Why Manage Risk

					                  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

				
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