← Back to Insights Market Update

WACC Volatility & Risk-Free Rates

With treasury yields fluctuating significantly, how do you normalize the risk-free rate and build defensible WACC? A framework for rate selection in volatile markets.

The risk-free rate is the foundation of discount rate construction. Every WACC calculation starts with it. But when 10-year Treasury yields swing 100+ basis points in a quarter, which rate do you use? The answer matters: a 50 basis point change in discount rate can move enterprise value by 5-10% for typical cash flow profiles.

The Problem with Point-in-Time Rates

Traditional practice says: use the yield as of the valuation date. Simple and objective. But this creates problems:

• Timing sensitivity — A valuation dated December 31 might use a rate 30 basis points different from December 15
• Market noise — Short-term rate movements may not reflect long-term expectations
• Quarter-over-quarter volatility — Values swing based on rate movements unrelated to company fundamentals

Auditors accept point-in-time rates, but sophisticated users ask: does this rate reflect a reasonable expectation of long-term returns?

Normalization Approaches

1. Spot Rate Approach (Traditional)

Use the Treasury yield as of the valuation date.

• Strengths: Objective, easily verifiable, widely accepted
• Weaknesses: Subject to daily volatility, may not reflect normalized expectations
• Best for: Regulatory filings with specific date requirements

2. Average Rate Approach

Use an average of rates over a period (30-day, 90-day, or 12-month).

• Strengths: Reduces timing noise, more stable period-over-period
• Weaknesses: May lag market conditions, requires justification of averaging period
• Best for: Portfolio valuations where consistency matters more than precision

3. Normalized Rate Approach

Use a rate reflecting long-term expectations, potentially different from current market rates.

• Strengths: Reflects economic fundamentals, stable across periods
• Weaknesses: Subjective, requires significant documentation
• Best for: Long-term strategic valuations, private equity holds

Building a Defensible Position

Regardless of which approach you choose, defensibility requires documentation:

The Maturity Matching Question

Which Treasury maturity should match your cash flows?

Cash Flow Profile	Suggested Maturity
Short-duration (5-year terminal)	5-year Treasury
Standard DCF (10+ year projection)	10-year Treasury
Long-duration assets (infrastructure)	20-year or 30-year Treasury
Mixed-duration (weighted average)	Weighted average based on cash flow timing

The 10-year Treasury is the most common default, but this default should be examined for each engagement.

Current Market Context

In environments with significant rate volatility, additional considerations apply:

When Rates Are Rising

• Spot rates may overstate normalized expectations
• Forward rates provide insight into market expectations
• Consider whether the current rate environment is temporary or structural

When Rates Are Falling

• Spot rates may understate normalized expectations
• Historical averages provide context for "normal" levels
• Consider floor effects on rate assumptions

In Inverted Yield Curve Environments

• Short-term rates may exceed long-term rates
• Curve shape itself conveys market expectations
• May require additional documentation of rate selection

Equity Risk Premium Implications

When the risk-free rate moves, equity risk premium (ERP) deserves examination:

• Historical ERP is calculated relative to historical risk-free rates—it may not apply when current rates differ significantly
• Supply-side ERP (Duff & Phelps/Kroll) updates quarterly and accounts for current rate environment
• Implied ERP can be derived from current market prices but requires more analysis

The key is consistency: if you normalize the risk-free rate, consider whether ERP should also be adjusted.

The FairvalueX Approach

Our discount rate documentation includes:

• Risk-Free Rate Build-Up with source documentation and selection rationale
• ERP Source and Date with clear citation to published estimates
• Beta Derivation from guideline companies with selection criteria
• Size Premium and Specific Risk with documented support
• Sensitivity Tables showing value impact of rate alternatives