Debt beta is the result of the ratio of credit spread and market risk premium. If it is taken into account, the company value usually increases.
It usually doesn't work without the risk-free base interest rate
In capital market theory, a risk surcharge model is almost always used to explain expected capital costs. The basis is a risk-free interest rate. A risk premium is added, which reflects the characteristics of the financing. In total, both components make up the capital costs of the form of financing. This applies both to equity instruments, which are generally valued on the basis of the CAPM, and to debt instruments.
Establish equivalence between valuation object and alternative investment
Many reviewers like to quote the sentence “To evaluate is to compare” on a regular basis. In the context of a future-oriented company valuation, this means, among other things, finding an opportunity interest rate for discounting that allows an adequate comparison. Comparability in terms of risk is, of course, omitted with the risk-free base interest rate. At least the two components of term congruence and currency correspondence remain; the feature of fungibility may be added.
Maturity congruence means “pay attention to the yield curve”
Future cash surplus must be measured at an interest rate that is congruent with the term. This applies both to the base interest rate and to the risk premium, although there is quite rarely a differentiation with regard to the latter. When it comes to valuing an individual cash flow, the base interest rate must be used, which corresponds exactly to this term. If there are several, possibly infinite, cash surpluses, either the corresponding interest rate can be charged and applied for each individual cash flow or a so-called cash value equivalent interest rate is used, which represents the overall interest rate structure — with appropriate weighting — as a unit interest rate.
Zero coupon interest rates and Svensson method
The abovementioned maturity-equivalent interest rates are not readily available on the capital market. The majority of government bonds traded are coupon bonds. So-called “strips” already have the character of a zero-coupon instrument, but these are usually never available for the entire running time range. The valuer in the EUR area can avoid the associated problems by directly using the base interest rates published daily by the Bundesbank using the Svensson method. Otherwise, the valuer must first derive a coupon interest rate structure curve from the available operating returns and convert this into a zero-coupon curve using the bootstrapping process.
Currency congruence and base interest rates outside EUR, USD, GBP, JPN
It is generally accepted that interest rates compensate for inflation expectations. Since there are generally different inflation expectations in different currency areas due to different monetary policies and economic activity, it stands to reason that base interest rates also differ as a result. The correspondence between the currency of the cash surplus and the currency of the base interest rate is therefore a second essential equivalence feature. Determining the base interest rate can now be somewhat unpleasant if the valuation is to be carried out in a local currency away from well-developed capital markets, such as the Mexican peso. This is where the evaluator faces several problems. On the one hand, there is rarely enough data to approximate a good risk-free interest rate structure. In addition, weak-currency countries often do not issue in their own currency. Even more serious is the problem that it is hardly possible to speak of a risk-free interest rate structure in these currencies, as the issuing countries are sometimes subject to a not inconsiderable default risk. Typically, this can be helped by means of a surcharge model. The basis is the interest rate structure of a fail-safe government in a liquid currency. In a second step, this interest rate structure is adjusted for the expected inflation delta between this currency and the target currency.
The base interest rate in valuation practice in Germany
Valuation practice in Germany is closely linked to IDW recommendations. With regard to the base interest rate, the IDW has published various statements on the determination of a cash value equivalent interest rate and its rounding.