l 01 corporate finance and risk management decisions

Corporate Finance and Risk Management Decisions

Lecture 1 of 10Dr. Tahir Durrani

CEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD

Fall 2007

Meditation for the week:

If you are willing to do all that is asked of you, seldom will you be asked to do all that you are

willing to do.

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Topic Objectives

The Irrelevance of Corporate Financing

and Risk Management Decisions

Corporate Hedging and Insurance

• Hedging and the Modigliani & Miller Theorem

• Agency Costs and Dysfunctional Investment

• Comparative advantage in risk bearing

Dr. Tahir Khan Durrani

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Risk is Pervasive

Risk: uncertainty about occurrence of a loss Importance of Uncertainty: if probability of loss is

zero or 1, there is no risk. Impossible to totally avoid risk; risk faced by

every entity. Risk can be managed but there are tradeoffs

involved. Your conscious and unconscious choices affect

your risk and others’ risk; positive and negative externalities exist.


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Categories of Risk

Pure Risk: possibilities of loss or no loss, no chance of gain, e.g. fire.

Speculative Risk: both profit or loss are possible, e.g. gambling.

Fundamental Risk: affects everyone or large number of persons.

Particular Risk: affects only one person


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Methods of Handling Risk

Avoidance- do not engage in

activity that incurs risk

Loss Control- prevention- reduction

Retention- active

- passive

Transfer- insurance

- other- contract

- hedging

- incorporation


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Retention and Insurance

Benefits of Increased Retention• Savings on premium loadings

• Reducing exposure to insurance market volatility

• Reducing moral hazard

• Avoiding high premiums caused by asymmetric information & price regulation

• Maintaining use of funds


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Costs of Increased Retention

• Closely held versus publicly traded firms with widely held stock

• Firm size and correlation among losses

• Correlation of losses with other cash flows and with investment opportunities

• Financial leverage


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Hedging is irrelevant under the Modigliani & Miller (M&M) assumptions

Perfect capital markets• No taxes, no transaction cost, no institutional

frictions and no costs of bankruptcy. Systematic information

• All investors, firms, and firm managers have the same information and have perceptions concerning the impact of new information on security prices that are both true and identical across investors.


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Hedging is irrelevant under the Modigliani & Miller (M&M) assumptions

Given investment strategies• Investment decisions by the firms are taken

as a given and as independent from financing decisions.

Equal Access• Firms and individuals can issue the same

securities in the capital markets on exactly the same terms.


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Capital Structure Irrelevance

The value of a company is independent of its capital structure.

Consider Corporation Superior with £100 of assets and no debt, • V(t)S = A(t)S = E(t)S = £100

Also consider Corporation Wasu faced with the same probability distribution as Superior, but with a debt of £50,• V(t)W = E(t)W + D(t)W


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In the absence of arbitrage the value of Superior should equal that of Wasu.

To see this, consider an investment strategy in which an arbitrageur buys 10% of the shares of Corp. Wasu, which will cost him,• 0.10E(t)W = 0.10[V(t)W – D(t)W]

He earns the following per year;• 0.10[Profits –R(t)DD(t)W]


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Now consider a second investment strategy, in which he borrows (D(t)W) on his own in order to invest in Corp. Superior. His net investment outlay is• -0.10D(t)W + 0.10E(t)S = 0.10[V(t)S – D(t)W]

He earns gross profits on his investment:• 0.10(Profits)

Since he must service his debt, his net profits per year are • 0.10[Profits – R(t)DD(t)W]


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Debt and the Leverage Irrelevance

M&M proposition II holds that leverage does not benefit either investors or the corporation no matter who does it.

A firm’s cost of capital is the return it must pay to investors in order to induce them to hold its securities.

We can define Wasu’s weighted average cost of capital (WACC) as follows:

EDWACC RED

ER

ED

DR


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Debt and the Leverage Irrelevance

To illustrate M&M Proposition II, we rearrange the firm’s WACC in terms of its equity cost of capital:

This equation tells us that the expected return on equity increases as the leverage of the firm increases.

But issuing debt increases the risk of holding equity, leading investors to demand a higher expected return on equity, leaving the overall cost of capital unchanged.

DWACCWACCE RRE

DRR


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Security Holder Indifference

At any given time t, the firm cannot do anything with its financial policy to affect the value of stocks and bonds in that period, but the same is not true at time t-1.

Let the current value of the firm be• V(t) = Et-1(t) + Dt-1(t)

At time t, the firm can issue new securities [debt & equity], then the value of the firm is• V(t) = Et-1(t) + Dt-1(t) + e(t) +d(t)


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At time t, the firm earns a total net cash inflow of X(t) and invests a total of I(t) in new investment projects, where I(t) is assumed under M&M to be given exogenously.

The sum of dividends (t) and interest (t) paid at time t must equal the net cash flow of the firm plus the proceeds from any new security issues.


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The firm’s cash flow constraint(t) + (t) = X(t) – I(t) + e(t) + d(t)

Substituting the firm’s cash flow constraint into the value of the firm allows us to express the total wealth of all security holders:• [Et-1(t) + (t)] + [Dt-1(t) + (t)]=X(t) - I(t) + V(t)

Because X(t) is determined by previous investment decisions and I(t) is assumed given, X(t), I(t) and V(t) are all independent of the firm’s financing decisions.


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Security Holder Indifference Combined security holder welfare is independent of

financing decisions made by the firm, but this is not so for individuals.

If existing debt is riskless, then new debt will expose the firm to the risk of default, which will impact both bondholders.

Since the combined value of the securities cannot be affected by financing decisions, the decline in Dt-1(t) that accompanies the issuance of new, risky debt results in an increase in Et-1(t).

A rise in Dt-1(t) is funded by a decline in Et-1(t)

• Given Fama and Miller (1972)’s priority rules.Dr. Tahir Khan Durrani

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The Irrelevance of Hedging and Insurance The value of the firm is also independent of

any deliberate actions taken by management to control risks through hedging or insurance.

Whether or not investors are holding perfectly diversified portfolios, shareholders should be indifferent to the risk management decisions made by corporate managers, provided the assumptions underlying the M&M propositions hold.


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Corporate Hedging and Insurance

Does this mean that hedging does not increase firm value?

If risk management increases firm value, it must increase expected net cash flows.


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Hedging and the M&M Theorem

If hedging affects the current firm value, then it must• Change expected tax liabilities

• Change contracting costs

• Change future investment decisions.


l 01 corporate finance and risk management decisions

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