In this course, participants will learn about the key financial decisions modern corporations face, as well as the alternative methods that can be employed to optimize the value of the firm’s assets. This is part of a Specialization in corporate finance created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon).
4.5 Why Manage Risk?
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From the course by The University of Melbourne
Corporate Financial Decision-Making for Value Creation
247 ratings
The University of Melbourne
247 ratings
Course 3 of 5 in the Specialization Essentials of Corporate Finance
From the lesson
Alternative Approaches to Risk Management
In the final week of this course we define and demonstrate the use of different derivative securities in risk management including; forwards, futures and option contracts. We explain the key drivers of option values and explain how options might be combined to provide different payoff structures. We conclude by considering how risk management might create value for shareholders.
Meet the Instructors
Paul KofmanDean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean PinderAssociate Professor
Faculty of Business and Economics
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.
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