Chapter Outline

1
Chapter Outline

• Principals of Business Valuation
• Valuation Formula
• Components of the Opportunity Cost of Capital
• Compensation for Risk
• Risk Management and the Opportunity Cost of
  Capital

2
Chapter Outline

• Risk Management and Expected Cash Flows
• Insurance Premium Loadings
• Insurance with No Loading
• Insurance with a Loading
• Services Provided by Insurers
• Insurance and the Likelihood of Having to Raise
  Costly External Funds
• Raising New Funds to Pay for Losses
• Increased Likelihood of Raising New Funds
• for New Investment Projects
• Insurance and Financial Distress
• Manager Compensation Example
• Implications for Other Claimants
• Financial Distress Prior to Bankruptcy

3
Objective of Corporate Risk Management

• Recall Objective
• Maximize Value to Shareholders
• Basic question addressed in this chapter
• Does reducing risk (variability in cash flows)
  increase equity value?
• Considering that shareholders can diversify on
  their own
• Answer yes, but it is important to understand
  why

4
The Basic Valuation Model

• Valuation Model
• Value PV(expected cash flows)
• Value
• where r opportunity cost of capital
• Key Issues
• How does risk management affect
• Expected Cash Flows?
• Opportunity cost of capital?

5
The Basic Valuation Model - An Example

• Assumptions
• Firm exists for one year
• 300 if no lawsuit
• Cash flows at end of year
• 100 if lose a lawsuit
• Outcomes are equally likely
• Opportunity cost of capital 10
• Value at beginning of year 200/1.1 182
• Value at end of year 300 or 100, depending on
  the outcome

6
Components of the Cost of Capital

• Opportunity cost of capital
• expected return you could earn on an
  alternative investment
• with the same risk
• return on risk free securities expected
  return for risk
• risk free rate a risk premium

7
Investor Diversification and the Risk Premium

• Intuitively, the risk premium should reflect the
  risk of the cash flows
• riskier cash flows gt higher risk premium
• However, investors can diversify some risk on
  their own
• Divide cash flow risk into two components
• Total Risk diversifiable risk
  nondiversifiable risk
• Risk premium only depends on nondiversifiable risk

8
Investor Diversification and the Risk Premium

• Summary
• Total risk of cash flows
• Diversifiable risk
  Nondiversifiable risk
• does not affect increases
• cost of capital cost of capital
• Other terms for nondiversifiable risk
• market risk
• systematic risk

9
Does Insurance Affect the Cost of Capital?

• Insurance generally reduces diversifiable risk
• gt Insurance generally will not affect the
  opportunity cost of capital

10
Does Hedging Affect the Cost of Capital?

• The same analysis applies to hedging using
  derivatives
• If hedging only reduces diversifiable risk, then
  hedging will not reduce the opportunity cost of
  capital

11
Hedging, Insurance, and Systematic Risk

• Hedging and insurance that reduces systematic
  risk (non-diversifiable risk) will reduce the
  opportunity cost of capital
• However,
• Systematic risk must be borne by someone
• Thus, the counterparty who takes on the
  additional systematic risk will require
  compensation for bearing this risk

12
Hedging, Insurance, and Systematic Risk

• The cost of compensating the counter-party will
  cause expected cash flows to decrease
• Thus, shifting systematic risk has two effects
• Lowers opportunity cost of capital
• Lowers expected cash flows
• Provided all parties value the cost of bearing
  systematic risk identically, then the two effects
  will offset each other and firm value will not
  change

13
Why do Corporations Reduce Risk?

• So why do firms reduce risk that shareholders can
  diversify themselves?
• Two possible explanations
• 1. Owners are not diversified (closely-held
  companies)
• 2. Risk reduction indirectly increases expected
  cash flows

14
Overview of the Effects of Insurance on Expected
Cash Flows

• Description Effect on Expected Cash
  Flows
• Pay loading Decrease
• Decrease cost of obtaining services Increase
• Decrease likelihood of having to raise
• new funds Increase
• Decrease likelihood of financial
  distress Increase
• Decrease expected tax payments Increase
• (examined in Ch. 10)
  

15
Insurance Premium Loadings

• Example
• 100 with probability 0.9
• Cash flows
• 70 with probability 0.1
• I.e., Loss of 30 occurs with probability 0.1
• Expected cash flows w/o insurance 97
• Expected cash flows with insurance depends on the
  insurance premium

16
Insurance Premium Loadings

• Assume full insurance can be purchased for 3
• Then loading
• Expected cash flows with insurance
• Assume full insurance costs 4
• Then loading
• Expected cash flows with insurance
• Main Point Ignoring other factors, insurance
  reduces expected cash flows by the premium loading

17
Services Provided by Insurers

• But part of loading is the cost of services
• Loss control
• Claims processing
• Is premium loading less than cost of obtaining
  services elsewhere?
• Why bundle insurance with services?

18
Likelihood of Raising Costly External Capital

• Raising external capital is costly
• Investment banker fees
• Underpricing costs
• If not insured (or hedged), then the firm has an
  increased likelihood of having to raise new
  capital
• To pay losses that could have been insured
  (hedged)
• For new investment projects
• Cost of raising capital may make new projects
  unprofitable
• Firm foregoes what otherwise would have been
  profitable new projects

19
Insurance vs Raising New Funds to Pay for Losses

• What if uninsured loss exceeds available internal
  funds?
• Raise new funds (use future cash flows to pay the
  loss)
• Declare bankruptcy
• Example of Cather Inc.
• Normal cash flow 15 per share, but there is
  0.9 chance of 20 per share loss
• 15 with probability 0.9
• First year cash flows
• -5 with probability 0.1
• Second year cash flow 25 with probability 1.0

20
Insurance vs Raising New Funds to Pay for Losses

• Important point
• Cather can issue equity (or borrow) against
  future cash flows to pay the loss if it occurs
• Is raising new funds (if a loss occurs) better
  than purchasing insurance?
• Answer must compare premium loading to the
  expected cost of raising new funds

21
Insurance vs Raising New Funds to Pay for Losses

• Suppose premium loading 20 of expected loss
• Expected loss 20 x 0.1 2 per share
• Premium loading 0.40 per share
• Suppose cost of issuing securities 25 of
  amount raised
• Probability of raising new funds 0.1
• Amount raised 20 per share
• Cost of raising funds 0.25 x 20 5 per share
• Expected cost of raising new funds 0.50 per
  share
• In this example, insurance is better

22
Insurance and Raising New Funds for Investment

• Basic idea
• More insurance
• gt internal funds will not be used to pay
  losses
• gt more internal funds available for new
  investment
• projects
• gt less likely to raise costly external capital
• gt value of new projects is greater
• gt less likely to forego otherwise profitable
  projects

23
Decreasing the Likelihood of Financial Distress

• Likelihood of financial distress affects the
  terms at which other claimants contract with the
  firm
• Other claimants require compensation for the risk
  that the firm goes into financial distress
• Less costly for the firm to reduce risk than it
  is to compensate these other claimants for risk
• Other claimants include employees, suppliers,
  customers, and debtholders

24
Decreasing the Likelihood of Financial Distress

• Why do other claimants require compensation for
  the risk of financial distress?
• They are risk averse and not diversified, e.g.,
• employees
• closely-held suppliers
• customers
• Bankruptcy imposes additional costs (above the
  loss in promised payments), e.g.,
• Collection costs for lenders
• Search and moving costs for employees
• Loss in the value of specific investments for
  suppliers

25
Management Compensation Example

• J.R. works for Garven Corp.
• Garven Corps end of year cash flows without
  insurance
• 1 million with probability 0.95 and 0 with
  probability 0.05 due to a lawsuit
• If cash flows 0, then J.R. does not get paid
• J.R. would accept 100,000 in compensation if he
  were certain to be paid
• J.R. requires 125,000 given the uncertainty
  about getting paid (expected compensation
  118,750)

26
Management Compensation Example

• Garven can purchase 400,000 of liability
  insurance for 25,000
• expected claim cost .05 x 400,00 20,000
• gt premium loading 5,000
• Insurance allows J.R. to be paid even if a
  lawsuit occurs
• J.R. accepts 100,000
• Reduction in expected compensation 18,750
• Loading from the insurance 5,000
• Net increase in expected cash flows 13,750

27
Management Compensation Example

• Main point insurance improved the contractual
  terms with J.R. and therefore increased value to
  the owners of Garven Corp.
• Same logic applies to other claimants

28
Investment Incentives of Firms in Financial
Distress

• Financial distress short of bankruptcy changes
  owners investment incentives in ways that can
  hurt other claimants
• Therefore, decreasing the likelihood of financial
  distress (short of bankruptcy) can also improve
  contractual terms with other claimants
• Investment incentives of owners of firms in
  financial distress
• Incentive to pass up good projects
  (underinvestment problem)
• Incentive to adopt risky bad projects
  (overinvestment in risky assets problem)

29
Underinvestment Problem

• Consider a firm in financial distress
• A good project (positive net present value) that
  requires new funds arises
• Owners may not want to invest their own money,
  because a significant part of the returns from
  the new project might accrue to other claimants
• In essence, the new project bails out other
  claimants

30
Overinvestment in Risky Assets Problem

• Consider a firm in financial distress
• A bad project (negative net present value) with
  considerable risk arises
• chance of really high returns
• greater chance of low returns
• Owners may have an incentive to adopt the risky
  project, because they have little to lose
• If the project has low returns then owners will
  get nothing, but they were likely to get nothing
  anyway
• If the project has high returns then owners will
  get something

31
Insurance and Investment Incentives

• Main point
• Decrease the likelihood of financial distress
  gt
• Decrease likelihood of underinvestment problem
• Decrease likelihood of overinvestment in risky
  assets problem
• gt improve the terms of contracts with other
  claimants

32
Summary of Why Firms Manage Risk

• Summary
• Reducing diversifiable risk does not reduce risk
  for diversified shareholders, but
• it can increase expected cash flows by
• reducing the costs of obtaining services
• avoiding costly external financing
• improving contractual terms with other claimants
• reducing expected tax payments