THE OBJECTIVE OF RISK MANAGEMENT
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1 THE OBJECTIVE OF RISK MANAGEMENT
2 Risk Management Suppose the firm is closely owned Proprietorship Partnership Privately held corporation Suppose the owner(s) are risk averse Risk management can make owners better off Reduces the risk, even firm specific risk
3 M&M Theorem M&M theorem: purely financial decisions do not affect firm value M&M assumes No taxes No bankruptcy costs No information asymmetry No agency problems We know that all of these are issues in the real world Financial decisions have real consequences for firm value
4 M&M Theorem Financial decisions affect firm value The effect must be on one or more of Taxes Bankruptcy cost Information asymmetry Agency problems
5 Firm Value A very simple model of firm value is the Gordon growth model: where d 1 is future dividend k is the WACC g is the growth rate V = d 1 /(k g)
6 Firm Value Risk management affects Taxes Bankruptcy cost Information asymmetry Agency problems Which in turn changes Future dividends (more broadly, cash flows to shareholder) WACC Growth
7 Firm Value Risk management is unlikely to change firm value directly CAPM: Risk are unsystematic/diversifiable or systematic/undiverifiable No reward for eliminating unsystematic risks Investors can eliminate unsystematic risks through diversification Systematic risk is priced in the market
8 Firm Value Suppose you transfer some of your systematic risk to X Your beta falls to 1 = 0 This increases the value of your firm (lower WACC) by V, where V is determined by the market price of risk X s now bears more systematic risk X s beta rises to X1 = x0 + This decreases the value of firm X (higher WACC) by V X must be compensated The payment of V to X offsets the increase in value of your firm and the decreases in value of firm X.
9 Firm Value Risk management has to work by affecting cash flows and/or growth d 1 = d 0 (1+g) V = d 1 /(k g) d 0 comes from firm s current profits after creditors are paid Result of past investments g comes from current investments, availability of future investment opportunities
10 Firm Value To maximize value the firm needs to have cash flow to Pay creditors (otherwise d 0 = 0) Invest (otherwise g = 0)
11 The objective of risk management is to ensure the firm has sufficient cash flow to Pay creditors Invest in growth opportunities With a high degree of confidence Firms want to fund investment internally, if possible Remember Pecking Order theory
12 For simplicity, suppose the firm can choose one of three risk management policies High risk Medium risk Low risk with different effects of the distribution of the firm s cash flows
13 Probability of Not Being Able to Meet Capital Risk Scenario Expected Cash Flow Standard Deviation in Cash Flow Expenditure, Dividend, and Principal and Interest Requirements Low risk $58.34 million $3.14 million 0.00% Medium risk $61 million $12.33 million 11.46% High risk $66.81 million $21.44 million 16.53%
14 In this example, the High and Medium policies have substantial risk of falling short of the goal of meeting debt service, dividend and planned capital expenditures Failure to meet debt service obligations leads to bankruptcy High probability leads to financial distress Failure to pay/reduction in dividends lowers firm value Failure to invest in growth opportunities lower firm value May need more costly external funds
15 The low risk plan leaves the firm with some risk If the firm eliminates all risk, it will earn the risk-free return Might as well invest in Treasuries Firm has to bear some risk if it wants to earn more than the risk-free return
16 The firm has to bear some risks What risks should it bear? Some risks are central to the business An oil exploration firm has to bear the risk of finding/not finding new deposits A clothing store has to bear the risk of stocking fashionable clothing The firm should have a comparative advantage at bearing these risks What are the firm s core competencies?
17 Other risks are incidental: Arise from bearing core risk but not central to the business E.g. bearing risk of fluctuations in oil prices, exchange rates It will often be advantageous to let some else bear these risks Hedge the oil price and FX risks
18
19 What is the firm s strategy? What risks are part of that strategy? Which of the risks are central to the strategy, which are not? E.g., Clothing store want to expand from U.S. to Canada Risk of different consumer tastes central to strategy (comparative advantage) Exchange rate risk is not central (no comparative advantage)
20 What risks are central to the strategy? Are there offsetting risks? Firm produces oil and petrochemicals When oil prices are high/low Oil well business is more/less profitable, petrochemical business less/more profitable The two divisions provide a natural hedge against oil price movements TXU Corp in BF&H Residential sales provided partial hedge of wholesale electricity prices
21 Consider examples of Dresser and Caterpillar in FS&S Both companies bore risks that were not central to their business Dresser oil price Caterpillar FX risk Both companies had to reduce capital expenditure due to reduced cash flow Both companies lost market position to competitors
22 Consider example of TXU on BF&H TXU decided it owned the risk of generation business Had partial hedge from residential electricity market Divested unrelated (non-strategic) businesses Australian utility, gas pipeline, telecom startup Use cash from asset sales to de-leverage Outsourced call center and billing No comparative advantage in these operations
23 Identify and understand your major risks Decide which risks are natural Determine your risk capacity and risk appetite Embed risk in all decisions Investment Commercial Financial Operational Align governance and organization around risk
24 Understand the difference between hedging and speculating Proctor & Gamble - Interest rate swaps Metallgesellchaft - 10 year oil futures w/ short term hedge Orange County leveraged interest rate derivatives Have operational controls over trading Barings Bank Nick Leeson Goldman Sachs - London Whale
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