L01CorporateFinance and Risk Management Decisions

7/29/2019 L01CorporateFinance and Risk Management Decisions

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Lecture 1

Dr. Tahir Khan DurraniCEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD

Meditation for the week:If you are willing to do all that is asked of you, seldom

will you be asked to do all that you are willing to do.



Topic Objectives

The Irrelevance of Corporate Financing

and Risk Management Decisions

Corporate Hedging and Insurance

Hedging and the Modigliani & Miller Theorem

Agency Costs and Dysfunctional Investment

Comparative advantage in risk bearing

Dr. Tahir Khan Durrani 2



3

What is Risk and Risk

Management



4

What is Risk

Risk exists if there is something you don’t

want to happen – having a chance to happen!!!



5

What is Risk – Take 2

The probability that some event will cause an undesirable outcome on the financial health

of your business and/or other business/family

goals



6

Components of Risk

Probability

of 5%

Probability

of 15%

Probability

of 60%

Probability

of 15%

Probability

of 5%

EVENT

Cause/Source Odor lawsuit

Potential

Outcome

#1

Potential

Outcome

#2

Potential

Outcome

#3

Potential

Outcome

#4

Potential

Outcome

#5 [minor nuisance] [catastrophic]



Components of Risk – Undesirable Outcome

Put simply, the UndesirableOutcome is what hurts!

- lower than expected production- catastrophically lower production

- inability to meet cash flow- loss of income- catastrophic loss of income- loss of life

- loss of buildings & other resources- loss of health- inability to get a permit or loan

X



Components of Risk – Event (Cause /

Source of Risk)

The Event is what caused thehurt:

- weather event

- injury/death of an employee- neighbors action against you- surplus production of milk- widespread poor grain production- low quality inputs- divorce or disagreement- downward slide in generaleconomy- and countless more!!!



Components of Risk – Probability

0

20

40

60

80

100

6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8

P e r c e n t

B AC

Probability is a measure of the likelihood that the Risk

Event will occur, e.g., 30% chance of rain



Back to the Beginning Exercise

Probability Distribution

0

2

4

6

8

10

8 . 5 9

9 . 5 1 0

1 0 . 5 1 1

1 1 . 5 1 2

1 2 . 5 1 3

1 3 . 5 1 4

1 4 . 5 1 5

1 5 . 5 1 6

1 6 . 5 1 7

1 7 . 5

25 Cent Range, Midpoints Are Shown (based on 1988-Dec. 2002

P

e r c e n t O c c u r e n c e

11.62-11.87(11.75 midpoint)



Back to the Beginning Exercise

Probability Distribution

0

2

4

6

8

10

8 . 5 9

9 . 5 1 0

1 0 . 5 1 1

1 1 . 5 1 2

1 2 . 5 1 3

1 3 . 5 1 4

1 4 . 5 1 5

1 5 . 5 1 6

1 6 . 5 1 7

1 7 . 5

25 Cent Range, Midpoints Are Shown

P e r c e n t O c c u

r e n c e



Family Goals

& Objectives

Overall Categories of Risk

Legal Risk Price Risk

Environmental

Risk

5 D’s Risk - Death- Disability

- Disagreement- Divorce- Disaster

ProductionRisk

HumanResource

s Risk

FinancialRisk

Relationship/Public

RelationsRisk

11



13

Risk Increases the More You Don’t Know

All The Potential Outcomes

The Probability of Occurrence

Cost of a Undesirable Outcome



14

All The Potential Outcomes

The Probability of Each Outcome Occurring

Cost of Undesirable Outcomes

Said Another Way:The more you do know and understand

about

the better long term risk manager you willbe.



15

What is Risk Management?

Assuring An Outcome



16

Risk Management is Assuring An

Outcome

0

20

40

60

80

100

6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8

P e r c e n t

Assuring anOutcome



17

Five Primary Means of Risk Management

Reduce1. Reduce the probability that the event will occur

2. Reduce the impact if the event does occur

Transfer

3. Transfer the cost of an undesirable outcome to someoneelse

Avoid 4. Completely avoid potential events thus providing a zero

probability that they will occurDo Nothing

5. Let the risk happen and be ready to bear theconsequences.



18

Price RiskWhat Happens to the Distribution When You Have a

Floor Price at $10.51?

12.05 13.58 10.51



19

What Happens to the Distribution When You

Establish a Short Fence from $12.05 to 13.58?

12.05 13.58 10.51



Level of Production

Employee Performance Interest Rates

Personal Injury/Death (you, employee,spouse)

Divorce

Disagreement

19



21

Production RiskRisk: Poor weather event causing the undesirable

outcome of lower than expected yields.Risk Management???

160 19595

Corn Yields

Transfer thecost of the

risk via cropinsurance

P d ti Ri k



22

Production Risk:Risk: of a poor weather event causing the undesirable

outcome of lower than expected yields

Risk Management???

160 19595

Corn Yields

Reduce the cost of the risk via spatial location, multiplevariety selection, and other cropping practices.



23

Financial RiskRisk: higher interest rates causing the undesirable

outcome of lower than expected income/cash flow

Risk Management???

Do Nothing

Cash Flow

Fi i l Ri k



24



Risk Management???

Cash Flow Transfer therisk via fixed

rate loans Do Nothing

Financial Risk



25



Risk Management???

Transfer the riskvia fixed rate

loans

Reduce the costof the negative

impact via lowerdebt financing

Do Nothing

Cash Flow



26

Human ResourcesRisk: Cost of hired labor not showing up or making a mistake

causing lower production, injury, or death

Risk Management???

Reduce the Risk via:-Regular employee meetings-Training programs-Well written position descriptions-Incentive plans



27

Transfer the riskvia disability andother insurance

Human ResourcesRisk: Cost of hired labor not showing up or making a

mistake causing lower production, injury, or death

Risk Management???



28

Avoid the risk bynot hiring any

employees

Human ResourcesRisk: Cost of hired labor not showing up or making a

mistake causing lower production, injury, or death

Risk Management???

l k



29

Environmental RiskRisk: manure spill causing the undesirable outcome of fines,

lawsuits, and loss of income

Risk Management???

Reduce the risk via:-Education-Facilities-Monitoring checks and systems-Field and manure trt. practices



30

Transfer the risk vialiability insurance

Environmental RiskRisk: manure spill causing the undesirable outcome of

fines, lawsuits, and loss of income

Risk Management???



31

Disability RiskRisk: poor health causing loss of income

Risk Management???

Incapacitated Avg. Health

Reduce incidence or impact of risk via:-Annual health exam - Quit smoking-Exercise -Disability Insurance

-Co-Manager



32

So, I now know What Risk

Management is,

but How do I do it???



33

How??? Step 1: Be aware, identify the risks you face.

Step 2: Evaluate: the likelihood that the risk will occur, and

how bad the hurt will be if it does occur

Step 3: Decide on how you will address the risk reduce, transfer, avoid, nothing, or some combination

Step 4: Implement What is the most frustrating words used in management??

Answer: “If I had only ……”

Step 5: Control Monitor to assure that what you said you would do, you did,

and that you are getting what you want out of your your riskmanagement strategies.

P i iti i Whi h Ri k t



34

Prioritizing Which Risks to

Address First

Probabilityof

Happening

Potential Impact

Act if cost effective

No action required

Immediate action

Action required

Small Catastrophic

High

Low



35

Risk Management Is An

Individual Decision

No one "right" decision

The "right" decision depends on the

characteristics of theoperation and

individual decision-maker

Risk

Revenue

1

2

3



36

Risk vs. Profitability

Risk

Revenue

1

2

3



Risk is Pervasive

Risk : uncertainty about occurrence of a loss Importance of Uncertainty: if probability of loss is

zero or 1, there is no risk.

Impossible to totally avoid risk; risk faced by every entity.

Risk can be managed but there are tradeoffs

involved.

Your conscious and unconscious choices affect your

risk and others’ risk; positive and negative externalities

exist.




Categories of Risk Pure Risk : possibilities of loss or no loss, nochance of gain, e.g. fire.

Speculative Risk : both profit or loss are possible,e.g. gambling.

Fundamental Risk : affects everyone or large

number of persons.

Particular Risk : affects only one person




Methods of Handling Risk

Avoidance- do not engage in

activity thatincurs risk

Loss Control - prevention- reduction

Retention- active- passive

Transfer - insurance- other

- contract- hedging- incorporation




Retention and Insurance

Benefits of Increased RetentionSavings on premium loadingsReducing exposure to insurance market volatility Reducing moral hazard Avoiding high premiums caused by

asymmetric information & price regulationMaintaining use of funds




Costs of Increased Retention

Closely held versus publicly tradedfirms with widely held stock

Firm size and correlation amonglosses

Correlation of losses with other cash

flows and with investmentopportunitiesFinancial leverage




Modigliani-Miller Theorem

A financial theory stating that the market value of afirm is determined by its earning power and the risk of its underlying assets, and is independent of the way itchooses to finance its investments or distribute

dividends. A firm can choose between three methods of financing: issuing shares, borrowing or spending profits(as opposed to dispersing them to shareholders in

dividends). The basic idea is that, under certain assumptions, itmakes no difference whether a firm finances itself withdebt or equity.




Hedging is irrelevant under the Modigliani &

Miller (M&M) assumptions

Perfect capital markets No taxes, no transaction cost, no institutional

frictions and no costs of bankruptcy.

Systematic information All investors, firms, and firm managers have the

same information and have perceptionsconcerning the impact of new information on

security prices that are both true and identicalacross investors.




Hedging is irrelevant under the Modigliani &

Miller (M&M) assumptions

Given investment strategies Investment decisions by the firms are taken as a

given and as independent from financingdecisions.

Equal Access Firms and individuals can issue the same

securities in the capital markets on exactly thesame terms.




Modigliani-Miller Theorem

Assume Efficient markets and no asymmetricinformation, No taxes, No transaction orbankruptcy costs, Investment decisions don’tchange ; ThenThe value of the firm is independent of itscapital structure.Financing choices are irrelevant! Value is created on the left-hand side of thebalance sheet, not the right-hand side.




Why is M&M useful?

It tells us what is important … Does debt affect investment decisions? Does debt affect taxes?

Can equity be issued at fair value? Are transaction costs or bankruptcy costs

important?

And what isn’t … Impact of debt on ROE and risk Cost of debt

relative to the cost of equity (rD vs. rE)




Capital Structure Irrelevance

The value of a company is independent of its capitalstructure. Consider Corporation Superior with £100 of assetsand no debt,

V(t)S = A(t)S = E(t)S = £100

Also consider Corporation Wasu faced with the same

probability distribution as Superior, but with a debt of £50,

V(t) W = E(t) W + D(t) W




Capital Structure Irrelevance

In the absence of arbitrage the value of Superiorshould equal that of Wasu. To see this, consider an investment strategy in whichan arbitrageur buys 10% of the shares of Corp. Wasu, which will cost him,

0.10E(t) W = 0.10[V(t) W – D(t) W ]

He earns the following per year;

0.10[Profits –R(t)DD(t) W ]




Capital Structure Irrelevance Now consider a second investment strategy, in whichhe borrows (D(t) W ) on his own in order to invest in Corp.Superior. His net investment outlay is

-0.10D(t) W + 0.10E(t)S = 0.10[V(t)S – D(t) W ] He earns gross profits on his investment:

0.10(Profits) Since he must service his debt, his net profits per year

are 0.10[Profits – R(t)DD(t) W ]




Debt and the Leverage Irrelevance

M&M proposition II holds that leverage does notbenefit either investors or the corporation no matter who does it. A firm’s cost of capital is the return it must pay to

investors in order to induce them to hold its securities. We can define Wasu’s weighted average cost of capital(WACC) as follows:

E DWACC R

E D

E R

E D

D R




Debt and the Leverage Irrelevance To illustrate M&M Proposition II, we rearrange the

firm’s WACC in terms of its equity cost of capital:

This equation tells us that the expected returnon equity increases as the leverage of the firmincreases.But issuing debt increases the risk of holding

equity, leading investors to demand a higherexpected return on equity, leaving the overallcost of capital unchanged.

DWACC WACC E R R

E

D R R


S i ld diff



Security Holder Indifference At any given time t, the firm cannot do anything with

its financial policy to affect the value of stocks andbonds in that period, but the same is not true at time t-1.

Let the current value of the firm be

V(t) = Et-1(t) + Dt-1(t) At time t, the firm can issue new securities [debt &

equity], then the value of the firm is

V(t) = Et-1(t) + Dt-1(t) + e(t) +d(t)




Security Holder Indifference

At time t, the firm earns a total net cashinflow of X(t) and invests a total of I(t) in newinvestment projects, where I(t) is assumedunder M&M to be given exogenously.

The sum of dividends (t) and interest (t)paid at time t must equal the net cash flow of

the firm plus the proceeds from any newsecurity issues.




Security Holder Indifference The firm’s cash flow constraint

(t) + (t) = X(t) – I(t) + e(t) + d(t) Substituting the firm’s cash flow constraint into the value of the firm allows us to express the total wealth of

all security holders: [Et-1(t) + (t)] + [Dt-1(t) + (t)]=X(t) - I(t) + V(t)

Because X(t) is determined by previous investment

decisions and I(t) is assumed given, X(t), I(t) and V(t) areall independent of the firm’s financing decisions.


Security Holder Indifference



Security Holder Indifference Combined security holder welfare is independent of

financing decisions made by the firm, but this is notso for individuals. If existing debt is riskless, then new debt will exposethe firm to the risk of default, which will impact both

bondholders. Since the combined value of the securities cannot beaffected by financing decisions, the decline in Dt-1(t)that accompanies the issuance of new, risky debtresults in an increase in E

t-1

(t). A rise in Dt-1(t) is funded by a decline in Et-1(t)

Given Fama and Miller (1972)’s priority rules.


The Irrelevance of Hedging and



The Irrelevance of Hedging and

InsuranceThe value of the firm is also independent of any deliberate actions taken by management tocontrol risks through hedging or insurance.

Whether or not investors are holding perfectly diversified portfolios, shareholders should beindifferent to the risk management decisionsmade by corporate managers,

Provided the assumptions underlying theM&M propositions hold.




Corporate Hedging and Insurance

Does this mean that hedging doesnot increase firm value?

If risk management increases firm value, it must increase expected net

cash flows.




Hedging and the M&M Theorem

If hedging affects the current firm value, then it must

Change expected tax liabilitiesChange contracting costsChange future investment decisions.




In view of M&M Theorem



Does Capital Structure affect value?

Empirical patterns Across Industries Across Firms Across Years Who has lower debt?

High intangible assets/specialized assets High growth firms High cash flow volatility High information asymmetry Industry leaders

Is capital structure managed? If so much time is spent on capital structure then there

must be some value to it (or managers/investors areirrational)



Debt and Equity Only?

Typically thought of and measured this way Much more complex

Investment opportunities and strategy (needs)

Financing (sources) Cash balance

Distribution: Dividend and repurchases

Debt capacity

Equity capacity Existing debt and equity

Other financial policies: Financial Hedging, CashFlow Volatility, Forms of Compensation



How does capital structure affect value?

To prove this we start in the “perfect world”

Based on the work of Miller and Modigliani

Shows that capital structure is irrelevant

Value is derived from market imperfections

Example: What if a firm is considering issuingdebt and retiring equal amounts of equity?



Capital Structure is IrrelevantMiller and Modigliani assume perfect

capital markets

Proposition #1: The market value of any firm is independent of its capital structure.



Market Imperfections: Taxes T

axes US Tax Code: Deductibility of interest leads to

lower cost of debt (Rd(1-t))

Simple specification overvalues benefit

Ignores personal taxes which

Decreases investors debt return

Increases investors preference for equity Capital gains: Defer and rate difference

Dividend: Some portion is deductible



Market Imperfections: Contracting Costs

In imperfect markets, alternative ways to contractoptimal behavior are necessary

Costs of financial distress

Underinvestment (rejecting NPV>0 projects), direct,indirect costs, etc.

Benefits of debt

Monitoring function, manages free cash flow problem(Accepting NPV<0 projects), etc.

Contracting costs and taxes are primary motives forstatic trade off theory debt



Can we quantify the value of market



Can we quantify the value of market

imperfections?

Debt adds value to the firm due to the interestdeductibility (assume taxes only)

Assume the simple case:

)(TaxShield PV V V U L

C

D

C D D

r

Dr TaxShield PV

)(



More Complex Tax Shields

Uneven and/or limited time payments

Discount all flows back to time 0

What r do you use? Certain the tax shield can be used: rD

Uncertain? Higher r



Financial Distress

As leverage increases, the probability therefore PV of financial distress increases

)()( t istressCosFinancialDPV TaxShield PV V V U L

• How do we estimate the cost of distress?

– Probability(Distress)*Cost of Distress

• Probability can be estimated in several ways

– Logit / Probit regressions

– Debt ratings



Financial Distress: Bankruptcy Costs

Direct Costs Legal, accounting and other professional fees

Re-organization losses

Estimated btw 4-10% of firm value (t-3)

Indirect Costs Reputation costs

Market share

Operating losses Estimated as 7.8% of firm value (t-2)



Financial Distress: Agency Costs

Risk shifting and asset substitution Shareholders invest in high risk projects and

shift risk to the debt holders

Shareholders issue more debt, diminishing olddebt holders protection

Underinvestment

Expropriating funds

Difficult to estimate

Oth Ad t f D bt



Other Advantages of Debt

Agency cost of Equity (motive) Shirking is less likely when issuing debt

Perquisites are less likely with debt

Over-investment is less likely with debt

Agency cost of Free Cash Flow (opportunity) Retained earnings versus dividends?

Growth and investment opportunities

Debt serves as a monitoring device, decreasingmanagerial discretion

Bankruptcy as a strategic move???

F l M d l f C it l St t



Formal Models of Capital Structure Pecking Order

Firms prefer to raise capital Internally generated funds

Debt

Equity Implies capital structure is derived from Financing needs and capital availability

Dynamic rather than static

Asymmetric information and signaling Static Trade Off

I li ti f St ti T d Off



Implications of Static Trade Off Static rather than dynamic

Taxes and Contracting Cost drive value

Readjustment may be sticky

Optimal trade off between cost of issuances and benefit

of capital structure Insights

Large, stable profit firms will have more debt

Higher the costs of distress lower debt

Lower taxes, lower debt

Less (more) favorable tax treatment of debt (equity),lower debt

E id T



Evidence: Taxes

This method usually overestimates the taxconsequence

Magnitude of leverage differences acrosscountries and tax regimes is not that big

Equity taxes (personal taxes) are overestimated(Miller)

Timing of capital gains

Higher effective marginal tax rate, higher theleverage (Graham, 2001)

Evidence



Evidence Contracting Costs: Consistent evidence

Higher (lower) the growth opportunities, higher (lower) thepotential underinvestment problem, lower (higher) theleverage

Higher growth opportunities would prefer Shorter maturity debt (or call provisions)

Less restrictive covenants More convertibility provisions

More concentrated investors (private)

Information costs

Consistent with market timing (SEO’s lead to -3% return) Inconsistent with signaling and pecking order

Taxes: Higher effective marginal tax rate, higher theleverage

MM: Proposition II



MM: Proposition II

How does leverage affect rE

Start with the WACC

Solve for rE

The rate of return on the equity of a firmincreases in proportion to the debt to equityratio (D/E).

D E ar

V

Dr

V

E r

)( Daa E r r

E

Dr r



MM: Proposition II (with taxes)

Dc E ar

V

Dr

V

E r )1(

))(1( Daca E r r E

Dr r

Wh Ab Fi i l Fl ibili ?



What About Financial Flexibility? The ability to quickly change the level and type of

financing

Value increasing if Growth opportunities exist

Company is willing to exercise and extinguish futureflexibility

New investments are unpredictable and large

Precautionary debt ratings cushion is valuable

Value destroying if the opposite is true

What do we do?



What do we do? Choosing a target capital structure

Minimize taxes and contracting costs (while payingattention to information costs)

Target ratio should reflect the company’s Expected investment requirements

Level and stability of cash flows

Tax status

Expected cost of financial distress

Value of financial flexibility

Dynamic management Financing is typically a lumpy process

Find optimal point where cost of adjusting capital structurei l f d i i f

L01CorporateFinance and Risk Management Decisions

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