Risk and Capital Management in Non-Financial Companies

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1 Risk and Capital Management in Non-Financial Companies 1. Introduction The recent past has seen the emergence of a number of trends in the financial markets: globalisation, deregulation, innovation, technological advancement, disintermediation and changes in the competitive structure of the financial sector. In turn, this has led to a re-assessment of the risk and capital management strategies of financial institutions and the role of financial regulation. These changes have also had a dramatic impact on the financial strategies of nonfinancial corporations. One of the most notable has been an expansion in the range of financial products available. In the area of risk management, an increasing number of risks can now be hedged, and for increasingly longer terms. A better understanding of derivative products and the processes and controls required for their application has made these risk management tools and techniques more accessible. Similarly, in the area of capital management 1, the increasing range and volume of available financial instruments has facilitated the creation of more complex capital and ownership structures that are more attuned to the specific needs of individual companies. Increasingly, corporations are recognising the need to focus on delivering shareholder returns. This has prompted greater attention to be directed towards assessing how balance sheet and risk management contributes to enhanced shareholder returns. The growth in leveraged buy-outs (the LBO movement ) has challenged conventional views about what constitutes optimal gearing strategy. 2 The availability of share buy-backs has put more pressure on companies to more actively manage their balance sheets. The fundamental issue is how to select, from the choices available, capital and risk management strategies that contribute to the maximisation of shareholder value. The academic literature does not have a well-accepted consensus view on the relationship between risk management strategies, financial strategy and value. Observation and empirical evidence documents a wide range of practices adopted by companies, suggesting that there is no single correct answer. The objective of this paper is to provide insights into the financial strategies of non-financial companies in so far as these strategies relate to risk management and capital structure. Section 2 puts forward some reasons for why the approach to risk and capital management Tony Carlton* in non-financial companies differs from that in financial institutions. This is followed in Section 3 by an overview of the principal financial strategy issues faced by non-financial companies, especially in the context of shareholder wealth maximisation. Section 4 outlines the principles underlying the concept of shareholder value and explains how these principles relate to risk and capital management strategies. The type of factors that need to be taken into account when determining value maximising risk and capital management strategies, as well as the link between these strategies and management incentive systems, are also considered. The final sections consider some implications for the role of the finance function in a non-financial company. The fundamental assertion of this paper is that nonfinancial companies must develop and implement risk and capital management strategies that demonstrably contribute to shareholder wealth creation. In addition to meeting shareholder demand, this will help focus the direction and efforts of the finance function. The value added by risk and capital structure management depends on the individual circumstances of the company and, in particular, the company s total risk profile, its tax profile, the specific risks and costs of financial distress, investment opportunities and the nature of company ownership. Hence, the optimum strategies are company specific it is inappropriate to apply formulaic rules of thumb. Acceptance that total risk is important inevitably leads to the conclusion that risk should be managed on a company-wide basis. In financial institutions the assessment of risk and the evaluation of capital needs are closely related. For non-financial companies, however, the link is less clear. Traditionally, the risks within the company have been managed on a segmented basis in line with business or functional responsibilities. Developing strategies that recognise the company s total risk requires a broad perspective on risk analysis that incorporates an understanding of the dynamics of each business. In addition, the management of risk needs to be more strategic in nature. Risk management adds value through the benefits of a more stable cash flow stream. A focus on short-term tactics and techniques does not necessarily enhance cash flow stability; strategic management of risk requires a longer-term perspective. 83 * General Manager, Finance, CSR Limited. 1 For the purposes of this paper, capital management refers to the process of determining the optimal capital structure of a non-financial company. There are, of course, a number of issues that relate to the optimal capital investment strategy that are not addressed here. 2 A leveraged buy-out (LBO) facilitates equity ownership of a company via a highly-geared transaction funded by a venture capital group.

2 Tony Carlton 84 To achieve such an approach, the finance function in a non-financial company must: place more emphasis on the process of risk management, especially the identification, understanding and measurement of exposures. Given that the solutions to many problems are now available through the use of derivative techniques, the focus should be on ensuring that the right problems are solved. This should involve not only the analysis of individual business and financial risks 3, but management of risk on a company-wide basis; direct greater effort to the area of performance measurement. The focus on risk management performance is a relatively recent one and follows from a number of developments including greater external reporting obligations, some high profile corporate derivative losses and an increased range of derivative products. Whatever method of performance measurement is chosen, it is important that the desired outcomes of risk management practices, and associated benchmarks and incentive systems, are aligned with the creation of shareholder value; ensure that the company is adopting a pro-active, and sufficiently aggressive, approach to capital management; better understand the potential linkages between capital structure strategies, risk management strategies and management incentive structures; and use risk measures that are appropriate for nonfinancial companies. While value-at-risk (VaR) techniques are becoming increasingly popular, such techniques are only appropriate for nonfinancial companies under limited circumstances. An approach to risk which focuses on the measurement of cash flow shortfall, or cash-flowat-risk, rather than the variance in market value, is probably more appropriate. 2. Why are Non-Financial Companies Different? The distinction between financial institutions and nonfinancial companies is critical to acquiring an understanding of the differences in approach to risk and capital in the two types of organisation. Further, given the relatively advanced state of development of disclosure requirements in financial institutions, this distinction is also relevant when determining how corporations can best publicly disclose exposures and risk management practices. This is an issue that is still not well addressed by those who regulate corporate disclosure requirements. Figure 1 summarises the key differences between financial institutions and non-financial corporations. In financial institutions risk is part of the intermediation process itself; the role of the financial Figure 1: Key Differences between Financial and Non-Financial Companies Financial Institutions Non-Financial Companies Regulatory Protect payments system and systemic risk Focus on corporate governance and disclosure Nature of Tradeable, financial assets, market makers Balance sheet comprises illiquid assets Assets Highly diversified portfolio Risk concentration Cash flows largely contractual Underlying cash flows non-contractual Diversification improves quality of the portfolio Portfolio diversification creates negligible value Role of Risk Raison d être to absorb and / or intermediate risk Risk arises from natural physical characteristics of underlying business Risk management is key focus and skill of Lower focus, less skills in the process management Aggregation and integration of company-wide Fragmented approach risks Risk Ability to statistically measure risk Limited ability to measure most of the risks due Measurement to limited observations, linkages and causal relationships 3 Business risks are incurred as part of the strategic decision making process of the company as well as in the company s day-to-day operations. Financial risks refer to the potential for changes in foreign exchange rates, interest rates or commodity prices to adversely impact on the cash flows of the company and consequently on that company s value.

3 Risk and Capital Management in Non-Financial Companies institution is to intermediate risk. 4 By contrast, in nonfinancial companies risk is a by-product of the underlying activities of the business lines. As highlighted in the Figure, non-financial companies typically deal with risks that are difficult to quantify and/or hedge. Also, the nature of the risks is such that risk management is more often fragmented than is the case in financial institutions. This may partially explain why non-financial companies are often characterised by a greater diversity of strategies relative to financial institutions. An important characteristic of nonfinancial companies is that the financial exposures arising from potential shifts in market prices (ie foreign exchange rates, interest rates and commodity prices) cannot be separated from the underlying business. The factors that drive cash flows are complex, and financial variables are inter-twined with the cash flows generated by a particular business. As a consequence, decisions about which exposures to hedge, or not hedge, are complex ones. Consider, for example, an Australian commodity exporter selling produce to the US. The exporter has exposure to the AUD/USD exchange rate as well as to changes in commodity prices. Understanding the exact nature of the exposure would require an understanding of the relationship between foreign exchange rates and commodity prices. Does a relationship exist and is it a causal one? Is the relationship stable over time or will it change as the structure of the global industry changes? If the commodity price and currency are perfectly negatively correlated then, in AUD terms, the exporter effectively has no exposure to the exchange rate. In this case, to hedge either the currency position or the commodity position would give rise to an exposure that previously did not exist. Another example is the indirect economic exposures of a locally operating company. A company operating solely in the local market, and competing with importers, can have as much exchange rate exposure as an export firm. A stronger AUD means that imports will become relatively cheaper, putting pressure on either the pricing or market share of the local supplier. Finally, one issue that must be addressed by many importing companies is the need to determine the effective currency of the commodity. Although many commodities are denominated in USD, the effective currency will depend on the interaction of marginal supply and demand, substitute products etc. Figure 2 provides a simplified representation of the corporate view of the world and attempts to explain how risk management fits within the broader strategy of a corporation. The objective of value maximisation is achieved through the performance, investment and financial strategies of the corporation. Unlike in many 85 Figure 2: Performance, Investment and Financial Strategies of Non-Financial Companies The Real Assets Financial Strategy Strategy Maximising long-term cash flows Financial strategy to lower overall Portfolio "How do we through cost of capital strategy create value?" strategy gearing superior operating performance dividend capital investment/growth options Ownership debt structure organisation design structure financial risk management Where Product markets for goods and Financial markets, where the Equity "Who do we services, (where the cash flows cash flows are valued market deal with?" are created) Risks strategic default Commodities commercial refinancing risk Currencies operating capital availability Interest rates technical cost of capital Risk operating leverage gearing/debt structure Management production location Risk derivatives Strategy volume/product mix strategies management insurance Options project selection processes self insurance diversification 4 Refer to the paper by Jenkins in this Volume for another perspective on the role of risk in financial institutions.

4 Tony Carlton 86 financial institutions, business strategies in non-financial companies, such as product diversification and location, are part of the risk management function itself. It is interesting to consider the range of real or operational responses that are available to nonfinancial companies to manage their risks: operating leverage (the mix of fixed and variable costs) is one way of responding to volatile markets; changing the location of production to a foreign country is a response to foreign exchange exposure posed by import competition; adjustments to production volumes can be made in response to anticipated variations in market prices; modifications to the business portfolio, through the screening of projects, abandonment of projects or divestment can be undertaken to impact directly on the risk profile of the company; and a diversified portfolio can be assumed in order to absorb risk. It is important to emphasise, however, that each of these risk management, or hedging, strategies will have its own economic costs and benefits in addition to those that may result from risk reduction. Nonetheless, the range of strategies at hand demonstrates that many of the risk management opportunities available to companies are deeply embedded within the individual businesses. It is also interesting to note from Figure 2 the interaction between real assets and financial markets; non-financial companies straddle the (real) product markets (where the value is created) and the financial markets (where cash flows are valued and traded). The performance of real assets is affected by events in the financial markets. The most obvious examples are the effects of exchange rate, interest rate and commodity prices on financial performance. However, just as potentially significant is the effect that financial strategies have on behaviour. For example, the gearing of a company can have a potentially significant impact on the behaviour of management and therefore the cash flows, and ultimately the value, of the business. This is best exemplified by the use of leveraged structures, such as LBO transactions, to facilitate the concentration of ownership. Strategies for achieving maximum value increasingly involve financial market tools, such as leveraged recapitalisations and spinoffs, as a means of adjusting the business portfolio and achieving improved incentive structures and corporate control mechanisms. While financial markets operate in terms of traded securities and readily observable values, businesses are focused on operating in the real asset markets. This highlights a critical role for the finance function in a non-financial company, namely, to act as the link between financial markets and business units. By applying financial market products to real businesses, the function adds value. This value is created not by duplicating the trading skills of financial institutions, but by acquiring a comprehensive understanding of the non-financial company s businesses and their operations, and by recognising when and how financial solutions can add value. 3. Risk and Capital Management in Non-Financial Companies Some Issues and Challenges The financial strategies of non-financial companies have been significantly impacted both by trends in financial markets and by changes in the corporate environment. Major changes in recent years have included: changes in the regulatory environment. Amongst other developments, these changes have enabled the use of share buy-backs and allowed for greater access to offshore markets; globalisation. Many companies now have access to a wide range of international markets. While this yields many benefits, it also means that companies are more quickly affected by changes in global financial markets and are increasingly subject to competitive pressures; disintermediation. The disintermediation trend has fundamentally changed the role of traditional commercial banks, providing companies with direct access to end-investors. In addition, the role of corporate lending has also changed, transforming the way that counterparties deal with banking providers; innovation. The development of new products has facilitated alternative risk transfer arrangements as well as more tailored capital structures; competitive structure of the financial sector. Competition amongst financial institutions has given rise to

5 Risk and Capital Management in Non-Financial Companies opportunities for end-customers to adopt reasonably aggressive approaches to supplier management and is also driving the process of innovation; and technology. Advancements in electronic technology have facilitated more efficient payment transfers. Also important are the dramatic improvements in computing technology that have allowed for more accurate analysis and pricing of derivative transactions. The combined impact of these changes in the financial markets has been an expansion in the available supply of competitively priced financial products. The increased availability of tools for hedging a wide range of financial exposures, along with the lengthening terms of these contracts and the ability to incorporate option-type features, means that companies are better able to fine tune hedging activities to their requirements. Similarly in the area of capital management, deregulation in the US and changing attitudes in Australia have made capital markets more accessible. Moreover, the greater acceptance of a wider range of counterparty credit qualities, together with the development of a diverse set of financing instruments, has facilitated the tailoring of capital structures. Perhaps the most significant trend, however, has been the development of a more active market for corporate control, and the accompanying focus on shareholder wealth creation. This focus on shareholder wealth comes at a time when there is increasing competitive pressures on virtually all companies. Hence, non-financial companies must focus on addressing the question of how risk and capital management strategies add value. Clearly, the impact on shareholder value should be the benchmark against which all alternative strategies for risk and capital management are evaluated. Against this background, there are a variety of challenges facing those responsible for setting financial strategies. A number of these issues raise fundamental questions about the value added by financial strategies and activities. Lack of Consensus as to How Risk Management Adds Value Despite the development of a wide range of tools for managing risk, an even more fundamental question must still be addressed, namely, how does risk management add value for shareholders? The relationship between risk management and shareholder value is difficult to determine. This is especially the case when considering capital structure and financial hedging strategies, eg interest rate and currency hedging. One source of guidance is given by Nobel Prize winners Modigliani and Miller who argued that financial strategies, such as capital structure and financial hedging, have no impact on value. 5 Their fundamental premise is that, as long as the cash flows and investments of the firm are given, the capital structure of a company cannot affect the value of that company since investors can duplicate any financial strategy in their own portfolio. This is an interesting conclusion that casts doubt on the value added by many corporate finance activities within non-financial companies. While many might perceive Modigliani and Miller s conclusion to be simply an abstract theoretical notion, there are numerous practical illustrations that suggest that financial hedging does not add value. For example, research by Copeland and Joshi questioned the economic benefits of currency hedging. 6 Their study, based on an analysis of the foreign exchange hedging strategies of 200 large companies, found that even the most complex hedging strategies did not necessarily reduce cash flow volatility. Hence their conclusion was that, in many instances, hedging is ineffective. This particular result is understandable since, as indicated by most surveys, companies generally hedge transactional exposures out to only 12 months. It is doubtful that such a strategy could have much of an impact on reducing long-term volatility. Moreover, even if the finance function succeeded in hedging all the financial risks of the company (a practical impossibility), financial risks are only a subset of a company s total exposure. Another commonly held view is that companies generally over-hedge their exposures. Again, this result is not surprising given that exposures are often separately managed within a company. As suggested earlier in the paper, there are also numerous examples where companies can, in fact, increase exposures through inappropriate hedging policies. Additionally, it is often felt that hedging offers only a short-term smoothing of reported profit and does not have a lasting impact on the company s fundamental profitability. Finally, a number of companies have policies in place that either preclude hedging strategies altogether or else employ them only in limited circumstances See Modigliani and Miller (1958). 6 See Copeland and Joshi (1996).

6 Tony Carlton 88 Companies take this approach for any one of a number of reasons. For example, the company might be of the view that shareholders buy shares in the company in order to acquire the relevant exposure. In hedging that exposure, company management may be acting in a way that conflicts with shareholder objectives. Similarly, it may be assumed that investors are well-diversified. Hence, they cannot benefit from the hedging strategies of individual companies and do not need the company to create a layer of protection that could potentially be very costly. All of this suggests that it is perhaps inappropriate to assume that the finance function s earnest endeavours at risk management are necessarily adding value for shareholders. The Relationship Between Performance Measurement and Shareholder Value A growing emphasis on productivity has highlighted the need for all functions within a non-financial company to demonstrate the value being added. Yet, a recent survey by the Australian Society of Corporate Treasurers reported that only 53 per cent of companies measured treasury performance. 7 Of these, one third were not happy with the performance measures used; the main reasons cited for this dissatisfaction were the simplicity of measures and the fact that measures were still underdeveloped. These results do not sit well with an activity that should be able to clearly demonstrate its contribution to shareholder value. The fundamental goal of any performance measurement system is to provide a basis for management decision making that produces the best balance of cost and risk, given the objectives, financial position and other constraints of the corporation. Performance measurement should encourage behaviour that reflects corporate objectives 8, while at the same time providing feedback to facilitate improvements in decision making. Fundamental to this is the selection of a benchmark that reflects the risk management objectives of the company. Failure to specify clear performance objectives for the risk management function may undermine the function. In particular, it could lead to: a lack of accountability; a failure to create or, at a minimum, preserve value through misspecified targets; and the adoption of a reactive risk management strategy that is certain to fail. Using the Right Risk Measure for Non- Financial Companies A number of papers in this Volume have made mention of VaR. 9 While VaR is a key risk measurement tool in financial institutions, the application of this technique in non-financial corporations poses a number of conceptual and implementation issues. As mentioned in the Introduction, often the focus in corporations is on the exposures generated by the specific cash flow patterns of physical positions, rather than on the values of positions. Also, the most common application of VaR in financial institutions is on traded financial instruments that are held over short time horizons and thus are assumed to be reasonably liquid. By contrast, non-financial companies hold few traded positions; positions are typically illiquid and of a much longer term. Despite these issues, the relative simplicity of VaR and the manner by which it encapsulates risk into a single number make it a seductive measure to use. Implementation of this type of technique by a non-financial company would require the company to address problems such as illiquidity, non-linear exposures, extreme observations and non-stationarity (especially for exposures measured over longer terms). Of course, financial institutions are faced with many of these problems also. Unless non-financial companies can develop an alternative risk measurement framework that is sufficiently rigorous they will be forced to rely on VaR techniques. External Reporting Framework for Financial Risks The disclosure regime imposed on non-financial corporations poses particular difficulties when risk is managed on an economic basis. Specifically, the external reporting of risk management activities can have a distorting effect. This point is well summarised by Kaplan and Leftwich: why information about a subset of a firm s assets (derivatives) warrants such attention reflects politics, not economics. 10 (This comment would seem to be supported by the results of a 1995 Chase/Wharton survey of US companies, which found that the biggest concern of companies in relation to the use of derivatives was the potential accounting treatment of positions. 11 ) External accounting rules are certainly tending towards requiring all derivative positions to be valued on a mark-to-market basis. These rules also allow the risk 7 Australian Society of Corporate Treasurers (1998). 8 Refer to the paper by Moss in this Volume for further discussion of performance structures. 9 See, for example, the papers by Matten, Moss and Funke Kupper in this Volume. 10 Kaplan and Leftwich (1998). 11 Bodnar, Hayt, Marston and Smithson (1995).

7 Risk and Capital Management in Non-Financial Companies associated with derivative exposures to be quantified using statistical techniques such as VaR. While such approaches are certainly legitimate, requiring nonfinancial companies to comply with measurement rules that are appropriate for financial institutions perhaps reflects a lack of understanding regarding the differences between the two types of organisation. Failure to appreciate this distinction has resulted in a disclosure regime for non-financial companies that focuses on the value of the derivative position rather than the net hedged position. In requiring derivatives to be marked-to-market, but prohibiting marking-tomarket of the underlying exposure, the accounting rules are imposing an approach which identifies gains (losses) in the derivative position yet ignores the associated losses (gains) on the underlying exposure. Similarly, the application of VaR to only the derivative position ignores the exposure associated with the overall position. Pressure for More Pro-active Capital Structure Management Historically, the financial policies of non-financial companies have been largely passive, reflecting the accumulated impact of a series of decisions at the margin. Today, however, the increasing pressure created by the developments outlined earlier in this Section have forced companies to be more pro-active in managing their capital structure. On the demand side, the focus on shareholder value has meant that companies simply cannot afford to have inefficient capital structures. On the supply side, innovation and deregulation, especially the legalisation of share buy-backs, have enabled companies to dramatically change their capital structures over a relatively short period of time. Figure 3 lists some of the tools that non-financial companies can use to adjust financial structures in light of changed market conditions or company circumstances. The main message is a simple one. Finance functions must continuously monitor the efficiency of the capital structure against the current requirements of the business units and against developments in financial markets. Even more fundamental than a freer regulatory environment are the challenges to more traditional (and conservative) approaches to setting capital structure targets posed by the LBO approach to financial structure. 12 The key elements of this approach are the aggressive use of debt and concentration of ownership. It is argued that companies that generate surplus cash (generally those in mature or low-growth industries) will tend to reinvest such cash in negative NPV projects (and management perquisites) rather than return significant funds to shareholders. These companies thus destroy value for shareholders. Such behaviour is also more likely to occur in conglomerates where funds from profitable businesses are at a higher risk of being invested in those divisions that are not performing as strongly. One way of overcoming this profligate use of cash is to inject a high level of debt into the business. The resulting repayment obligations effectively precommit a large proportion of future cash flows. High debt levels also allow a greater concentration of equity ownership, particularly management equity, allowing significantly leveraged returns. 89 Figure 3: Capital Structure Management Determine overall financial strategy Debt Equitylinked debt Equity Determine desired structure of each class of funding Select type of funding instrument Issuing strategy and tactics Interest rate risk management On-going adjustments increase gearing through share buy-backs etc reduce gearing through equity issues change equity structure through carve-outs repay debt through debt buy-backs, repayment defeasance use flexible debt facilities to tap markets opportunistically significantly change interest rate exposure, without repaying debt, through swaps 12 Refer to the Appendix for an illustrative application of the traditional approach to determining capital structure.

8 Tony Carlton 90 While this type of argument is partly behind the LBO movement, it has also driven the use of other aggressive financial strategies by non-financial companies. One example is leveraged recapitalisation. Under this strategy, a company funds a major share buyback through the use of large-scale debt funding, often resulting in a capital structure very similar to an LBO company. While there have been a number of examples of these strategies in the US, there do not appear to be any Australian companies adopting such approaches at present. Moreover, the limited numbers of buy-backs that have been undertaken by non-financial companies in Australia have generally been motivated by a desire to return divestment proceeds to shareholders. Proponents of the aggressive use of debt cite the failure of internal control systems to appropriately constrain the business risks arising in those companies that are subject to the surplus cash flow problem. There is a wide range of companies subject to this risk, including many industrial companies operating in markets that are traditionally characterised by surplus capacity. The LBO approach can essentially be viewed as one that outsources the process that drives corporate performance. One alternative approach is the adoption of economic value added/shareholder value added performance measurement systems Risk, Capital Management and Shareholder Value The previous Section identified a number of issues facing non-financial companies, thereby highlighting the difficulties in demonstrating value added. In order to determine risk and capital management strategies in a non-financial corporation, it is necessary to explore those factors that underpin the valuation of the firm. The purpose of this Section is to review recent theory and empirical research to determine whether there are guidelines available for selecting value maximising strategies. Figure 4: Key Drivers of Company Value Business Unit Specific Value Drivers (examples) High-level Value Drivers market size market share volume/price raw material prices staffing levels wage rates production efficiency operational improvement Revenue Operating costs Cash profit Growth Options corporate tax rate franking credits tax effective structures Taxes Cash flows from operations (years 1-10) X Business unit value receivables payables inventory plant life replacement policy maintenance Working capital Capital expenditure Investment required to support operations cost of equity for business cost of debt gearing effective tax rate Project/cost of capital Discount rate sustainable cash flow after year 10 duration and growth cost of capital Terminal value (year 10) 13 Refer to the paper by Funke Kupper in this Volume for further discussion of economic value added techniques.

9 Risk and Capital Management in Non-Financial Companies The most commonly accepted model of shareholder value has as its foundation the notion that value is determined by expectations of long-term cash flows, discounted at the risk-adjusted cost of capital. Figure 4 describes the framework for a typical financial model based on this approach. The Figure highlights that a wide range of variables, some of which are under the control of management, and others which are external to the company, impact on value. A model that incorporates key operating variables will provide longterm cash flow forecasts and the appropriate setting for the determination of long-term financial goals. This model raises two questions in relation to risk and value: how should those risks confronting the business be measured and how does the choice of risk measurement technique impact on the perceived value of the business? 4.1. Measuring Risk Without doubt, all companies face a wide variety of risks, including strategic, operational, financial, environmental and technological risks. Figure 5 summarises one way of classifying some of the risk factors faced by corporations into broad risk classes. The total risk of a company is a measure of the combined impact of these risk factors on the cash flows generated by each of the business streams, after taking into account hedging and other risk mitigation techniques. Traditionally, the risks within the company have been managed on a segmented basis in line with business or functional responsibilities. The identification of risk in non-financial companies is a difficult task and there exists no consensus about how best to tackle it. The task of quantifying these risks is even more difficult. The ideal approach would quantify each risk on the basis of its likelihood of occurrence and potential impact on the cash flows of the business. Forecasting and simulation models are useful tools if such a methodology is to be adopted. The difficulty is in incorporating the totality of risks into the approach. Consequently, in practice any quantitative approach needs to be supported by a rigorous, qualitative evaluation of risks, to allow an overall assessment of exposure to be made. The objective of the risk management function, therefore, is to monitor and manage the actual occurrence of each risk. In a qualitative sense, new and existing risks can be represented on a risk grid or map. 14 For a number of risks, hedging may not be possible and so significant reliance is placed on management processes for screening and monitoring risks. Some of the mechanisms for effective screening of business risks include the use of the strategic planning process and the use of a number of metrics to assess historical and prospective performance. Such a process requires that management understand the 91 Figure 5: A Taxonomy of Business Risks Strategic Financial Operational Commercial Technical Risks of plans failing Risks of financial controls failing Risks of human error or omission Risks of business interruption Risks of physical assets failing or being damaged business cycle poor marketing strategy poor acquisitions strategy changes in consumer behaviour political/ regulatory change treasury risks lack of counterparty/ credit assessment sophisticated fraud systems failure poor stock/ receivables reconciliation design mistakes unsafe behaviour employee practices risks sabotage loss of key executive supplier failure lack of legal compliance equipment breakdown infrastructure failure fire explosion pollution drought and other natural perils poor technology Source: PricewaterhouseCoopers (1997). 14 Refer to Bennett s response to this paper for further discussion of qualitative approaches to managing risk.

10 Tony Carlton 92 nature of the risks, the types of potential outcomes, the company s capacity to absorb risk, and strategies to mitigate risk, such as training, enhanced risk screening of new projects etc The Relationship Between Risk and Shareholder Value The cost of capital approach to valuation implies that changes in the risk profile of the company will only affect that company s valuation through the impact on cash flow or the discount rate. This gives rise to the question of how risk is factored into the valuation model. The most common application of the cost of capital approach is through the use of the capital asset pricing model, which differentiates between systematic risk and non-systematic risk. 15 The measurement of each of these risks has implications for determining the appropriate cost of equity. Systematic risk cannot be diversified away. It reflects the influence of general economic activity on the volatility of returns and is measured by the well-known beta factor. Investors demand compensation in exchange for assuming systematic risk and hence this type of risk must be incorporated into the cost of capital calculation. By contrast, non-systematic risk is particular to each company. A basic premise of modern valuation theory is that for well-diversified investors the non-systematic risks associated with particular projects will cancel out. As a consequence, such risks do not require additional compensatory return. Hence, the most appropriate way to incorporate these risks into the valuation process is to include them in the calculation of expected cash flows, not via an adjustment to the discount rate. While the above discussion does give some insight into the value consequences of business risks on corporate value, it is less clear about the capital structure and hedging strategies associated with financial risks. As noted earlier, the original Modigliani and Miller propositions argued that financial strategies, such as capital structure and financial hedging, have no impact on value. Their fundamental argument is that, as long as cash flows and investments are given, financial strategies cannot affect value as well-diversified investors can duplicate these strategies themselves. This is behind their well-known propositions that capital structure does not matter. Similarly, well-diversified investors do not benefit from company specific hedging actions as these risks can be eliminated if the investor holds a welldiversified portfolio or, under the assumptions of the model, if the investor can duplicate a financial strategy. Since financial strategies only influence diversifiable risk, there is no change to the required discount rate. If risk management and capital structure decisions are to add value, therefore, it must be through their effect on cash flows, and it is here where most academic effort has been placed. How Can Risk Management Add Value? The conclusion to be drawn is that risk management can add value in certain circumstances. This is demonstrated by considering the assumptions on which the Modigliani and Miller proposition (that financial strategies do not add value) is based. The key assumptions are: no taxes; no costs of bankruptcy; that operating and investment cash flows are given; and that management acts to maximise shareholder value. Relaxing these assumptions highlights how financial strategies can, in fact, add value: taxation. The asymmetric treatment of tax losses means that the smoothing of cash flows improves the values of those cash flows. This arises because positive taxes must be paid as earned whereas the benefit of tax losses is only realised when future taxable income accrues. This factor may be especially relevant in Australia where the focus of companies is on servicing franked dividends; financial distress. In addition to bankruptcy, financial distress includes the costs to the company of actions by suppliers, customers and employees who may be concerned about the financial status of an organisation well before it becomes bankrupt. Clearly, companies with potentially high costs of financial distress, ie those with high switching costs or with a high service or reputation content in their product offering, will benefit from the lower risk of financial distress occasioned by a risk management program; and under-investment. It could be argued that firms make decisions in line with long-run shareholder value when cash flows are available to meet investment 15 See, for example, Ross, Westerfield and Jordan (1995).

11 Risk and Capital Management in Non-Financial Companies requirements. Shortfalls in cash flows lead companies to approach external markets to fund new projects. In turn, the costs of external financing may result in the cancellation of value creating expenditures (such as expenditures on research and development), thus reducing the long-run value of the company. Companies with significant opportunities for growth, but limited access to funding, will benefit from a well-designed and executed risk management program that seeks to avoid cash flow shortfalls. The implication of these sorts of analyses is that in some situations risk does matter and, hence, risk management can add value. Whether this is the case depends on the situation of each company (eg tax, financial risk, growth options, competitor behaviour), the size and nature of the company s risks, and the company s own risk tolerance. It should be emphasised, however, that all of the situations mentioned above relate to the impact of shortfalls in cash flow, rather than cash flow volatility. The implication of this is that risk management in non-financial companies only adds value if the cash flows of the business can be enhanced (by adjusting the lower tail of the profit and loss probability distribution). Thus, the objective of corporate risk management should be to eliminate costly lower-tail outcomes. 16 As mentioned at various points throughout this paper, the relevant risk measure is the probability of cash flow shortfalls, rather than a measure of potential changes in the value of the position. To determine the risk profile of the company, a simulation-based approach can be used to analyse various worst-case scenarios and assess the impact of these on the cash flows of the firm. The above discussion implies that the optimal risk management strategy is company specific a conclusion consistent with the observation that there is a wide diversity in the risk management practices of companies. A number of companies do not use derivative products and, for those that do, there is a wide range of uses adopted. For example, larger companies tend to hedge more than smaller companies. While this result appears to be somewhat inconsistent with the argument that says larger firms should be more immune from risk, it most probably reflects the economies of scale required to establish comprehensive risk management programs. Additionally, companies with greater growth opportunities, including higher research and development expenditures, also tend to have higher levels of hedging, as do companies with more financial risk. All of this is in line with the earlier discussion that concluded that the most appropriate risk management solutions for an individual company are peculiar to that company. The above arguments point to a number of factors that explain how risk management can add value. There is also interesting empirical evidence suggesting a strong relationship between management incentives and risk management behaviour. For example, Tufano (1996) analyses risk management strategies in the US gold mining industry, and observes that the main determinants of hedging decisions are the level of management ownership and the nature of management compensation contracts. Lower levels of hedging are associated with lower levels of management ownership. This does not imply a relationship between shareholder value and risk management, however, it does suggest that risk management performance benchmarks need to be aligned with shareholder objectives. This conclusion has implications for the selection of performance benchmarks and for the management of multiple risks within companies. The core of any effective performance measurement system is the selection of a benchmark. The analysis implies that the appropriate benchmark is most properly determined by the circumstances of the company two companies with similar exposures can legitimately have different benchmarks and follow different risk management strategies. One possible approach is to compare performance against a benchmark strategy. That is, rather than compare performance against a fixed outcome, such as a certain return or cost of funds, actual performance is compared against the results of a pre-agreed risk management strategy that yields an acceptable risk-return profile (expressed as a probability distribution of future cash flows). The benchmark strategy reflects informed judgements about issues such as debt capacity, funding for growth and dividends, and franking-credit policy. The approach must also take into account the risk tolerance of the company (ie what the company regards as an acceptable decline in cash flow) as well as external factors such as expected market volatility. CSR has adopted a risk management framework for financial risks that allows each exposure in each See Stulz (1996) for further discussion of this objective.

12 Tony Carlton 94 Figure 6: CSR s Risk Management Approach selective hedging for individual exposures each Business Unit responsible for managing their own exposure Board not involved in detailed strategic or tactical decisions but does have assurance in proper management processes required development of benchmark and defined limits for each exposure reporting requirements specified no speculative transactions to be undertaken transactions must comply with approved risk management process approval for new instruments for specific application credit limits not to be exceeded delegated authorities for individual transactions treasury provides expertise, dealing, systems Approved exposure Approved strategy Approved benchmark Approved hedging limits Approved instruments Conditions of use of each instrument CSR Credit Limits Policy business to be managed individually at the business unit level (see Figure 6). Such an approach ensures that the responsibility for risk management is delegated to the business units. Decentralisation also ensures that individual business units are accountable for their own performance. The framework specifies for the company as a whole a range of controls, responsibilities and reporting obligations that each business must follow when managing its exposures. How Can Capital Management Add Value? Not surprisingly, the same factors that provide the risk management process with an opportunity to add value also influence a company s optimal capital structure. Specifically, the benefits of debt are achieved through: taxation. The existence of tax benefits on interest, relative to dividends, creates a tax-induced motive to borrow funds (as opposed to raising equity). The significance of this factor may also depend on the debt tax shield available to the entity; financial distress. Given excessive leverage, the tax benefit described above will eventually be counteracted by the increased risk of financial distress and the many costs that are associated with it, such as those relating to bankruptcy and the actions taken by customers, suppliers and employees in response to a perceived deterioration in financial quality. The trade-off between these two factors will, in theory at least, lead to an optimal capital structure. Companies will have different optimal capital structures depending on their taxable income capacity and the costs of financial distress; under-investment. The problem of underinvestment is also regarded as a significant determinant of capital structure strategy. Firms with valuable growth options have a higher risk of following a sub-optimal investment strategy when debt levels are excessive hence the debt levels of such firms are expected to be lower; benefits of debt in controlling over-investment. One additional dimension, which is unique to the capital structure decision, relates to the benefits that higher levels of debt can bring to situations where a company has considerable surplus cash flow. This issue was raised in the discussion of capital structure management in Section 3. Of course, the benefits of higher leverage need to be balanced against the associated increase in risk. A significant amount of empirical research into what drives a company s capital structure decisions has been undertaken. As with risk management, the conclusions drawn from this research are wide ranging. Some of the main findings are: there is significant divergence in the choice of capital structures between firms; there is some evidence, albeit weak, of a relationship between a company s tax position and its use of debt; and the most consistent variable that appears to explain differences in gearing is the extent of growth opportunities available to companies. As expected, companies with more opportunities appear to have lower debt ratios. As with risk management, the conclusion is that capital