Winter 2010/2011 Module III: Risk Management Motives steinorth@bwl.lmu.de
Perfect financial markets Assumptions: no taxes no transaction costs no costs of writing and enforcing contracts no restrictions on investments in securities symmetric information investors take prices as given (because they are too small to affect prices) ( real-world financial markets are imperfect) 51
Risk management and shareholder wealth Would shareholders want a firm to spend cash on reducing the volatility of its cash flow? Assumptions: The only benefit of risk management is to decrease share return volatility. Shareholders are investors who care only about expected return, volatility. Shareholders hold a well-diversified portfolio of risky assets (market portfolio or a portfolio not too different from it). Shareholders allocate their wealth between the risk-free asset and a diversified portfolio of risky assets. (recall what you know from the CAPM) Reduction of volatility by reduction of diversifiable risk (unsystematic risk) systematic risk 52
Reduction of diversifiable risk The only benefit of the payment is a reduction / elimination of diversifiable risk of the shares If reduction is costly: expected cash flows are reduced. But: firm value does not depend on diversifiable risk Shareholders are diversified They have no reason to care about diversifiable risks. Shareholders do not want the management to decrease the firm s diversifiable risk at a cost. They can eliminate the firm s diversifiable risk by diversification at zero cost. Reduction of diversifiable risk does not increase shareholder wealth. 53
Reduction of systematic risk through financial transactions Institute for Risk Management and Insurance Reduction of systematic risk reduces the firm s ß, (but increases the risk buyer s ß) in financial markets, every investor charges the same for systematic risk (this price is determined by the CAPM) The buyer wants to be paid to take additional systematic risk. The firm cannot create value by selling market risk to other investors at the market price of that risk: µ SML ß is reduced expected return is reduced share price remains unchanged ß Reduction of systematic risk does not increase shareholder wealth. 54
The risk management irrelevance proposition Institute for Risk Management and Insurance In a perfect capital market, a firm cannot create value by hedging risks, if the cost of bearing the risk equals the cost of passing it to the capital market. A firm can not contribute to the shareholders welfare through risk management. This holds for diversifiable and for systematic risk: Hedging irrelevance proposition: Hedging a risk does not increase firm value when the cost of bearing the risk is the same, regardless of whether the risk is borne within the firm or outside the firm by capital markets. 55
Risk management in imperfect capital markets Capital market imperfections Situations can arise where investors cannot mimic risk management of the firm or the cost of bearing the risk inside the firm differs from the cost of bearing it outside the firm. For risk management to increase firm value, it must be more expensive to take risk within the firm than paying the capital markets to take it. 56
Bankruptcy costs and the cost of financial distress (I) motivation A study of bankruptcy for 31 firms over the period from 1980 to 1986 finds an average ratio of direct bankruptcy costs to total assets of 2.8 %, with a high of 7 % (Weiss 1990). Direct costs of bankruptcy are the costs incurred as a result of bankruptcy filing, e.g. hiring lawyers, court costs, payment of financial advice Costs firms incur because of a poor financial situation are called costs of financial distress. They can occur even if the firm never files for bankruptcy or never defaults, e.g. cuts in investments leading to losses in future profits. Reducing the costs of financial distress is one of the most important benefits of risk management. Present value of future bankruptcy costs reduces the present value of a firm that has debt relative to one that does not. 57
Bankruptcy costs and the cost of financial distress (II) Institute for Risk Management and Insurance A strategy that reduces the probability of bankruptcy reduces the expected costs of bankruptcy as well. Creditors charge a spread as compensation for the costs coming up in the case of bankruptcy. Thus, shareholders can improve the conditions of debt financing by reducing the bankruptcy risk. Bankruptcy costs create a wedge between cash flow to the firm and cash flow to the firm s claimholders. By hedging, the firm increases its value: It does not have to pay bankruptcy costs. Claimholders (shareholders, debitors) get the firm s entire cash flow. In this situation, claimholders individual risk management cannot substitute risk management within the firm. 58
Stakeholders (I) There are individuals and companies whose utility depends on how well a firm is doing but who cannot diversify the impact of firm risks on their individual situation ( stakeholders ) workers suppliers customers Should a firm care about stakeholders? 59
Stakeholders (II) Owners (shareholders) of a firm want the firm to be managed in a way that maximizes their welfare. Sometimes it is advantageous for shareholders to reduce other stakeholders risks: - Shareholders may want other stakeholders to make long-term firm-specific investments, e.g. advanced firm-specific vocational training of employees or R&D-expenses of suppliers. Stakeholders might be reluctant to make firm-specific investments if they question the firm s financial health. - The firm has to pay the stakeholders directly to make firm-specific investment, e.g. higher compensation for workers,... - Such economic incentives can be more expensive than hedging. 60
Reduction of tax burden when taxation is convex (I) Institute for Risk Management and Insurance Recall: Risk management can only create value if it is more expensive to assume risk within the firm rather than to pay the capital markets to bear it. Corporate taxes can increase the cost of taking risks within a firm. Risk management can reduce the (expected) present value of taxes. 61
Reduction of tax burden when taxation is convex (II) Convex (progressive) taxation: higher levels of earnings are taxed at higher tax rates convexity can arise from tax exemptions, deductions for certain expenditures,... The residual income after tax is concave. Assume risk-neutral owners/management Insurance against a fair premium is worthwhile (same argument as for a risk-averse insured with a concave utility function) Formally: If the tax function T( ) is strictly convex and the income w is random, Jensen s inequality yields: T[E(w)] < E[T(w))] Taxes based on the expected value of income are lower than the expected value of taxes on random income. Full insurance at the fair premium increases the mean of the income after taxes. 62
Convex taxation An example Linear taxation with a tax deduction T(w) The company s income is two-point distributed (w 1 ; 0,5; w 2 ), where w 1 = w 2 -L T(w 0 ) Tax deduction w 0 w 63
Convex taxation An example Linear taxation with a tax deduction T(w) The company s income is two-point distributed (w 1 ; 0,5; w 2 ), where w 1 = w 2 -L Consider the effect an insurance contract against a premium of 0.5 L has on expected taxes T(w 2 ) E[T(w)] =0.5T(w 1 ) +0.5T(w 2 ) T(E[w]) T(w 1 ) w 1 E[w] w 2 w Tax deduction 64
Convex taxation Carry forwards Linear taxation with a tax deduction Carry forward of losses - Negative income of this year can be used as a deduction against future earnings. - Assumptions: Firm can carry forward every of losses with interest. As before: Linear taxation with tax deduction. - The expected present value of every carried forward is a tax relief of -1. - In our example with linear taxation all (even negative) income is taxed at the marginal rate. no convexity 65
Convex taxation Carry forwards Linear taxation with a tax deduction T(w) T(w 2 ) E[T(w)] = T(E[w]) T(w 1 ) w 1 E[w] w 2 w 66
Agency costs and dysfunctional investment (I) Institute for Risk Management and Insurance Facing the threat of insolvency, shareholders hold the so called Default Put Option, as the value of their share cannot be negative. Shareholders have some control over management decisions agency relationship between shareholders and bondholders. In the case of insolvency (firm value < nominal value of liabilities) further negative consequences are borne by the creditors, e.g. a huge loss. Potential problem: Investment in projects with negative net present value, but with a high return if they are successful: If the project fails and significant losses occur, a major share is borne by the other bondholders (asset substitution). Similar: Shareholders have an incentive to pass up certain positive NPV projects if they pay for the full cost but benefit only if the firm does not go bankrupt (underinvestment). Creditors anticipate these problems higher cost of debt that can be reduced by risk management. 67
Agency costs and dysfunctional investment (II) - Asset substitution Value of claims From the perspective of shareholders: Heads I win, tails you lose 45 D Z-D A: starting situation, risk-free Consider a risky project, that either increases the firm s value by Z-A or decreases the firm s value by A-Y (each with a probability of ½) A-D Y D A Z Total company value 68
Agency costs and dysfunctional investment (III) - Underinvestment Value of claims 45 D N N Y Y* DC A Z Z* Similar situation as before (initial firm value is A, risky project from the last slide has been chosen; random final wealth is Y or Z) Now consider an additional investment opportunity that certainly increase the firm s value by N at a cost of C. Total company value 69
Large undiversified shareholders (I) Investors holding a large position in a firm's diversifiable risks may not have a balanced private portfolio: These investors care about firm-specific risks. The firm may have a competitive advantage in hedging these risks relative to the large shareholder. Should the firm hedge in order to please the larger shareholder? Large shareholders have high incentives for monitoring and may be able to increase firm value because they may have some ability in evaluating the actions of management and provide value through their skills and knowledge. managers do not necessarily maximize firm value; monitoring can make it more likely that they do. 70
Large undiversified shareholders (II) A firm s risk generally makes it unattractive for a shareholder to have stakes large enough to make monitoring worthwhile. A firm that manages the risk may make ownership more attractive to shareholders with a competitive advantage in monitoring. If this shareholder gets involved, other shareholders benefit. 71
Manager incentives Performance-related compensation gives managers incentives to maximize firm value. Manager compensation is risky and depends strongly on parameters that the management can influence / control. Managers are risk-averse. If their compensation depends on company performance, their decisions on behalf of the company will reflect their risk-aversion. They may refuse risky projects with a positive NPV although these projects increase the welfare of (risk-neutral) shareholders. Also, risk management can reduce value volatility that is not under the management s control. Managers accept lower compensation to attain the same utility; saving compensation enhances firm value. Risk management improves the owners ability to observe the impact of management performance on share prices ( compensation can be related more closely to effort). 72
The cost of external post-loss financing If a firm suffers a loss and lacks sufficient internal funds to finance the loss (post-loss financing), external sources must be used. External post-loss financing tends to be expensive. Hence, it can be advantageous for a firm to assure financing terms ex ante (pre-loss financing), e.g. through insurance. 73
Optimal capital structure and risk management Institute for Risk Management and Insurance Interest paid is deductible from income. A levered firm that pays interests pays less in taxes than one without interest payments for the same operating cash flow. Debt comes with a tax benefit. It increases the value of the firm relative to the value of the unlevered firm. An increase of the firm s debt increases the likelihood of financial distress. By having more debt, firms increase their tax shield from debt, but increase the present value of costs of financial distress. The optimal capital structure balances the tax benefits of debt against the costs of financial distress. A firm can reduce the present value of the costs of financial distress through risk management by making financial distress less likely. The firm can take more debt. 74
Core risk and incidental risk Investment opportunities are risky by nature. All firms take risks. This is how they earn profit. A firm can have a comparative advantage or disadvantage in taking certain risks. A firm faces core risks and incidental / noncore risks: Core risks concern the firm s areas of competence the firm has a comparative advantage in taking these risks. A firm has no special advantage in handling incidental risks. Idea: A firm can transfer incidental risks to outsiders in order to free up capacity to assume more core risk ( coordinated risk management ). 75
Selected empirical evidence Cummins, Phillips & Smith (2001) Expected costs of financial distress and tax considerations as motives (among others) for insurers use of financial derivatives. Grace, Klein & Phillips (2005) Insolvency costs for insurers are higher than for other firms. Hoyt & Liebenberg (2006) The use of ERM significantly increases firm value (measured by Tobin s Q). Graham & Rogers (2002) Firms hedge to increase debt capacity and because of expected financial distress costs. Minton & Schrand (1999) Higher cash flow volatility is associated with lower average levels of investment in capital expenditures, R&D, and advertising. Smithson & Simkins (2005) Literature review regarding the value of RM. 76