June 2007 Capital Adequacy Extension © Copyright 2007, CCRO. All rights reserved. Page 86 of 92 In order to assess the firm’s return on capital for the expansion of the marketing business, a Risk Adjusted Return on Capital (RAROC) measure will be used. This will be defined as follows: RAROC = Incremental Economic Value/Incremental Equity where, Incremental Economic Value = Incremental Economic Profit – Capital Charge Incremental Economic Profit = Free Cash Flow for Equity (FCFE) Capital Charge = Incremental Equity * Capital Utilization Rate Capital Utilization Rate = Return on Equity (ROE) – Risk Free Rate Additional points are as follows: • As mentioned above, incremental equity covers the firm’s increased risks due to the expansion opportunities and is a proxy for the company’s additional risk capital requirements. • The economic value created is defined as the economic value from a default-risk neutralized project therefore, there is a charge for the incremental equity associated with the expansion of the marketing business. • The Committee decided to use FCFE (vs. Net Operating Profits Less Adjusted Taxes – NOPLAT) to measure economic profit since it wanted to capture the potential for financial distress manifested in higher interest expenses. • The capital utilization rate represents the cost to the firm created by the required return on the new equity minus the risk free rate the firm would receive if it invested the new equity dollars in a risk free investment34. (For purposes of the firm, the required ROE is 12% and the risk-free rate is 5% therefore, the capital utilization rate is 7%). Economic profit from the model is as follows: The incremental economic profit is $165MM ($782MM - $617MM) and the incremental equity is $75MM. The firm will use a capital utilization rate of 7% (see above) creating a capital charge over the 5 year period of $30MM35 34 While the firm does not have to raise the equity dollars to expand its marketing activities, this action would make the investment default risk neutral and allow the firm to determine the new marketing expansion’s economic value created given risk neutrality. 35 $75MM present value, 7% annual interest rate for 5 years = $105MM at 5 years difference is $30MM ($105MM - $75MM) Without Marketing Expansion With Marketing Expansion Economic Profit (FCFE) $617MM $782MM