The percentage yield on traditional savings and money market accounts continues to drop, as presented in a chart in the USA TODAY on 4 April 2008. We can also refer to the CD interest rates as a risk-free rate of return. This means that there is very little - actually, no risk - putting your money into this investment vehicle.

Using the 5-year CD rate above as our risk-free rate of return, any return we can get in any other investment above 2.75% is called a risk premium. In essence, risk premium measures the extra return we expect to receive for taking risk. If we invested our money in the stock market and expected an 8% return, then our risk premium would be 5.25% (8% minus 2.75%). So, what does this mean to an owner of a private, closely held company?

When the risk-free rate decreases and other rates of return remain constant, then the risk premium increases. If, however, there is no real increase in risk, then the risk premium becomes much more attractive. Here is an example - let's assume your business generates a return on your equity of 12% consistently every year. This means that, based on the current risk-free return, your current risk premium is 9.25%. Last year, let's assume the risk-free rate was 4%. Compared to a risk premium of 9.25% now, your risk premium was 8% just one year ago. If the risk in your firm really did not change, then your firm's risk premium just made your business a more attractive investment.

Perhaps one more example will help clarify this a little further. Let's assume the risk-free rate of return is 6% and your company's return is 8%. Empirical research demonstrates that emerging and medium-sized businesses represent some of the riskiest equity investment options available. With a risk premium of just 2%, or with the opportunity to earn just 2% more per year while exposing oneself to so much more risk, the risk-free investment becomes the most attractive investment option.

Using the corporate finance principles of risk premium, your business may be the most valuable thing you invest in right now while the risk-premium is high. Contact a CFO Consultant today to help you with your business investment.