Additional Material for Risk Management -CAPM and WACC-

The Capital Asset Pricing Model (CAPM) I

Mono-periodical equilibrium model of the capital market

ri = rf + i rM rrf

with: Expected rate of return of the bond ri Interest rate of a risk free asset rf

i
rM

Systematic risk of the bond Expected rate of return of a market portfolio

CAPM
ri = rf + i * [ rM - rf ]
ri : r f: Required rate of return of a shareholder towards company i Longterm rate of return of a risk free asset

i = Cov (rM, ri)/Var (rM): Firm-specific risk factor r M: Average rate of return of a risk carrying asset

CAPM Calculation

Application of CAPM:
Portfolio Stnd. Dev. 13,12% Mean= Stnd. Dev.= Adjusted Mean= Portfolio Weights x(j) SUN MSFT 102,7% 0,0% SUN MSFT 1,6% 1,5% 12,8% 9,0% 1,6% 1,5% GM 0,0% GM 1,3% 5,1% 1,3% Sum of Portfolio Weights 103% Not = IBM APPLE P&G 0,0% 0,0% 0,0% IBM APPLE P&G 1,3% 0,9% 1,1% 9,3% 13,0% 5,5% 1,3% 0,9% 1,1% 100% J&J 0,0% J&J 1,2% 6,7% 1,2% MERCK 0,0% MERCK 1,3% 7,4% 1,3% FORD 0,0% FORD 1,3% 5,5% 1,3% INTEL 0,0% INTEL 1,4% 11,4% 1,4%

TEN-STOCKS-CAPM.XLS Avg. Portfolio Return 1,60% >= Min Return 1,60%

Scenario 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24

Probabilities 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24 1/24

Portfolio Return by Scenario -0,8% 12,9% -18,8% 23,0% 14,2% -7,8% -9,1% -2,1% 13,0% -3,5% -6,3% -13,8% 22,6% -4,5% -8,3% -1,9% 10,6% 14,2% 21,7% 4,1% -4,7% -29,2% 3,6% 9,4%

Adjusted Security Returns SUN MSFT -0,8% 2,0% 12,5% 3,2% -18,3% 1,1% 22,4% 6,4% 13,8% 1,4% -7,6% -2,3% -8,8% -5,3% -2,1% 0,5% 12,6% 4,2% -3,4% 0,6% -6,1% 10,9% -13,4% 1,9% 22,0% 20,0% -4,4% -7,9% -8,1% -9,4% -1,8% 29,1% 10,3% -1,4% 13,8% -1,5% 21,1% 8,5% 4,0% -10,0% -4,6% -3,3% -28,4% -5,2% 3,5% 5,4% 9,2% -12,1%

by Scenario GM IBM -0,1% 16,1% -2,2% 10,4% 4,3% -11,9% 2,3% -5,8% 2,0% -3,5% -4,6% -9,9% -6,5% 6,0% 2,2% 3,8% -2,9% 6,2% 12,1% 1,0% 7,8% 20,9% -2,9% -7,6% 6,2% 0,9% -1,5% -11,0% -3,9% -7,1% 4,9% 14,3% -0,5% 5,2% -2,4% 1,7% 11,4% 14,6% 1,8% -6,8% 7,1% 1,9% -3,7% -9,7% -4,7% 8,6% -7,1% 6,2%

APPLE -9,7% 3,2% -7,0% 2,9% 10,8% -16,0% 8,4% 13,9% -4,9% 7,3% 8,5% -9,8% -16,7% 1,4% 16,0% -3,2% 1,4% -10,6% 26,5% 27,9% 3,4% -17,8% 7,9% -22,4%

P&G -0,6% -4,2% 1,5% -2,1% 2,2% 1,3% -3,3% -2,2% 7,9% -0,3% 8,0% -2,8% 5,6% 2,1% -6,3% 7,8% 7,8% 0,6% 5,9% -14,3% 2,0% -3,3% 10,2% 3,0%

J&J 11,5% -3,4% -2,2% -0,6% 4,4% 0,8% -4,4% 2,3% 3,2% -4,7% 7,3% -7,4% 15,2% -1,3% -8,9% 14,8% -2,7% 6,5% -4,3% -9,6% 0,9% -1,4% 8,9% 3,8%

MERCK 5,8% -6,6% -7,1% -3,8% 5,8% -1,0% -1,6% 1,1% 6,2% 3,9% 11,3% -5,1% 12,8% 0,6% -9,6% 6,2% -1,6% 12,8% 0,5% -12,6% 7,8% -11,7% 5,2% 10,8%

FORD 1,1% 4,9% 8,9% 3,3% 0,7% -12,4% -1,1% 2,4% -7,8% -1,1% 3,7% -2,6% -1,4% 1,3% -5,6% 9,7% 6,9% 0,3% 6,5% 4,1% 3,9% -4,2% -2,6% 11,9%

INTEL -5,7% 3,5% -6,3% 16,1% 8,4% -5,8% -0,7% 3,2% 16,6% 12,1% 12,4% 0,2% 20,9% -15,6% -5,0% 7,0% -4,1% -9,4% 26,5% -2,7% -2,8% -19,6% -2,2% -12,5%

The Dividend Growth Model (DGM)

The market price of a share is interpreted as the present value of all future dividends
Assumption: Constant dividend growth

rEC
With: rEC D1 K0 g

D 1 = +g K0

Equity cost rate Dividend in period 1 Current share price Dividends expected growth rate

Advantage: Simple and future oriented model Disadvantage: Difficult prediction of the growth rate g

DGM Calculation

Application of DGM:

Interest calculation of borrowed capital (BC)

Common practice:
Interest

rate for interest-bearing BC = Interest rate for bonds of the public sector with mean duration Interest rate for non-interest-bearing BC (Non-interest-bearing liabilities) = 0

Weighted Average Cost of Capital (WACC)

rEq ,a.t . Eq rBC ,a.t . BCi b BCn i b rTC ,nom ,b.t . = +0 + 1s Eq TC 1s BC TC TC
with:

rTC ,nom ,b.t . Nominal total capital cost rate before taxes

rEq ,a.t .
rBC ,a.t . s Eq

Equity cost rate after taxes Borrowed capital cost rate after taxes Effective business tax debit of the equity Effective business tax debit of the interest-bearing borrowed capital (Target) market value of the total capital (Target) market value of the equity (Target) market value of the interest-bearing borrowed capital

s BC
TC Eq BCi b

BCn i b (Target) market value of the non-interest-bearing liabilities (= non-interest-bearing

borrowed capital)

WACC Calculation

Application of WACC:
Comparable Companies Firm 1 Firm 2 200 200 35% 1,25 1,65 0,76 Firm 3 300 200 38% 0,90 1,41 0,64 Av erage Amount of equity Amount of debt Tax rate Equity beta 1+ (1-T)D/E Unlev ered equity beta 200 100 40% 1,10 1,30 0,85

Input cells are in yellow .

DATA

RESULT

0,75

Project or Acquisition DATA % Debt % Equity Tax rate 1+ (1-T)D/E Unlev ered project beta Project equity beta Risk-free rate Market risk premium Project equity beta Market risk premium Equity risk premium Plus risk-free rate Cost of equity 40% 60% 40% 1,40 0,75 1,05 6,00% 7,40% 1,05 7,40% 7,74% 6,00% 13,74%

RESULT

= av erage of unlev ered equity betas of comparable firms

DATA

= yield on long-term Treasury bonds = historical av erage excess return of S&P 500

RESULT

Note: The estimate of the market risk premium is the arithmetic av erage from 1927-1997, based on the Ibbotson Associates "Stocks, Bonds, Bills and Inflation" data. DATA RESULT W eights After-tax cost of debt 5,4% Cost of equity 13,7% W eighted av erage cost of capital 40,0% 60,0% Cost of debt 9,0% W eighted Cost 2,2% 8,2% 10,4%

Nominal interest rate vs. Real interest rate

If applying on actual replacement values: Conversion of a nominal interest rate into a real interest rate No duplicate consideration of the price alteration component Fisher-equation:

rreal = rnom

Asset-specific interest calculation

Different price trends in separate product divisions

rreal,u = rnom pu
with:

rreal,u real interest rate in the capital goods sector u

pu annual price change rate of the capital goods sector u

Determination based on statistical surveys and forecast values Approach of the general inflation rate in exceptional case only

The integrative approach I

Goal: Key date calculations for the companys entire investment holdings Consolidation of the depreciation component and the interest component Assumption:

Capital spending order flows back in annual installments (Annuities) The company reinvests continously

Creation of an average amount of depreciation and interest for all stages of life of the fixed asset

The integrative approach II

The annuity approach:
I= DS n DS1 DS 2 + +...+ 1+r (1+r )2 (1+r )n

With:

I DSt
r

Amount of investment Debt service in year t = 1,..., n Useful life of the capital good Discount rate

By assuming constant annual rates DS =DS1 =DS 2 =...=DS n , the calculation is simplifyied to:

I =DS
t =1

1 =DS (1+r )t

1 (1+r )n r

The integrative approach III

With

rreal ,u = rnom pu

the asset-specific capital cost rate

rnom pu CCRu = 1 1 (1+rnom pu )nu

results.