How would one think about determining a discount rate that is appropriate for a definite-life royalty stream? I assume it would be less risky than an Equity Risk Premium figure, as in theory it can’t go negative and less volatile…
Thoughts?
havent looked at curriculum yet but I would assume it would lower than equity & higher than fixed income
You are correct, yield on corporate bonds should be used. I found this detail in literature even before joining to CFA program and I am quite sure is also proved somewhere in curriculum.
Royalty streams are similar to preferred stock valuation since the royalty stream does not typically grow. The valuation is the annual cash flow received from the royalty divided by a discount rate that lies between equity and fixed income. Equity risk premiums are 5-7% greater than the risk free rate and bond yields are pretty low for 10 yr Treasuries. So depending on the credit of the royalty “payer” you could adjust up from long term bond yields or downward from equity discount rates. A similar approach in Level II equity valuation was the "Build-Up Method.
-Marc