Okay.

So we've covered forwards, futures, options, caps, collars, and

floors fairly comprehensively I think.

This final session will be spent working out how it is possible for

risk management to actually create value for shareholders.

To demonstrate the problem, let's head back to Judy.

Recall that she spent $0.50 per bushel buying options to manage

the risk associated with the price of corn increasing past $9 per bushel.

Now intuitively, if Judy, on behalf of Kellogg's,

is paying $0.50 for something that is worth $0.50,

then there should be no impact upon the market value of Kellogg's shares

because all she has done is replace $0.50 in cash with an asset,

the option, that is also worth $0.50.

Professor Christine Brown wrote an article in 2001 that reviewed the literature that

explained why risk management might create value for shareholders.

She identified four explanations for value creation.

Managerial self-interest, the non-linearity in corporate taxes,

the costs of financial distress, and the existence of capital market imperfections

particularly with respect to transaction costs.

So let's first consider managerial self interests.

Put yourself in the shoes of a CEO of a large listed company.

Now, as a CEO, it is extremely difficult for you to hedge the risk associated with

all of your human capital you have tied up in the firm.

Now, human capital refers to the value of your labor skills to the market.

It's almost impossible to diversify this asset,

as you can't really be a ten percent CEO to ten different companies.

Actually, let's pause there.

I do recall from our last module together that a lot of managers claim

that diversification was a great excuse to take over other companies.

Now, perhaps they were thinking about diversifying their own risk rather than

the risk of the company's cash flows.

Anyway, lets get back to it.

It seems reasonable to assume that in negotiating their remuneration package,

that managers will demand a more valuable package as the risk of the company's cash

flows increases.

By not permitting managers to hedge,

it subjecting management's own human specific capital to greater risk.

And the manager will demand greater compensation.

Conversely, risk management can reduce the risk faced by managers,

resulting in reduced compensation packages, and ultimately,

enhanced returns to shareholders.

Now most tax codes around the world are progressive in the sense that higher tax

rates are applied to higher income levels.

Now what we can do now is demonstrate that a reduction in the volatility of taxable

income can lower expected taxes for firms facing non-linear tax functions.

And by non-linear,

we simply mean where we don't have a flat tax rate applied to each dollar earned.

Well, the natural consequence of hedging is to reduce earnings volatility.

To illustrate this point, let's consider a firm facing the following situation.

The table on the right-hand side of this page outlines an exaggerated non-linear

tax function where higher and higher tax rates are charged against higher and

higher income levels.

The firm generating only $100,000 in taxable income, pays tax at only 8%.

Yet, a firm that owns $1 million, pays tax on total earnings at a rate of 80%.

It's highly exaggerated.

Now, let's consider two scenarios that the firm faces.

In the first, if it doesn't hedge, then it expects to earn $300,000

of income this year and $700,000 of income the year after.

So, that's one million dollars in total earnings over the two years.

The tax levied on $300,000 this year is $72,000.

And in the next, it'll be $392,000.

So the total tax liability over the two years will be $464,000.

In contrast, if the firm were to hedge, then it could completely smooth its

earnings, thereby generating $500,000 each year, or once again, $1 million in total.

Now, given the non-linear tax function that this firm faces,

the tax levied each year is only $200,000.

So, $400,000 in total.

Hence, the net effect of hedging when faced with the non-linear tax function is

a reduction in taxes paid from $464,000 to only $400,000.

The third way in which risk management might actually act to increase the wealth

of shareholders can be demonstrated by reference to the trade-off theory of

capital structure that we discussed all the way back in module two of this course.

Now, recall that the trade-off theory suggested that the value of a firm

with debt, in its capital structure, was equal to the value of a comparable firm

with no debt, plus the present value of any tax shields from debt,

less the present value of any financial distress costs.

Now, we also know that the present value of financial distress cost is calculated

as the product of the probability of the firm entering financial distress and

the cost incurred in case of distress.

Hedging can act to reduce the probability of financial distress, and

hence, reduce the present value of financial distress costs, and

hence, increase the value of the firm with debt.

Finally, another way in which risk management may act to increase the value

of shareholders claims is based upon transaction costs and

the relative costs of obtaining external versus internal finance.

If we begin with what seems to be a fairly intuitively sensible assumption that there

are lower transaction costs associated with raising funds internally,

within the firm, rather than externally in capital markets, then it follows

that the less often we are forced to go to external capital markets to raise funds,

the better off our shareholders will be.

So what's the link to hedging?

The argument here is that hedging enables a firm to better match its cash inflows

with its cash outflows.

So there is less chance of an unexpected deficit in its cash budget, and therefore,

a lesser likelihood that the firm will have to access external markets.

And therefore,

transaction costs are reduced which ultimately benefits shareholders.

So, there you have it.

In a perfect capital market, free of transaction costs and

other market imperfections, like agency costs and taxes, there is no reason at all

why hedging should be expected to create any value for shareholders.

Once we allow for an imperfect capital market, we see that there are at least four

reasons why hedging might be expected to create value.

Firstly, it may provide shareholders the opportunity to reduce executive

compensation.

Secondly, when taxes are a non-linear function of income, we can show that

the company's tax burden can be reduced through income smoothing via hedging.

Thirdly, hedging can act to reduce the probability of financial distress,

thereby reducing expected financial distress costs.

Finally, hedging can make it much more unlikely that the firm will need to incur

the significant transaction costs associated with accessing

external capital markets, because of any unexpected cash flow deficit.

Throughout this module, we have detailed how firms utilize, fixed payout

derivatives in the form of forwards and futures contracts to hedge risks.

We then introduced options contracts where we distinguish between calls and

puts, payoffs, profits, intrinsic values, and premiums.

We also spent a fair bit of time talking about the factors that impacted upon

the value of option.

This led naturally to a discussion of how options could be combined

with positions in the underlying asset, so

as to enable the formation of caps, floors, and ultimately collars.

And we've concluded with a discussion of how risk management might be expected to

increase the value of shareholders' wealth.

And that concludes this course on Corporate Financial Decision-Making for

Value Creation.

Across the last four modules,

we've dealt with the four big questions facing the modern corporation.

Firstly, the internal investment decision.

Where a firm needs to decide which of the internally generated

projects it should take on.

Secondly, the financing and payout decisions.

Where we consider alternative ways to fund investment,

as well the impact on debt on the returns of shareholders, and the optimal

amount of earnings that should be returned to shareholders in the form of dividends.

Thirdly, external investment buyer takeovers and

divestment buyer corporate restructuring where we identified the methods by which

value could be created by either growing a firm, or

in the case of corporate restructuring, by making the firm smaller.

Then finally, we've dealt with the risk management decision.

It's useful at this stage to remind you all that this course is

the third in a series of four that contribute to the specialization

Essentials of Corporate Financial Analysis and Decision-Making.

We began the specialization with the language and

tools of financial analysis, where we established the accounting tool set

that is the foundation of all financial analysis.

The second course in the specialization, the role of global capital markets,

provided the environmental context within which the modern corporation operates.

And here, we describe the various roles of different market participants and

instruments.

This third course is dealt specifically with the key decisions faced by the modern

corporation, and how those decisions might be optimized to enhance shareholder value.

Looking ahead, the next course in the specialization

is alternative approaches to valuation and investment.

In this course, we'll begin by developing a greater understanding of exactly what we

mean when we talk about risk.

This will lead to a demonstration of the benefits of diversification and

the determinants of these benefits,

which in turn, brings us to a point where we can explicitly link

the concepts of risk and return in a practical setting.

In the third module of that course, we will turn our attention back to our

financial statements for our sample company, Kellogg's, and ask ourselves,

how might we use these statements to arrive at a company-wide cost of capital?

We conclude the fourth course with the discussion of an area of finance that is

seen by many to be both revolutionary, as well as, extremely insightful when

thinking about how firms approach key financial decisions.

That's real options analysis.

We hope that you've enjoyed this course.

And we here at the University of Melbourne look forward to your participation in

the next one.

Cheers.

4.5 Why Manage Risk?

Corporate Financial Decision-Making for Value Creation

Meet the Instructors