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The COVID-19 outbreak and corresponding actions have created an unprecedented level of uncertainty in the global economy. Despite the lifting of shelter-in-place orders, businesses globally are still faced with restrictions and additional costs to ensure the safety of employees and customers. These restrictions and additional precautions have placed additional difficulty in projecting the future performance of businesses, especially those reliant on heavy foot traffic such as retail and restaurants. Further, as more employers encourage employees to work from home, there is added pressure on the commercial real estate industry as firms recognize the ability to reduce office space.
Based on the risk factors outlined above, it is expected there will be a significant increase in the cost of capital highlighting the uncertainty of future cash flows. However, both the cost of debt and equity have been reduced based on traditional indicators. Economic stimulus plans from the federal government and dovish policies from the Federal Reserve have led to lowered interest rates and increased access to debt. As Chairman of the Federal Reserve, Jerome Powell, has indicated, the Federal Reserve plans to keep its target interest rates near zero (between 0.0% and 0.25%) for the foreseeable future while the country continues to recover from the pandemic.
A company’s cost of capital is intended to reflect the level of risk related to an investment in the company. The current interest rate environment is reflective of a low-risk economy, due to inflationary policies. Due to the heightened uncertainty in the global economy, it is believed this is not a true representation of the current risks of future cash flows.
In order to capture the elevated levels of risk not being captured by the current interest rate environment, sources such as the Duff and Phelps Cost of Capital Navigator have encouraged an additional 150 basis points be added to the base cost of equity adjustment. By adding an additional 150 basis points to a company’s implied cost of equity, it would represent the cost of equity that reflects a risk-free rate near the levels seen in December 2019 (when the risks of COVID-19 were not known or knowable).
As society adjusts to the new normal, so will the financial industry as it determines the proper appropriation of risk factors related to changes in the global economy. The GBQ team stands ready to assist you with your business questions as we move through and beyond the pandemic.