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Chapter Outline 9.1 Principals of Business Valuation Valuation Formula Components of the Opportunity Cost of Capital Compensation for Risk 9.2 Risk Management and the Opportunity Cost of Capital Chapter Outline 9.3 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 9.4 Summary Objective of Corporate Risk Management Recall Objective: – Maximize Value to Shareholders – Basic question addressed in this chapter: Does________ risk (variability in cash flows) ________ equity value? – Considering that shareholders can diversify on their own Answer: _____, but it is important to understand why The Basic Valuation Model Valuation Model: Value = PV(expected cash flows) E (Cash Flow t ) Value = t 1 (1 r ) t where r = opportunity cost of capital – Key Issues: How does risk management affect – ________ Cash Flows ? – _________ cost of capital ? The Basic Valuation Model - An Example – Assumptions: Firm exists for one year $____ if no lawsuit Cash flows at end of year = $____ if lose a lawsuit Outcomes are equally likely Opportunity cost of capital = 10% Value at beginning of year = $____/1.1 = $182 Value at end of year = $300 or $100, depending on the outcome Components of the Cost of Capital Opportunity cost of capital = expected return you could earn on an alternative investment with the same risk Opportunity cost of capital = return on risk free securities + _______ return for risk = risk free rate + a risk premium Investor Diversification and the Risk Premium – Intuitively, the risk premium should reflect the risk of the cash flows riskier cash flows ==> higher risk premium – However, investors can diversify some risk on their own Divide cash flow risk into _____ _____________: – Total Risk = diversifiable risk + nondiversifiable risk – Risk premium only depends on ____________ risk Investor Diversification and the Risk Premium Summary: – Total risk of cash flows = Diversifiable risk + Nondiversifiable risk _____ ____ affect ________ cost of capital cost of capital Other terms for nondiversifiable risk: – market risk – systematic risk Does Insurance Affect the Cost of Capital? – Insurance generally reduces _________ risk? ==> Insurance generally will ____ _______ the opportunity cost of capital? Does Hedging Affect the Cost of Capital? – The same analysis applies to________ using derivatives – If hedging only reduces diversifiable risk, then hedging will not reduce the opportunity cost of capital Hedging, Insurance, and Systematic Risk Hedging and insurance that reduces systematic risk (non- diversifiable risk) will ______ the opportunity cost of capital However, – Systematic risk must be_______ by someone – Thus, the counterparty who takes on the additional systematic risk will require __________ for bearing this risk Hedging, Insurance, and Systematic Risk The cost of compensating the counter-party will cause expected cash flows to _______ Thus, shifting systematic risk has two effects: – ________ opportunity cost of capital – _________expected cash flows Provided all parties value the cost of bearing systematic risk _________, then the two effects will _______ each other and firm value will not change Why do Corporations Reduce Risk? – So why do firms reduce risk that shareholders can ________ themselves? – Two possible explanations: 1. ________ are not diversified (closely-held companies) 2. Risk reduction indirectly _______ expected cash flows Overview of the Effects of Insurance on Expected Cash Flows Description Effect on Expected Cash Flows Pay loading ________ Decrease cost of obtaining services ________ Decrease likelihood of having to raise new funds ________ Decrease likelihood of financial distress ________ Decrease expected tax payments _________ (examined in Ch. 10) Insurance Premium Loadings – Example: $100 with probability ___ – Cash flows = $70 with probability ___ • I.e., Loss of $30 occurs with probability ____ – Expected cash flows w/o insurance = _____ – Expected cash flows with insurance depends on the insurance premium Insurance Premium Loadings Assume full insurance can be purchased for ____ - Then loading = $ 0 – Expected cash flows with insurance = $100 - $3 = $ 97 – Assume full insurance costs $4 Then loading = $ ___ Expected cash flows with insurance = $100 - $4 = $96 Main Point: Ignoring other factors, insurance reduces expected cash flows by the premium loading Services Provided by Insurers – But part of loading is the cost of ________ Loss control Claims processing Is premium loading less than cost of obtaining services elsewhere? – Why bundle _________ with services? Likelihood of Raising Costly External Capital Raising external capital is costly – Investment banker fees – __________ 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 ______ • Firm foregoes what otherwise would have been __________ new projects 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 = $__ per share, but there is 0.9 chance of $___per share loss $___ with probability 0.9 – First year cash flows = $____ with probability 0.1 – Second year cash flow = $25 with probability 1.0 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 _______ _____ _____ (if a loss occurs) better than purchasing insurance? – Answer: must compare _____________ to the _________ cost of raising new funds) Insurance vs Raising New Funds to Pay for Losses Suppose premium loading = ___% of expected loss – Expected loss = $20 x 0.1 = $2 per share – Premium loading = $ _____ 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 = $ ____per share – Expected cost of raising new funds = $0.50 per share In this example, insurance is better Insurance and Raising New Funds for Investment – Basic idea: More insurance ==> internal funds will not be used to pay ______ ==> more internal funds available for new investment projects ==> _____ likely to raise costly external capital ==> value of new projects is _______ ==> less likely to forego otherwise profitable projects 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 ______ risk than it is to compensate these other ________ for risk Other claimants include ________, suppliers, _________, and debt holders Decreasing the Likelihood of Financial Distress Why do other claimants require compensation for the risk of financial distress? – They are ______ _________ and not diversified, e.g., • employees • closely-held suppliers • customers – Bankruptcy imposes _________ _______ (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 Management Compensation Example J.R. works for Garven Corp. Garven Corp’s 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 $_________ in compensation if he were certain to be paid J.R. requires $________ given the uncertainty about getting paid (expected compensation = $118,750) Management Compensation Example Garven can purchase $________ of liability insurance for $25,000 • expected claim cost = .05 x $_________ = $20,000 ==> 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 = $________ Loading from the insurance = $5,000 Net increase in expected cash flows = _________ Management Compensation Example – Main point: insurance improved the __________terms with J.R. and therefore increased value to the owners of Garven Corp. – Same logic applies to other claimants Investment Incentives of Firms in Financial Distress Financial distress short of bankruptcy changes owners’ investment incentives in ways that can _______ other claimants – Therefore, decreasing the likelihood of financial distress (short of bankruptcy) can also ________ contractual terms with other claimants Investment incentives of owners of firms in financial distress – Incentive to _____ ___ good projects (underinvestment problem) – Incentive to adopt risky _____ projects (over investment in risky assets problem) 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 _____ _____ money, because a significant part of the returns from the new project might accrue to other claimants – In essence, the new project _____ _____ other claimants Overinvestment in Risky Assets Problem Consider a firm in financial distress A bad project (________ net present value) with considerable risk arises – chance of really_____ returns – greater chance of _____ 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 _______, but they were likely to get nothing anyway – If the project has high returns then owners will get something Insurance and Investment Incentives – Main point: Decrease the likelihood of financial distress ==> – Decrease likelihood of _______________ problem – Decrease likelihood of _______________ in risky assets problem – ==> improve the terms of contracts with other claimants Summary of Why Firms Manage Risk? Summary – Reducing diversifiable risk does not________ risk for diversified shareholders, but – it can increase expected cash flows by _________ the costs of obtaining services avoiding costly external financing __________contractual terms with other claimants reducing expected _____ payments