1/16/2018 THE OBJECTIVE OF RISK MANAGEMENT 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 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 1
1/16/2018 M&M Theorem ■ Financial decisions affect firm value ■ The effect must be on one or more of – Taxes – Bankruptcy cost – Information asymmetry – Agency problems Firm Value ■ A very simple model of firm value is the Gordon growth model: V = d 1 /(k – g) – where d 1 is future dividend – k is the WACC – g is the growth rate 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 2
1/16/2018 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 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. Firm Value ■ Risk management has to work by affecting cash flows and/or growth V = d 1 /(k – g) ■ d 1 = d 0 (1+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 3
1/16/2018 Firm Value ■ To maximize value the firm needs to have cash flow to – Pay creditors (otherwise d 0 = 0) – Invest (otherwise g = 0) Objective of Risk Management ■ 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 Objective of Risk Management ■ 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 4
1/16/2018 Objective of Risk Management Probability ility o of Not Being A Able le to to Meet C Capita tal l Stan andard D Devi viat ation i in Expend nditur ure, Divi vidend nd, a and d Princi Principal a and d Int Interest Risk Scena Risk S enario Expect cted ed Ca Cash sh Flow Cash F Ca sh Flow Requ Re quir irem ements ts 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% Objective of Risk Management ■ 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 Objective of Risk Management ■ 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 5
1/16/2018 Objective of Risk Management ■ 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”? Objective of Risk Management ■ 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 Objective of Risk Management 6
1/16/2018 Objective of Risk Management ■ 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) Objective of Risk Management ■ 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 Objective of Risk Management ■ 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 7
1/16/2018 Objective of Risk Management ■ 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 Objective of Risk Management ■ 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 Objective of Risk Management ■ 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” 8
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