Estimating the Cost of Capital in Today’s Economic and Capital Market Environment

1. Estimating the Cost of Capital in Today’s Economic and Capital Market Environment

2. What is the Economic and Capital Market Environment Today?

3. Unprecedented End to 2008 Late-2008 events • 9/7 Freddie and Fannie in receivership • 9/14 Lehman files bankruptcy • 9/15 BoA acquires Merrill Lynch • 9/16 AIG taken over by US government • 9/16 Reserve fund breaks the buck • 9/18-19 FSA (UK) / SEC (US) prohibit shorts • 9/26 WaMu bought by JP Morgan Chase • 9/28 Fortis Bank is nationalized • 9/29 Lehman sells Neuberger Berman for $2B • 10/3 $700B bailout plan passes (TARP) • 10/9 Wells Fargo buys Wachovia • 10/13 Mitsubishi acquires 21% of Morgan Stanley • 10/29 Fed cuts key lending rate to 1% • 11/7 BoE and ECB cut interest rates • 11/10 AmEx becomes bank holding company • 11/12 TARP to be used to purchase banks’ stock • 11/23 Citigroup bailout announced • 12/16 Fed reduces target rate to 0-.25% • 12/19 GM and Chrysler support announced • 12/30 Fed to start buying MBS and Treasuries

4. Unprecedented Government Intervention

5. Estimated Support Tops $10.5 T Figures as of March 27, 2009. Source: CNBC; MSNBC; US news; LA Times; National Archive; US Dept of Defense; US Bureau of Reclamation; Library of Congress; NASA; Panama Canal Authority; FDIC; Brittanica; WSJ; Time; CNN.com.

6. Bear Market

7. Highest Volatility in 20 Years & Lowest Equity Values Since 1996

8. Corporate Spreads

9. Stock Market Turbulence

10. Recession or Depression? • Economic contractions result from disruptions in the capital formation (lending and investing) • They come is two basic forms – recessions and depressions • Recessions • Economic / capital contractions arising from a combination of high debt levels relative to income and tight central bank policies (usually to fight inflation) • Central banks can effectively increase credit creation and capital availability through monetary policy (which lowers the cost of capital enough to reach the desired level of economic growth) • Recessions end when lower interest rates and increased money supply: • reduce debt service relative to incomes, • shrinks monthly payments for items bought on credit, and • raises the prices on income producing assets like stocks, bonds and real estate, producing a ‘wealth effect’ on spending

11. Recession or Depression? • Depressions • Economic / capital contractions arising from a shortage of credit worthy borrowers and a shortage of money to lend and invest (deleveraging dynamic) • In depressions 1) large numbers of debtors have obligations to deliver payments that far exceed their income producing capability (making additional lending unlikely), and 2) typical Central Bank responses are ineffective (largely because rates are already near zero and because increased money supply does not restart capital formation) • Depressions typically end when: • debt restructurings reduce debt service obligations, • businesses and individuals take drastic steps to reduce costs, • increased money supply reduces debt service burdens, • governments drastically increase spending, • and the economics of the capital formation process can be restored

12. Observations • The failure of Lehman Brothers was the tipping point that started a massive deleveraging in the capital markets • Selling pressure in September and October was not so much about changes in the risk premium or about changes in longer-term growth expectations – it was a massive deleveraging event • The need for liquidity by certain investors overwhelmed everything else - hedge funds, prop desks and others were major sellers • Market activity since that time has been a more rational evaluation of the future expected cash flows expected from risk assets • The non-financial corporate bond market is a bright spot in terms of new credit creation • Non-financial corporate bonds came to market at a net rate of 3.5% of GDP in the first quarter, fast even for a boom period • What we have experienced is a top-down macro event that has dramatically affected most financial assets and substantially changed expectations regarding future cash flows and growth

13. What Does It Mean? • None of us have seen anything like this in our professional careers

14. What Does It Mean for Estimating the Cost of Capital? • First, the basics: • Capital formation – the process of investors/lenders choosing to provide capital to capable recipients (borrowers and sellers of equity) in exchange for a believable claim for both the return of capital and a return on capital – still occurs in a rationale manner • those who are considered worthy has changed dramatically • Capital markets continue to function as an efficient discounting mechanism where assets prices reflect the present value of expected cash flows discounted at the marginal cost of capital • Different investors have different required returns, but the marginal cost of capital is reflected in market-based security pricing • The cost of capital is still accurately reflected in stock prices, but the challenge of determining investors’ cash flow expectations becomes much more challenging

15. What Does It Mean for Estimating the Cost of Capital (continued)? • Risk premiums have increased, but the real story is that expectations regarding future cash flows and growth has been substantially lowered, resulting is large declines in risky assets • As far as the overall cost of capital, declines in risk free rates has acted as an offset where risk premiums have increased • Don’t forget, investment decisions are made by institutional investors within an overall portfolio context

16. What Does It Mean for Estimating the Cost of Capital (continued)? • Street research tends to lag investment reality during periods of rapid change • Bond ratings (same issue) • The form of DCF that best matches investor behavior is probably the most accurate • The market is making firm judgments about who is worthy and who is not. For those falling outside that ‘circle of trust’, capital is either not available or more costly. For those still deemed capable, the cost of capital is reasonable • The nature of regulation provides utilities with a substantial protection that is particularly valuable in periods such as this in terms of keeping the cost of capital relatively low • This top down macro event will continue to have a significant impact on security pricing and expectations regarding cash flows and growth

17. Thank You