1/16/2018 THE OBJECTIVE OF RISK MANAGEMENT Risk Management - - PDF document

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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

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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 = d1/(k – g)

– where d1 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

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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

• f firm X.

Firm Value

■ Risk management has to work by affecting cash flows and/or growth

V = d1/(k – g)

■ d1 = d0(1+g) ■ d0 comes from firm’s current profits – after creditors are paid – Result of past investments ■ g comes from current investments, availability of future investment opportunities

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Firm Value

■ To maximize value the firm needs to have cash flow to – Pay creditors (otherwise d0 = 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

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Objective of Risk Management

Risk S Risk Scena enario Expect cted ed Ca Cash sh Flow Stan andard D Devi viat ation i in Ca Cash F sh Flow Probability ility o

• f Not Being A

Able le to to Meet C Capita tal l Expend nditur ure, Divi vidend nd, a and d Princi Principal a and d Int Interest Re Requ 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

• f 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

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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

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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

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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”