June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 85 of 92 From the simulation, the model came up with an available equity distribution over 5 years with the following values/percentiles: Percentiles/% of Default Available Equity P94/6% $142MM P95/5% ($31)MM P96/4% ($99)MM P97/3% ($206)MM P98/2% ($513)MM P99/1% ($754)MM One can see that the available equity goes to 0 between 5% and 6% by counting the number of default scenarios in the simulation the exact value is 5.25%. If the firm’s risk appetite can handle this default probability then the company has sufficient equity. Alternatively, if the firm’s default probability is 3% then the company is undercapitalized by $206MM33. 10.2.7. EMTCo New Marketing Opportunities In order to determine the return on capital of the expansion of EMTCo’s marketing activities, the incremental return and capital requirements must first be addressed. These are determined by running the model with and without the new marketing activities (The results above were indicative of running the model without the new marketing opportunities). Running the model with the new marketing business opportunities (and assuming the current hedge guidelines are in effect) yielded the following: • Probability default increased from 5.25% to 6.25% • The available equity distribution indicated an additional $75MM of required equity to maintain the firm’s original 5.25% default probability. Therefore, if EMTCo decides to expand its marketing activities and increase its equity by $75MM then the expansion activities will not add any default risk to the firm. The $75MM represents the incremental equity required to support the expansion of marketing activities, or, the additional equity required to cover the increased risks associated with the expansion activity. In this model, this incremental equity is analogous to the additional risk capital required. 33 These percentile values are approximations due to the non-linearity of adding economic capital to the firm. The model should be re-run with additional economic capital to determine the exact value.