RISK MANAGEMENT AND VALUE CREATION

RISK MANAGEMENT AND VALUE CREATION

Risk Management and Value Creation On perfect capital market, risk management is irrelevant (M&M). No taxes No bankruptcy costs No information asymmetries No agency problems Risk management must work through on or more of these channels to change firm cash flow 2

Core vs. Incidental risks Every firm faces: Core risks: Very business of the particular firm; exploit these risks for profit Incidental risks: Risks that arise as part of undertaking core risks Firms want to maximize profit relative to the risk assumed Should assume the risks with the highest reward ratio No comparative advantage in bearing incidental risk Incidental risks should be transferred to outsiders Frees up capacity to assume more core risk This approach is called Enterprise Risk Management. 3

Limits of diversification Stock markets allow business risk to be pooled. However, most businesses will not issue stock. If owners are not well diversified, risk management will reduce owner s risk Beneficial because owners are individuals who are risk-averse for the most part 4

Limits of diversification Other stakeholders of the firms might not be well diversified Example: Workers, managers, suppliers, creditors, the general public, They might benefit from actions that reduce diversifiable firm risk because they are risk-averse. Example: An employee might find it hard to diversify the risk that the firm goes out of business and he loses his job. Employee s earnings are tightly tied to the well-being of company. Being risk-averse, the risk of job loss makes him worse off. If the firms takes actions to lower the likelihood of bankruptcy, this is beneficial to the risk-averse employee. the firm because it no longer has to pay a risk premium. Risk management improves contractual terms with stakeholders of the firm. 5

Taxation If tax rates are progressive, risk management can reduce expected tax burden on the firm. Tax rate progressivity: tax rates increase as taxable income increases Then, after-tax earnings are an increasing and concave function of taxable earnings Reducing the variability of pre-tax earnings reduced average tax payment Increases average after-tax income 6

Taxation: Graphically Net Income With RM Without RM Net Income Taxes Low Average High Taxable Income 7

Taxation: Interest tax shield on debt Debt interest payments are tax deductible. Tax shield: Amount by which tax payments are reduced as a result of the ability to deduct an expense when calculating taxable income. Trade-off: debt increases the likelihood of financial distress. Tax benefits of debt must be weighed against the cost of financial distress. Risk management reduces agency problems associated with debt This allows firms to have a higher debt levels than without risk management RMI. Higher debt level => greater benefit from tax shield. Graham and Smith (1999): Tax benefit from hedging for 50% of the firms. On average: 1% red. in volatility of taxable income reduces NPV of taxes by 1%. 8

Taxation: Carryforwards and carrybacks Companies can undo some of the progressivity of tax rates Loss carryforward/carryback allow firms to smooth income over time Loss carryforward: Company can apply current year s net operating losses to fu-ture years profits to reduce tax liability (any of the seven years following the loss) Loss carryback: Apply net operating losses retroactively to preceding year s income to reduce tax liabilities in previous year (three years preceding the loss) Insurance companies face a preferential tax treatment when it comes to interest earned on the funds needed to pay future losses. By obtaining insurance, firms can benefit to some extent from that effect 9

Financial distress Financial distress is a condition where a company cannot meet or has difficulty paying off its financial obligations to its creditors. The chance of financial distress increases when a firm has high fixed costs, illiquid assets, or revenues that are sensitive to economic downturns. Financial distress is costly: direct and indirect costs Direct costs: Legal and court fees Accountancy fees Other administrative costs 3% - 7% of total assets Indirect costs: Contracting costs Productivity time lost Foregone opportunities Reputational loss Inefficient asset sales 10%-20% of firm value 10

Financial distress: Firm value Who bears the cost of financial distress (ex ante)? Creditors anticipate risk of financial distress: contracting terms reflect expectations Other stakeholders: compensation for potential financial distress Shareholders bear the cost of financial distress Effect of financial distress on firm value: Firm value = Firm value without financial distress - Expected NPV of the cost of financial distress Measures that reduce NPV of financial distress cost increase firm value 11

Financial distress Risk management can help reduce the expected NPV of financial distress cost The firm is less likely to be in state where it cannot pay its obligations Probability of being financially distressed is lower Which lowers the expected NPV of financial distress cost 12

Agency problems Agency problem: Conflict of interest in relationship where one party (agent) is expected to act in another s best interest (principal). If agent is self-interested and her own interests differ from the principal s, inefficient outcomes can arise. Agency problems arise between shareholders and creditors. Shareholders control decision making processes within the firm Creditors lend their money without control over decision making processes Shareholders might exploit bondholders/creditors. The possibility of this happening is costly for the firms 13

Agency problems Several forms of agency problems Asset substitution: Risky project is adopted despite its negative NPV Underinvestment: Risky project is not adopted despite its positive NPV Underinvestment can arise dynamically over time as a commitment problem Shareholder cannot credibly commit to they will not behave badly Debtholders/bondholders: Fixed payment of principal and interest Only if firm value is sufficient to cover obligations Shareholders: Receive the residual claim Are paid after the bondholders 14

Agency problems Graphically: Asset substitution value of claims X: initial situation w/o new project Y, Z: firm value w/ new project (both values equally likely) Shareholders D Debtholders Z - D Y X - D 0 Y D X Z value of the firm

Agency problems: Asset substitution Shareholders have incentive to implement a negative NPV project. Why? If things go well (X Z), they capture all the upside. If things go bad (X Y), the debtholders bear most of the downside. Heads I win, tails you lose! 16

Agency Problems: Asset Substitution Example: The value of the firm is 120, Face value of debt is 100 Risky project is equally likely to pay off 30 or to lose 40 (net of any financing costs); interest rate is 0. Note that firm is bankrupt if project fails! What is the project s NPV? Find the shareholder s payoff with/without the project. Do they want to implement it? Do the same for the debtholders. 17

Agency problems: Asset substitution NPV = 0.5 30 0.5 40 5 Shareholders: Payoff w/o project: 120 100 20 Expected payoff w/ project: 0.5 150 100 0.5 0 25 Shareholders are in favor of the project! Debtholders: Payoff w/o project: 100 Expected payoff w/ project: 0.5 100 0.5 80 90 Debtholders are against the project! 18

Agency problems: Asset substitution Reason for the problem: firm is financially distressed (debt overhang) RM can help reduce the likelihood of a firm being financially distressed 19

Agency problems: Asset substitution Example (con t): Firm faces liability suit for 80 Value of the firm is 200 with a prob. of 90% and 120 with a prob. of 10% if the firm loses a liability lawsuit. Face value of debt is 100. Shareholders would implement a risky project that is equally likely to pay off 30 or to lose 40 if the firm value is 120. Would they implement it if the firm wins the lawsuit? The firm can buy full coverage liability insurance at the actuarially fair price. With insurance, would the shareholders still want to implement the risky project? 20

Agency problems: Asset substitution Assume firm wins lawsuit. Shareholders decision: Payoff w/o project: 200 100 100 Payoff w/ project: 0.5 230 100 0.5 160 100 95 Shareholders do not want the project! Loss in case of liability lawsuit: 80. Actuarially fair premium: 10% of 80 = 8. Share-holders decision: Payoff w/o project: 200 8 100 92 Payoff w/ project: 0.5 230 8 100 0.5 160 8 100 87 Shareholders do not want the project! 21

Agency problems: Underinvestment Similar problem Positive NPV project Senior debtholders realize benefits, shareholders realize costs Shareholders decide to forego the project Arises when firm is financially distressed (debt overhang) Risk management can help reduce the likelihood of firm being financially distressed RM reduces likelihood of situations in which shareholders would want to forego positive NPV projects (RM reduces probability of debt overhang) Signal that company is unlikely to suffer from underinvestment problem Improves contracting conditions to raise equity 22

Costly external financing Without RM: higher likelihood of large losses that must be paid either from internal funds or by raising new funds. External funds can be raised through borrowing But if a large loss has just occurred, this might be very costly/unfavorable External funds can be raised by issuing new securities Investment banker fees Legal and regulatory costs (filing appropriate paperwork) Underpricing costs 23

Costly external financing Without RM: higher likelihood of paying for losses from internal funds. Funds are less likely to be available when profitable investment opportunities arise. Using external funds reduces NPV of new projects because external funds are more costly than internal ones Some projects with positive NPV if internal funds can be used but negative NPV if external funds have to be used will be foregone due to bad timing. 24

Costly external financing: Pecking Order Theory Pecking Order: Internal funds Debt Convertible securities Equity Cash flow risk management preserves internal funds and avoids the forfeiture of positive NPV projects. Key to creating corporate value is making good investments Key to making good investments is generating enough cash internally to fund those investments Cash flow so crucial to the investment process can often be disrupted by risk, potentially compromising a company s ability to invest. 25

Access to services Insurers provide services beyond indemnification of losses Loss control: Insurers may help identify exposures, reduce the likelihood of losses, and reduce potential downtime. Claims processing: Handling of claims Part of the loading can be viewed as the cost of obtaining these services. If loading is less than the cost of obtaining these services elsewhere, insurance increases firm value. 26

Access to services Insurers can offer loss control and claims processing services on better terms than other corporations. Why? Specific expertise in these areas: Experience with loss control in similar companies Years of claims data Claims processing on a daily basis Procedures and routines are already in place Insurers have comparative advantage; can offer services at competitive prices 27

Others Some insurance is compulsory (e.g. workers comp, auto/truck liability) Financial accounting factors: RM reduces variability of accounting numbers; this helps investors predict earn-ings and cash flows more accurately RM reduces likelihood of the firm triggering default and having to incur the costs of renegotiating its debt contracts. Managers bonuses are based on reported earnings. Less volatile earnings increase likelihood of earnings exceeding level necessary for mangers to receive a bonus. Less volatile earnings allow the firm s shareholders to monitor managers more effectively (at lower cost). 28