With all the dollar printing going on, many business people wonder: what if the US government fails to repay its mounting debt? What effect would this have on the global financial markets? And, more importantly, how will this affect what my business is worth?
Risk free rate of return and discount rate
The devil, as usual, is in the details. Just take a look at how business risk is assessed by professional business appraisers and savvy investors. To build up your discount rate, you start with the so-called risk-free rate of return.
The idea is that there must be an investment that you can put your money into and get this money back on time and in full measure. Not to mention being paid interest for investing in the asset. All other investments are seen as more risky because there is a likelihood you could lose some or all of the money you put in.
US government guarantee of no default
So what is this risk-free investment? You guessed it – government obligations by the biggest economy in the world – the USA Treasurys. Investors everywhere expect Uncle Sam to pay off its debt at maturity, plus reward your patience with interest income.
US Treasury yields are the proxy for risk free rate of return
So you can use the yields of long-term US Treasurys in your business valuations as a proxy for the risk-free rate of return. All other risks, such as those for diversified investments in equities and specific industries or companies of different market capitalization sizes, are added on top of the risk-free rate. As a result, you build up the discount rate to value your subject company.
Since the math is a simple addition of risk premia, you can guess what would happen to discount rates should Uncle Sam renege on its debt. A default on US Treasurys would tell the investors world-wide that the US is no longer a safe investment. Therefore, the notion of the Treasury yields as a measure of risk-free return goes out the window.
Doomsday scenario – no risk free investment
In the absence of a viable alternative, this would throw the global financial markets into turmoil. Why? Because you could not assess the risk of any other investment. To all intents and purposes, the risk-free rate of return could not be measured.
For cautious investors this would mean that discount rates could become arbitrarily large. As a result business values would plummet.
Given the importance of the safe haven of US government debt, it is better to allow Uncle Sam to print dollars than see it forced into a default. Until, that is, a solid alternative is found to dethrone the US dollar as the world’s reserve currency.
Count your blessings meantime.