1

SBWL Kurs IV - Finance

Corporate Risk Management

Univ.Prof. Alexander Mrmann, Ph.D.

WU Vienna
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1 Overview of lecture
Why is risk and its management important for individual households and
corporations?
Asymmetric eects of gains and losses on valuation

Underlying reasons for asymmetry

for individual households: risk-aversion (diminishing marginal utility)
for corporations: tax, bankruptcy costs, agency costs between dierent
stakeholders (shareholders, creditors, manager)

What are the side-eects of risk transfer?

adverse selection (asymmetric information at time of contracting)
moral hazard (change in incentives after contracting)
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2 Structure
1. Risk Management of Individual Households

2. Risk Sharing and Asymmetric Information (including market game)

3. Corporate Risk Management and Capital Structure

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3 Details
Schedule

Bachelor SBWL Finance: Fachprfung

O ce: Building D4, 4.234

O ce hours: by appointment
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Main readings: Slides, problem sets, and past exams at Learn@WU, exer-
cises during class

Background readings
Berk, DeMarzo: Corporate Finance
Stulz: Risk Management and Derivatives
Grinblatt, Titman: Financial Markets and Corporate Strategy
Doherty: Integrated Risk Management
Harrington, Niehaus: Risk Management and Insurance
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1 Risk Management of Individual Households

1.1 Why is risk costly to individuals?

1.2 Diversication and risk reduction

1.3 Insurance
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1.1 Why is risk costly to individuals?

Individuals make decisions by maximizing their expected utility of nal
wealth n
X
E [U (W )] = pi u (wi)
i=1

Risk-averse individuals have concave utility functions (diminishing marginal

utility) u0 > 0, u00 < 0

Implications:
increase in utility by a specic gain is lower than the decrease in utility
by an identical loss
gains and losses have asymmetric eects on utility
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Certainty equivalent and risk premium

Risk-averse individuals prefer a risk-free payo to a risky payo with iden-

tical expected value

The certainty equivalent (CE) of risky wealth W is the risk-free wealth

that yields same utility, i.e. it is implicitly dened by
n
X
u (CE ) = pi u (wi)
i=1

for risk-averse individuals we have

CE < E [W ]
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Risk premium is the dierence between expected wealth and CE

RP = E [W ] CE

for risk-averse individuals we have

RP > 0
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How do individuals deal with risk?

Households face dierent kinds of risks with nancial consequences: in-

come (labor, investment), damage of property, illness, etc.

Reduce or avoid risk

precautionary actions and choice of investment

Transfer risk to other individuals (risk sharing)

mutual assistance in families and associations, diversication, insur-
ance, derivatives

Retain risk and accommodate to the consequences of bearing risk

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Insights

Risk matters because the impact of losses and gains is asymmetric. For
risk-averse households, losses and gains (with the same absolute size) have
dierent absolute eects on the agents utility: losses have a larger absolute
eect than gains

Risk-averse individuals demand a risk premium to bear risk that increases

the variability of their wealth

Risk-averse individuals are willing to pay a risk premium to reduce the

variability of their wealth: they are willing to accept a lower level of wealth
in exchange for a lower variability of their wealth
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1.2 Diversication and Risk Reduction

N individuals face identically distributed losses L1, L2, ..., LN (of random
size) with expected value E [L1] and variance 2 (L1)

The average (equally shared) loss is

1
L= (L1 + L2 + ::: + LN )
N

How does the expected value and the variance of the loss change through
pooling (diversication)?
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The expected value of the loss does not change through pooling
1
E [L] = E [L1 + L2 + ::: + LN ] = E [L1]
N

The variance of the loss changes through pooling, depending on the cor-
relation between losses

Cov (L1; L2) = E [(L1 E [L1]) (L2 E [L2])]

Cov (L1; L2)
(L1; L2) =
(L1) (L2)
2 (L + L ) = 2 (L ) + 2 (L ) + 2Cov (L ; L )
1 2 1 2 1 2
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if losses are uncorrelated, then the variance decreases in the number of

individuals and tends to zero in the limit
2 (L )
2 (L) 1
=
N

if losses are perfectly positively correlated (identical outcomes), then

the variance stays the same
2 (L) = 2(L1)

generally, if losses are positively correlated with correlation coe cient

(L1; L2), then
2 (L )
2 (L) 1
= (1 + (N 1) (L1; L2))
N
In the limit it tends to 2(L1) (L1; L2).
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Average versus aggregate risk

The variance of the aggregate risk is unaected by any risk sharing arrange-
ment
2 (L + L2 + ::: + LN ) = N 2 (L ) (1 + (N 1) (L1; L2))
1 1

2 (N L) = N 2 2 (L)

= N 2 (L ) (1 + (N 1) (L1; L2))
1

The variance of the aggregate risk increases in the number of individuals.

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Insights

Through risk sharing (diversication) the (average) risk that each individual
has to bear can often be reduced considerably =) risk becomes more
predictable

The higher the degree of correlation the lower the individual benet of risk
sharing

Increasing the pool of participants in a risk-sharing arrangement increases

the variance of the total risk, but reduces the variance of the average risk.
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Diversication and the CAPM

The same principle that is underlying risk sharing is underlying portfolio

diversication

The value of diversication and insurance stems from an e cient realloca-

tion of risks among individuals

CAPM
selection of portfolio of risky stocks is independent of nancing decision
and risk preferences
each individual optimally invests in the market portfolio and a risk-free
asset
the relevant risk is the risk of the market portfolio
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E [R i ] R F = i ( E [R m ] RF )
where
Cov (Ri; Rm)
i= 2 (Rm )
.

Unsystematic risk ( i = 0) can be diversied =) no risk premium is

required in the capital market for bearing unsystematic risk

Systematic risk ( i 6= 0) cannot be diversied =) the risk premium for

an individual risk is determined by its contribution to the total risk (i.e.,
the risk of the market portfolio)
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1.3 Insurance
The role of insurers: organize risk sharing as intermediaries
reduction in number of contracts to be written
reduction in the number of transactions after a loss
reduction of counterparty risk (premium paid in advance)

Organizational form
mutual insurance company
stock insurance company
Lloyds of London
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Diversication and Solvency

How does diversication aect the probability that an insurance company

becomes insolvent, that is - using the above notation -

prob (L1 + ::: + LN > total resources)

We apply the Central Limit Theorem: Let L1, L2, ::: be a sequence of
identically distributed and independent random variables with E [Li] =
and 2 (Li) = 2. Then the probability distribution of the average
standardized random variable
N
P
1 Li
N
i=1
p
= N
converges to a normal distribution with expected value 0 and variance 1.
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The density function of a standard normal distribution is given by

1 z 2 =2
f (z ) = p e
2
and its graph equals a bell-shaped curve.
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The insurance company owns initial capital C and charges a premium P

per policy. The probability of insolvency thus is

prob (L1 + ::: + LN > N P + C )

0 1
XN
1 1
= prob @ Li > P + C A
N i=1 N
0 1
N
X
1 1
= prob @ Li > (P ) + CA
N i=1 N
0 P p 1
1 N L
@ N i=1 i N 1
= prob p > (P ) + p CA
= N N
p !
N 1
prob Z > (P )+ p C
N
where Z is standard normally distributed.
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Let us investigate the following four situations

1. P = , C = 0

prob (L1 + ::: + LN > N P ) prob (Z > 0) = 50%

the probability of insolvency is approximately 50% and does not depend
on the size of the pool N
2. P = , C > 0
!
1
prob (L1 + ::: + LN > N P + C ) prob Z > p C
N
the probability of insolvency is lower than the one in case 1:, it increases
as we increase the size of the pool N (because the threshold decreases),
and it converges to 50% as N ! 1
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3. P > , C = 0
p !
N
prob (L1 + ::: + LN > N P ) prob Z > (P )

the probability of insolvency decreases as we increase the size of the

pool N (because the threshold increases) and converges to 0
4. P > , C > 0

prob (L1 + ::: + LN > N P + C )

p !
N 1
prob Z > (P )+ p C
N
the probability of insolvency is lower than the one in case 3:, it con-
verges to 0 as N ! 1, but it may increase for some range of small
N and thereafter decrease
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Optimal level of insurance

Demand side: Individual with utility function u has wealth w and incurs
loss of size L with probability p.

Supply side: Insurer oers coverage I at premium rate c per unit of cov-
erage =) total premium P = c I
expected prots

E[ ]=P p I = (c p) I

actuarially fair premium () zero expected prots

c=p
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Expected wealth

E [W ] = p ( w L + (1 c) I ) + (1 p) (w cI )
= w p L
| {z }
(c p) I
| {z }
expected wealth without insurance expected prots E[ ]

Maximization of expected wealth

if c > p then I = 0 - inconsistent with empirical observation
if c = p then indierent
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Optimal amount of insurance coverage determined by

max p u (w L + (1 c) I ) + (1 p) u (w cI )
I

The rst order condition is

(1 c) pu0 (w L + (1 c) I ) c (1 p) u0 (w cI ) = 0

i.e.
1 c 1 p u0 (w cI )
=
c }
| {z p u0 (w L + (1 c) I )
| {z }
marginal rate of substitution of wealth marginal rate of substitution of utility
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1 c 1 p u0 (w cI )
=
c p u0 (w L + (1 c) I )

if c = p then
w cI = w L + (1 c) I ,
i.e. full insurance is optimal I = L.

if c > p then
w cI > w L + (1 c) I ,
i.e. partial insurance is optimal I < L.
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Determinants of insurance demand

Risk aversion: insurance demand increases if the individuals degree of risk

aversion increases

Wealth: if higher wealth implies lower degree of risk aversion, then insur-
ance demand decreases if the individuals wealth increases

Loading: an increase in the cost of insurance has two aects

substitution eect: higher cost of insurance decreases demand
income eect: higher cost of insurance decreases wealth (which might
increase insurance demand)
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Main forms of partial insurance

Fixed deductible: the insurer covers losses in excess of the deductible

Proportional deductible: the insurer covers a proportion of the loss

Upper Limit: the insurer covers all losses up to the upper limit

Optimal insurance structure: xed deductible

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Which types of events should individuals insure?

If premium is actuarially fair: all

If premium is actuarially unfair?

answer via risk premium () willingness to pay for insurance in excess
of fair premium

Maximum premium Pmax individual is willing to pay for full insurance (if
the only other option is no insurance)
u (w Pmax) = p u (w L) + (1 p) u (w)

Risk premium
RP = Pmax Pf air = Pmax p L
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High frequency - low severity

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Toaster insurance

Would you buy an insurance contract for the event that your toaster breaks
down, given that the insurer charges a loading in excess of the fair premium,
e.g. to cover administrative costs?
No, even if you are risk averse you do not want to buy insurance on
losses that are small, even if the frequency is relatively high. You are
locally risk neutral.
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High severity - low frequency

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Cow insurance

Would you buy an insurance contract for the event that a cow falls from
the sky directly onto your house?
Yes, the risk premium for events causing large losses is relatively high,
even if their occurrence is relatively unlikely.
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Insights

Risk-averse individuals optimally buy xed deductible contracts if insurance

premiums are actuarially unfair

Risk-averse individuals optimally insure rather high severity - low frequency

events than high frequency - low severity events
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Reality
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Other discrepancies between predictions of theory and reality

Realization of events do not aect insurance demand (unless they provide

new information or aect the insurers assets)
insurance demand increases after events, in particular after natural
catastrophes
the higher the frequency of contacting the individual the lower the
likelihood of cancelling the policy

Risks with non-monetary losses should not be insured

insurance of heirlooms
term life insurance of children and elderly people
premium rebates
bonus point systems
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Why do individuals behave dierently?

Loss aversion

Anxiety and regret

Salience

Risk-averse over large losses, risk-loving over small losses

Subjective probabilities, distorted beliefs

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2 Risk Sharing and Asymmetric Information

2.1 Moral Hazard

2.2 Adverse Selection (including market game)

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2.1 Moral Hazard

Insurance and loss control

Self-insurance or loss reduction: reducing the magnitude / severity of

a potential loss

Self-protection or loss prevention: reducing the likelihood of a loss

Setting: individual with utility function u has wealth w and incurs loss
of size L with high probability ph or low probability pl < ph if individual
invests in loss control at a disutility c
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Optimal loss control without insurance: invest in loss control if

pl u (w L) + (1 pl ) u (w) c > phu (w L) + (1 ph) u (w)

i.e. if

(ph pl ) (u (w) u (w L)) > c

|{z}
| {z }
increase in expected utility through loss control cost of loss control

Loss control reduces the risk to be borne by risk-averse individuals.

Optimal loss control with insurance: under fair insurance (=) full
insurance) invest in loss control if

u (w pl L) c > u (w phL)
i.e. if
u (w pl L) u (w phL) > c
Loss control does not reduce risk under full coverage but the premium.
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Comparison
it is possible that loss control is optimal if risk cannot be insured but
not optimal of risk can be insured, namely if

(ph pl ) (u (w) u (w L)) > c > u (w pl L) u (w phL)

Without insurance, the individual bears the risk which involves a risk
premium. Loss control reduces both the expected loss and the risk
premium.
With full insurance, loss control only reduces the expected loss. The
risk is transferred to the insurance company (and diversied in the
market).
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Moral Hazard

Suppose loss control is optimal under full insurance, i.e.

u (w pl L) u (w phL) > c

A problem arises if it is not possible to commit to investing in loss control

(e.g. loss control is unobservable or not veriable in front of a court)

This creates a conict (trade-o) between risk shifting and incentives to

invest in loss control

Empirical prediction: individuals who purchase more insurance coverage

invest less in loss control which results in higher claim frequency
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Imagine the following sequence of events:

1. the individual signs an insurance contract and pays the premium
2. the individual decides whether to invest in loss control or not

At stage 2: with full insurance coverage it is always optimal to not invest in

loss control (the benet of loss control is transferred to insurance company
and individual only bears the cost)

At stage 1: the insurance company anticipates this optimal behavior at

stage 2, and demands a premium reecting the choice, i.e. phL, which
implies a level of utility u (w phL)
=) the individual would be better o with full insurance and commitment
to loss control, since
u (w phL) < u (w pl L) c
i.e. the individual bears the cost of the moral hazard problem
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It may be optimal for the individual to retain some risk since this provides
him with incentives to invest in loss control at stage 2

At stage 1: the insurance company anticipates this optimal behavior

at stage 2 and is able to charge a lower premium reecting the optimal
investment in loss control at stage 2

At stage 2: it must be optimal for the individual (even without commit-

ment) to invest in loss control under the contract that is signed at stage
1. This is the case if
pl u (w L + (1 pl ) I ) + (1 pl ) u (w pl I ) c
phu (w L + (1 pl ) I ) + (1 ph) u (w pl I )
i.e. if
(ph pl ) (u (w pl I ) u (w L + (1 pl ) I )) c
This condition is the incentive compatibility constraint.
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For the maximum amount of coverage I (i.e. minimum amount of risk)

for which the individual still has an incentive to invest in loss control the
above equation holds with equality, i.e.
(ph pl ) u w pl I u w L + (1 pl ) I =c

The individual is better o retaining risk and avoiding the moral hazard
problem if
pl u w L + (1 pl ) I + (1 pl ) u w pl I c> u (w phL)
| {z } | {z }
EU under retaining risk and incentive for loss control EU under full coverage

Dierence in premium
phL pl I = ph L I + (p p )I
| {z } | h {z l }
due to reduced coverage due to incentive to invest in loss control
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Implications

Because of asymmetric information about eort to reduce the loss proba-

bilities, insurance markets may fail to provide the e cient risk allocation.
Individuals may bear some risk to retain incentives to reduce the expected
loss.

This is not a special problem of insurance markets. It also arises in capital

markets. Consider a risk-averse entrepreneur. E cient risk allocation im-
plies that the entrepreneur retains a rather small fraction of future prots.
But providing the entrepreneur with incentives to exert eort can make it
optimal that the entrepreneur participates in future prots and therefore
bears a substantial part of the risk. Thus, there is a trade-o between risk
shifting and incentives.

There are gains from overcoming problems of asymmetric information and

moral hazard. The art in risk management is to design contracts that
reduce the ine ciencies associated with this trade-o.
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General structure: Principal-Agent Problem

The principal-agent problem includes a principal who writes a contract

with an agent about factors that are under the control of the agent but
have eect on the principal. The natural question that arises is how the
principal can write contracts that induce the agent to make decisions that
favor the principal.
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2.2 Adverse Selection

Market game in class: Instructions are distributed during class.

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Adverse selection in insurance markets

Setting: individuals are (genetically) heterogeneous in their risk type, e.g.

dierent likelihoods of accidents, ph > pl , but identical loss size, L

Insurance with known risk types: if the insurance company knows each
individuals risk type, it can oer contracts that reect the true risk char-
acteristic of each individual

Insurance with unknown risk types: Often it is neither possible for the
insurance company to observe the risk characteristic nor is it possible for
the individual to prove his risk type
=) insurance company cannot oer dierent premiums for same level of
insurance coverage
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Pooling of risks

To break even, the insurance company has to set a premium that reects
the average expected loss (pooling price)
for high risk individuals it is optimal to buy insurance at this price
for low risk individuals it might be optimal to not buy insurance at this
price
=) the insurance company ends up with only high risk individuals (adverse
selection) and demands the appropriately high premium
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Separation of risks

The low risk individuals may be able to dierentiate themselves from the
high risk individuals by their willingness to bear part of the risk
high risk individuals will choose full insurance coverage over partial
insurance
low risk individuals will retain some risk by choosing partial insurance
coverage over full insurance (self-selection constraint)
both contracts reect the true risk characteristics (separating con-
tracts)
=) insurance company screens dierent individuals through self-selection
device
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Formal Analysis

The insurance company oers two contracts to separate types, h = (Ih; Ph)
and l = (Il ; Pl )
high risk individuals will optimally choose contract h
low risk individuals will optimally choose contract l
the company makes zero expected prots

Contract h oers full coverage at a fair premium rate for h, i.e. h =

(L; phL)

Contract l oers partial insurance at a fair premium rate for l, i.e. Pl = pl Il

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The following self-selection (truth-telling) constraints must be satised

u (w phL) phu (w L + (1 pl ) Il ) + (1 ph) u (w pl Il ) (1)

pl u (w L + (1 pl ) Il ) + (1 pl ) u (w pl Il ) u (w phL) (2)

The following participation constraints must be satised

u (w phL) phu (w L) + (1 ph) u (w) (3)

pl u (w L + (1 pl ) Il ) + (1 pl ) u (w pl Il )
pl u (w L) + (1 pl ) u (w) (4)
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Participation constraints (3) and (4) are satised since both contracts are
fairly priced

Self-selection constraint (1) for high risk types must be binding and spec-
ies the maximum partial coverage Il < L such that high risk types will
just prefer contract h, i.e.

u (w phL) = phu w L + (1 pl ) Il + (1 ph) u w pl Il

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Substitution into the self-selection constraint (2) for low risk types implies

pl u w L + (1 pl ) Il + (1 pl ) u w pl Il
u (w phL) = phu w L + (1 pl ) Il + (1 ph) u w pl Il
i.e.
u w pl Il u w L + (1 pl ) Il
This inequality holds since Il < L.

Dierence in premium

phL pl Il = ph L Il + (p p )I
| {z } | h {z l }l
due to reduced coverage due to selection of low risk types

Insurance company makes zero expected prots

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Intuition
high risk individuals value insurance coverage relatively more than low
risk individuals
low risk individuals trade-o the advantage of benetting from a lower
premium against the disadvantage of bearing a higher fraction of the
loss themselves

Empirical prediction: individuals who purchase more insurance coverage

are of higher risk type, e.g. measured by claim frequency
true in health insurance and annuities
false (opposite) in life and long-term care insurance
 62

Implications

Because of asymmetric information about loss probabilities, insurance that

has to break even may fail to provide the e cient risk allocation. Individ-
uals with low loss probability may have to retain some of this risk to signal
their low loss probability.

This is not a special problem of insurance markets. It also arises in capital

markets. Consider the following situation. A risk-averse entrepreneur wants
to sell (part of) his rm to shareholders in the capital market and invest
the proceeds in a diversied portfolio. If there is asymmetric information
about the level of the rms future prots, the entrepreneur may retain
a higher fraction of his rm to signal a high level of future prots. As a
consequence, not all gains from reallocating risk in the capital markets can
be realized.

There are gains from overcoming problems of asymmetric information and

adverse selection.
 63

General structure

Adverse selection describes a situation in which an informational asymme-

try exists at the time of contracting.

Potential remedies
risk classication, e.g. through risk factors (age, location, gender,
credit rating, ...)
screening by market side with inferior information, e.g. through self-
selection device
signalling by market side with superior information, e.g. through edu-
cation, warranty
governmental regulation, e.g. social insurance, ood and terrorism
insurance
 64

Insights

The role of moral hazard and adverse selection in risk transfer:

moral hazard arises when the risk seller has an inuence on the risk
adverse selection arises when the risk seller knows the risk better than
the risk buyer

Moral hazard and adverse selection problems are of central importance in

risk transfer

Retaining some of the risk can mitigate moral hazard and adverse selection
problems: to retain incentives to avoid losses and to signal low risk, the
risk seller has to participate in the loss realizations
 65

3 Corporate Risk Management

3.1 Irrelevance of Capital Structure

3.2 Irrelevance of Risk Management

3.3 Relevance of Capital Structure and Risk Management

3.4 Empirical Evidence

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Setting:
entrepreneur: no money, but idea for project (investment decision =
operating strategy)
investors: money, but no idea

Questions:
In which projects should be invested? (investment decision at rm
level)
How should those projects be nanced? (nancing decision at capital
market level)

Intertwined question: Should and how should risk be managed? (also

nancing decision)
 67

Financing Policy

What is the best source of funds?

debt (i.e. borrowing)
equity (i.e. issuing stock)
internal funds (i.e. cash)

What is the optimal mix of those funds, i.e. capital structure?

How is it related to the rms real operations, i.e. investment policy?

 68

3.1 Irrelevance of Capital Structure

Modigliani and Miller (MM):

In a frictionless market (no taxes, no cost of nancial distress, no incentive
or information problems)

the total value of a rm is equal to the market value of the total

cash ows generated by its assets. It is not aected by its choice of
capital structure.

That is

The value of the pie depends on its size.

The size of the pie does not depend on how it is sliced.

=) Value is created by operating decisions only, not by nancing decisions.

 69

Intuition: Homemade leverage

If investors prefer dierent capital structure (risk prole) than the one
chosen by the rm they can borrow or lend on their own to achieve the
desired structure (homemade leverage)

Homemade leverage is perfect substitute for the use of leverage at the rm

level

Entrepreneurs choice of capital structure does not aect the opportunities

available to investors

Since investors can buy or sell securities on their own, no value is created
when the rm buys or sells securities for them
 70

Extension of MM

MM Theorem applies to all aspects of nancial policy

debt-equity mix is irrelevant
long-term vs. short-term debt is irrelevant
dividend policy is irrelevant

All nancial transactions are zero NPV transactions and therefore do not
create value
 71

Unlevered equity (no debt): value of rm V U = E U to equityholders

U.
(shareholders) is discounted expected value of future cash-ows C = CE
The return is
U
CE VU
U
RE =
VU
CAPM implies
h i
U
E CE VU
R F = U ( E [R m ] RF )
VU
i.e.
h i
E C U
E
VU =
1 + R F + U ( E [R m ] RF )
 72

Levered equity (debt and equity): value of rm V L is discounted expected

value of future cash-ows C = CEL + C L to equityholders and debtholders.
D
The value of the rm V is the sum of value E L to equityholders and of
L

value DL to debtholders, i.e.

V L = E L + DL

MM: the value of the rm only depends on C and therefore not on the
capital structure, i.e.

V L = E L + DL = V U = E U
 73

Because of lesser risk, debt requires a lower return than equity. For risk
free debt we can write
CDL
DL =
1 + RF

BUT: debt raises the cost of equity

h i h i
E CE U E CE L L
CD
U ( E [R ]
= L ( E [R ]
+
1 + RF + m RF ) 1 + RF + m RF ) |1 +{zRF}
| {z } | {z }
=V U =E U =E L =DL
Since C = CEU = C L + C L we have
E D
L> U

=) levered equity is riskier than unlevered equity and requires higher risk
premium
 74

Example

Project requires investment of 800 and generates cash ows of either 1:400
or 900 with equal likelihood

Suppose RF = 5% and risk premium is 10% (cash ows depends on

overall economy)
0; 5 1:400 + 0; 5 900
NP V = 800 + = 200
1; 15
 75

Unlevered equity
0; 5 1:400 + 0; 5 900
V = EU = = 1:000
1; 15

entrepreneur can raise 1000 by selling equity in the rm, pay investment
cost 800, and keep 200 as a prot.
expected return to shareholders
1 1
40% + ( 10%) = 15%
2 2
 76

Levered equity: borrow DL = 500

cash ows to debtholders
L = 500 1; 05 = 525
CD

cash ows to equityholders either 1400 525 = 875 or 900 525 =

375
value of equity

EL = V DL = 1:000 500 = 500

 77

expected return to shareholders

1 1
75% + ( 25%) = 25%
2 2
=) risk premium of levered equity 20%, i.e.
0; 5 875 + 0; 5 375 0; 5 875 + 0; 5 375
E L = 500 = 6= = 543
1; 25 1; 15
 78

3.2 Irrelevance of Risk Management

Risk transfer and nancing

Stock corporation: risk sharing in the capital market

Insurance and derivatives contracts are additional (alternative) means to

transfer risk to the capital market
 79

Risk transfer: reallocation of nancial resources across time and states

Insurance: pay insurance premium and receive payment that indemni-
es losses
Option: pay option premium and receive contingent payment that de-
pends on the value of the underlying
Future: zero payment today, state contingent positive or negative pay-
ment that depends on the value of the underlying

=) Risk transfer decision is equivalent to a nancing decision (risk nancing)

 80

MM and risk management

Value of rm depends only on rms real investment decisions (operating

strategy)

Financing decisions (mix of debt and equity) only determines how cash
ows are split between dierent nancial claims

Operating decisions are independent of nancing decisions

Firm value is independent of nancing decision

risk transfer is a nancing transaction: reallocation of funds across time
and states (it determines how the pie is sliced)
risk transfer on the level of the rm is irrelevant
 81

Value of rm E to shareholders is discounted expected value of future

cash-ows CE to shareholders
E [C E ]
E=
1 + RF + (E [Rm] RF )

Shareholders are only compensated for systematic risk

Does risk management increase value of rm to shareholders and thus

shareholders wealth in frictionless market?

Suppose shareholders care only about expected return and volatility of

wealth =) they hold market portfolio and risk-free asset. Suppose risk
management reduces volatility of returns
 82

Risk Management reducing unsystematic risk

value of rm does not depend on diversiable risk
risk management is costly and reduces expected future cash-ows E [CE ]
but has no other impact

=) Risk management reduces value of rm E to shareholders

Shareholders do not want management to engage in risk management

reducing diversiable risk, since they are diversied through the capital
market
 83

Risk Management reducing systematic risk, e.g. by taking short position

in market portfolio
e1 invested in rm has same systematic risk as e invested in market
portfolio
sell short e of market portfolio per e of shareholder equity and invest
in risk-free asset =) rm has now = 0
risk management does not increase value of rm since selling short has
a negative risk premium; shareholders have to pay the investor who
bears systematic risk
the reduction in is completely oset by reduction in future cash-ows

=) reducing systematic risk at rm level does not increase value of rm

Shareholders can reduce systematic risk themselves through the capital

market
 84

Insights

The costs of bearing risk within the rm or outside the rm are identical.
diversiable risk does not aect the share price and investors do not
care about it since it gets diversied within their own portfolios
shareholders of a rm require the same risk premium for systematic risk
as all investors; eliminating it for shareholders implies that investors who
take it on require the same risk premium.

Risk management is irrelevant (risk management by the rm can be repli-

cated by any investor outside the rm)
 85

3.3 Relevance of Capital Structure and Risk Management

Important questions

How do nancing and risk transfer decisions aect the rms

operating decisions and/or
cash ows and cost of capital
beyond the eects that are also present in a frictionless market?

What is the dierence between risk management on the level of the rm

and on the level of individual investors?
management may have more knowledge about the rms risks
 86

Risk transfer and nancing

The reasons why a rms nancial decisions matter (i.e. impact the total
rm value) are also the reasons why a rms risk transfer decisions matter
Taxes
Costs of nancial distress
Information and incentive problems

Objective of Investors: maximize total value of the rm with consideration

of interest tax shields, nancial distress costs, agency costs/benets of
debt, and adverse selection
If debt is fairly valued, maximizing the total value of the rm is equiv-
alent to maximizing the total shareholder value
 87

Costs of nancing

Benets of debt
Interest tax shields
Adverse selection (information about claims value pecking order of
nancing)
Leverage increases rm value because it commits the rm to making fu-
ture interest payments, thereby reducing excess cash ows and wasteful
investment by managers

Disadvantage of debt
Tax disadvantage because of excess leverage (interests higher than
EBIT)
Direct and indirect costs of nancial distress
Risk shifting incentive (over investment problem)
Debt overhang (under investment problem)
 88

Consequences: nancing aects

tax burden

costs of raising and holding capital

operating decisions

value that stakeholders attach to rm

The problem is that losses and gains may have asymmetric eect on
rm value.
 89

Taxes (benet of debt = cost of equity)

Dierent nancial transactions are taxed dierently

interest payments are tax exempt but dividends and retained earnings
are not

=) After-tax costs of debt are lower than after-tax costs of equity (if interests
are lower than EBIT)

Taxes are a convex function of operating prots

increasing marginal tax rate
pay full taxes on prots but dont get immediate deduction for losses

=) After-tax prots are a concave function of operating prots

=) Reducing the volatility of operating prots through risk management at
the level of the rm reduces the expected tax payment
 90

Financial distress

In a frictionless capital market with complete information, a rms nancial

claimants can always agree to pursue the operating strategy that maximizes
total rm value

Claimholders will restructure the rms nancial claims so as to continue

operations if this strategy maximizes total rm value

Financial distress has no eect on the optimal operating strategy

=) Operating decisions (including liquidation) are independent of nancial

distress

As nancial distress has no eect on operating decisions, it has no eect

on rm value
 91

Costs of nancial distress

Direct costs: Costly outside experts are often hired by the rm to assist with
the bankruptcy process. Creditors also incur costs during the bankruptcy
process. They may wait several years to receive payment. They may hire
their own experts for legal and professional advice
The average direct costs of bankruptcy are approximately 3% to 4% of
the pre-bankruptcy market value of total assets.
Indirect Costs: While the indirect costs are di cult to measure accurately,
they are often much larger than the direct costs of bankruptcy.
Loss of Customers, Loss of Suppliers, Loss of Employees, Loss of Re-
ceivables, Fire Sale of Assets, Delayed Liquidation, Costs to Creditors
It is estimated that the potential loss due to nancial distress is 10%
to 20% of rm value
Homemade risk management at the level of capital markets cannot avoid
the impact of bankruptcy costs =) Risk management at the level of the
rm reduces expected bankruptcy costs
 92

Agency Cost of Financing

Costs result from the eects of risky debt on the rms operating strategy
and problems of reorganization when information and incentive problems
are large

Eects of nancing decisions on the choice of operating strategy

Debt overhang (under investment problem)
Risk shifting incentive (over investment problem)
Adverse Selection
 93

Agency Cost of Financing

After a large loss rm has excessive debt

The loss increases the default probability and therefore decreases the value
of the outstanding debt

Raising new equity may be di cult, expensive, and even impossible (be-
cause of information and incentive problems) =) dilution of existing shares
 94

Debt-overhang problem (underinvestment problem, cost of debt)

If the rms debt is risky, shareholders may be reluctant to carry out new
projects because most of the benets would go to rms existing debthold-
ers.
Carrying out new projects may change the structure of the rms cash
ow to the advantage of debtholders
Raising external capital benets outstanding debt to the disadvantage
of existing shareholders (new claimholders must break even and existing
shareholders incur the costs)

=) Existing shareholders may forgo protable investment opportunities to

avoid raising new equity (underinvestment in protable projects)

This problem is particularly severe in nancial distress.

 95

Risk-shifting problem (overinvestment problem, cost of equity)

A share of rms stock with risky debt is equivalent to a call option

if the value of the rm exceeds the repayment obligation to debtholders,
shareholders exercise the option and repay the debt
otherwise, shareholders are protected by limited liability and declare
bankruptcy
therefore, shareholders benet from increased risk at the expense of
debtholders

=) Firms will tend to liquidate assets too late and remain in business too long

=) Firms in distress will adopt excessively risky strategies to gamble for res-
urrection (overinvestment in excessive risks)
 96

Adverse-selection problem (cost of equity)

When raising new capital, investors are not sure about the correct value
of their claim and fear that management is better informed
raising capital is particularly advantageous for rms whose prospects
are overestimated in the market
rms that are undervalued (whose prospects are underestimated) may
not be willing to raise new external capital (and even forgo projects
with positive NPV)

Raising new capital may be interpreted as a negative signal about the rms
prospects and the rm may not be able to raise new capital (or only at
very high costs) if information asymmetry is high
 97

Pecking Order Theory

The costs of raising external capital increase when the potential problems
of asymmetric information for valuing the claim increase

Implications for the type of nancial claim

Cash, risk free debt: no problem
Risky short-term debt: medium problem
Risky long-term debt: bigger problem
Equity: biggest problem

Implications for the timing of raising capital: try to take on capital when
information asymmetry is low
 98

Pecking Order Theory

The costs of raising external funds are borne by existing shareholders

The value of the new project depends on how it is nanced

For existing shareholders, the same project is worth more when nanced
with internal rather than external risky funds
For existing shareholders, the same project is worth more when nanced
with debt rather than equity

When funding their investment needs, rms will

preferably use retained earnings
revert to debt as second nancing source
issue new equity as a last resort

However, this theory does not provide a clear prediction regarding capital
structure. While rms should prefer to use retained earnings, then debt,
and then equity as funding sources, retained earnings are merely another
form of equity nancing.
 99

Free Cash Flow Problem (cost of cash and equity)

Managerial incentive problems (play golf, expand power, empire building,

avoid interference from capital market)

Pecking order theory =) internal funds are the preferred source of nanc-
ing BUT
excessive internal funds may give managers too much exibility and
increase the potential for conicts with shareholders
there is more free cash ow that can be wasted to pursue the managers
own interest

Implications
provide managers with incentives, e.g. stock options
use debt to force managers to pay out funds (debt is a sword, equity
is a cushion)
 100

Managerial incentive contracts and risk management

Due to managerial incentive problems, management receives compensation

contract that is related to rm performance (to align managers incentives
with those of owners)

Firm performance depends on factors outside managements control (e.g.

exchange rates, interest rates, commodity prices)

Hedging can insulate the rms performance from these factors

clearer picture of managements actual performance
design better managerial incentive contracts
improved performance

=) Relating compensation to rms performance becomes eective in aligning

incentives
 101

Summary: Information and incentive problems

The problems above (debt-overhang, risk-shifting, adverse selection, free

cash ow) do not exist if the dierent claimants have symmetric informa-
tion and can commit to maximizing total rm value

If a group of claimants is aected negatively, it is compensated accordingly

However, if there is asymmetric information about the size of the pie or if

one cannot commit to a certain strategy, opportunistic behavior by the dif-
ferent parties induces an eect of nancing decisions on operating decisions
which can create ine ciencies.
 102

Summary: Information and incentive problems

The debt-overhang and risk-shifting problem may arise when the rm has
risky debt outstanding

The adverse-selection problem may arise when the rm wants to raise risky
capital

All three problems are also present outside nancial distress but nancial
distress often aggravates these problems

=) Asymmetric consequences of losses and gains

=) Risk nancing may reduce the probability and consequences of excessive

debt
 103

Means to reduce costs of nancial distress

Reduce debt level (high level of equity)

Risk management (insurance or derivatives)

allows higher leverage
lower cost of raising capital

Contingencies in debt contracts

forgiveness of principal or interest after certain events
automatic conversion into equity = automatic debt restructuring
 104

Risk management

Insurance and hedging with derivatives serve to assure that the rm has the
cash ow it needs to pursue protable investment projects (avoid external
shock to internal resources)

Risk management can reduce the need to nance investments externally

However, a complete hedge may not be optimal

 105

Hedging decisions should take into account

eect of input price changes on cash ows (e.g. the rm may raise the
output price after an increase in input prices)
correlation between cash ow and the value of investment opportunities
(e.g. when input prices increase the investment opportunities may be
less valuable =) lower investment level is optimal)
competitorsdebt level and hedging strategies (if competitors are hedged,
they will be in a good position to invest despite adverse movements in
prices, but competition might also be higher)

Key questions:
How sensitive are cash ows to exogenous factors that are to be hedged?
How sensitive are investment opportunities to these factors?
 106

Summary: Capital and risk management

Use of funds
operating expenses, R&D
capital expenditure (CAPEX), new projects
contractual obligations (wages, debt)
dividends
investment in nancial assets incl. insurance and derivatives

Source of funds
external: issuing equity and raising debt
internal: cash ow from assets in place, cash, nancial assets incl.
insurance and derivatives
 107

Matching use of funds and source of funds is no issue in frictionless markets

no interrelation between use and source of funds
only real investments matter
rm can raise funds to nance investments with positive NPV

With capital market frictions

taxes, frictional cost of raising funds, costs of restructuring nancial
claims
interactions between real investments and source of nancing
adverse eects on contracting parties
 108

With market frictions matching use and source of funds becomes important
to avoid
costly external nancing
forgone investment opportunities
nancial distress

Costs dier depending on industry

information asymmetry between management and investors
value of growth options, maturity of industry
importance of specic investments, e.g. workers, suppliers
dierences in the magnitude of nancial distress costs: technology rms
will likely incur high nancial distress costs due to the potential for loss
of customers and key personnel, as well as a lack of tangible assets
that can be easily liquidated
dierentials in the volatility of cash ows
 109

Pharmaceutical company: high growth options, specic investments, di -

cult to evaluate for outsiders
high cost of forgoing investment opportunities and laying o workers
high cost of raising funds under nancial pressure
high cost of risk transfer

=) high level of cash and very low debt to absorb risk

Gold mining rm: low growth options, easy to evaluate, low level of asym-
metric information
low cost of raising funds, potential free cash ow problem
low cost of transferring gold price risk

=) potential benet of high debt level: taxes, reduce free cash ow

 110

Insights

Risk management on the level of the rm creates value (to shareholders)

by
decreasing expected tax payments
reducing the costs of nancial distress
reducing the need to access external capital markets
improving the design of management compensation contracts

Asymmetric eects of prots and losses on value of rm