifeof the investment. This means that 10- or 20-year government
bond yields are more relevant as a proxy for the risk-free rate.
At the height of COVID-19, those yields were under pressure forsafe-haven countries, due to a combination of investor flights
to quality and central bank QE policies. Investors were trying
to preserve capital and turned to the government bonds of18
“Fitch Places United States’ ‘AAA’ on Rating Watch Negative,” Fitch Ratings,May 24, 2023, https://www.fitchratings.com/research/sovereigns/fitch-placesunited-states-aaa-on-rating-watch-negative-24-05-2023.
19
See for example, S&P Global Ratings, “Default, Transition, and Recovery:
The U.S. Leveraged Loan Default Rate Could Hit 2.5% By March 2024 Given
Persistent Inflation and Higher Interest Rates,” May 25, 2023.

Reprinted with permission from AIRA Journal

countries that are considered relatively safe, including the U.S.,
Germany, and the UK. Additionally, unprecedented QE policies
placed downward pressure on long-term interest rates.
Now, we face a situation in reverse. We are not only seeing thesize of balance sheets decreasing (quantitative tightening), butalso central banks raising policy rates much more quickly thanbefore. Long-term interest rates for major economies are backto levels observed in the aftermath of the 2008-2009 global
financial crisis. This is unlikely to change substantially by the endof 2023, as central banks will continue to raise policy interest
rates through at least mid-2023, and keep them at those levels
through the rest of the year.

Winners and Losers
While economic recession is a real risk, central banks may needto hold interest rates at a much higher level than pre-pandemic
until inflation is brought under control. Some financial institutions
may benefit from higher rates, if their earnings stem primarily
from a spread between the interest rates they charge on loans
versus what they pay on deposits. However, there are negative
headwinds to deal with: recessions are typically accompanied bya rise in bad debts, which hurts banks’ bottom lines. We could
see consumers defaulting on their car loans or home mortgages,
for example, or businesses being forced to restructure their debt
or file for bankruptcy protection.
Non-financial corporations with high brand recognition havebeen successful at passing on higher prices to their customers,
thereby maintaining or improving margins; but this is not thecase across the board and many companies are struggling.
Moreover, borrowing costs make financing the purchase ofanother company more expensive. We have already seen asignificant drop in reported M&A activity and financing dayto-day operations has become more expensive. Consequently,
businesses may further decrease or delay planned M&A
investments or capital expenditures, such as building new plants
or opening new stores. High risk-free rates will have a significant
impact on those decisions. The higher interest rate environment
will thus continue to weigh negatively on economic activity.
All this uncertainty also contributes to a higher equity (or market)
risk premium—the additional return that investors require
to induce them to invest in equities rather than government
securities considered free of default risk. While investors
have become more optimistic recently (compared to 2022), in
recessionary environments the earnings volatility of businesses
rises, which increases the risk of investing in the equity of thosecompanies.

Long-term Inflation Expectations
Global financial markets are still trying to ascertain if central
banks will manage a soft landing while attempting to get inflation
under control. Amidst this highly uncertain environment, costs ofcapital inputs have risen substantially relative to the beginningof 2022 and are again approaching levels observed just after the2008-2009 global financial crisis.
Reprinted with permission from AIRA Journal

The challenge will be whether central banks are able to get
inflation back to their target level (typically around 2.0% formajor developed economies) in a speedy fashion. If history is ofany guidance, we should recall that the 1970s and 1980s wereperiods of central bank policy mistakes, when many countries
had to deal with painful double-digit interest rates as the processof bringing down inflation turned into a protracted affair.
The danger right now is that market participants are starting toincorporate higher inflation expectations into long-term decisions.
Economists call this a de-anchoring of inflation expectations.
Certainly, we have seen long-term inflation expectations for theU.S. rise significantly since the height of the pandemic. Back inJune 2020, Kroll’s analysis found that consensus expectations forlong-term inflation (5 to 10 years out) in the U.S. stood at 2.0%.
Fast forward to October 2022, those expectations rose to 2.9%,
subsequently coming back down to 2.4% in May 2023.20
While these may not seem like big swings, in economic terms therise is quite significant. The U.S. grappled with subdued inflation
for much of the period following the global financial crisis, all theway through the height of the pandemic. The fear back then wasthat the developed world would enter a deflationary spiral akinto what Japan struggled with for two decades. During this period
the Fed tried with little success to bring inflation up to its 2.0%
target.
A major objective of global central banks is to ensure pricestability, which has now been compromised. We are seeing apendulum swing as central banks attempt to recover some of
their credibility and achieve their main mission. To lose the fightagainst inflation has negative reverberations on the stability andfunctioning of global financial markets.
In that context, the aggressive monetary policy stand isunderstandable. However, this has a direct bearing on long-termrisk-free rates and cost of capital estimates. Businesses may haveto deal with an environment of higher cost of capital for theforeseeable future.
Note: Statements and rate references in this article were
accurate at the time of writing.
20
See Kroll’s Cost of Capital Infographics, https://www.kroll.com/en/cost-ofcapital/cost-of-capital-infographics.

ABOUT THE AUTHOR

Carla Nunes, CFA
KrollCarla Nunes is a managing director in
the Office of Professional Practice (OPP)of Kroll, based in the Philadelphia office,and a Kroll Institute Fellow. She hasover 25 years of experience. In her OPP
role, she provides firm-wide technicalguidance on a variety of valuation,
financial reporting and tax issues. She isalso the global leader of Kroll' Valuation
Digital Solutions group, which produces
the cost of capital thought leadershipcontent and data housed in the Cost ofCapital Navigator.

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