MANAGING RISK
This handout explores ways in which management can reduce company risk and thereby raise firm value and share value. We begin by explaining how reducing risk can enhance value. This is followed by a discussion of the multitude of risk-management techniques in common practice by mid-sized and large companies in the United States and abroad.
HOW RISK MANAGEMENT CREATES VALUE
The typical large company spends heavily on insurance, forward contracts, swaps, and other risk management techniques in order to reduce (hedge against) uncertainty (risk) associated with firm asset values, cash flows, and taxable income, that is, to reduce total risk. [Note that we are not talking about beta risk. We are referring total risk, or variance (more specifically, coefficient of variation, which is variance divided by mean). The reduction in risk can produce savings that exceed the cost of implementing the risk management process. This can happen because risk management techniques can:
1. Reduce financing costs by lessening reliance on relatively expensive external capital.
2. Reduce the likelihood, and expected cost, of financial distress.
3. Reduce management costs and improve management decisions.
4. Reduce taxes.
We now consider each of the above benefits of hedging.
Hedging to Reduce Financing Costs
Internal financing is the use of cash generated by operations to finance expenses and capital outlays. External financing is the use of funds from borrowing or from the sale of new equity (issuing new shares). Internal financing is cheaper in two important ways. First, there are no fees to investment bankers, accountants, lawyers and others who are involved in accessing the capital markets. Second, unlike external equity finance, internal financing is not interpreted by the markets as a sign that management believes that the firm’s shares are overpriced. This effect explains the share price decline that often accompanies the sale of new shares.
Reducing the uncertainty associated with cash flow from operations (internally generated funds) lessens the probability that the firm will have an unexpected insufficiency of internal funds to finance investment, an insufficiency that would have to be remedied by resorting to expensive external financing. To illustrate, assume that, over the next 5 years, annual net cash flow from operations is expected to be anywhere from $450 million to $650 million and that capital outlays are forecasted to be a stable $500 million annually. If the company were to have several successive years in which cash flows were below $500 million, the firm would have to turn to the external capital markets to finance part of the $500 million capital budget. On the other hand, there would be no need for external financing if the annual cash flow from operations could, through hedging, be constrained to a range having a minimum of $500 million.
Hedging to Avoid Financial Distress Costs
Financial distress is the inability, or imminent inability, to service debts as scheduled. In extreme cases, this results in bankruptcy and takeover of the firm by creditors. Hedging stabilizes asset value and can reduce the probability that asset value will sink so far as to produce financial distress. These costs can take various forms.
Direct financial distress costs - direct expenditures to deal with the financial distress:
· Legal fees
· Accounting fees
· Investment bank fees
· Lenders’ time in seeking payment from borrower
· Management time used in bargaining with lenders
· Disruption of the business as lenders take control (if a change of control occurs)
Indirect financial distress costs:
· Under-management of the firm because management is distracted by the financial distress, and because shareholders’ have less incentive to maintain effective firm management because the company might have to be surrendered to creditors
· Reduced access to external capital
Problems made worse by the presence of financial distress:
· Loss of customers because they believe that the firm will be less likely to survive and therefore less likely to honor warranties, provide services, provide parts, etc.
· Departure of key employees because the firm is more likely to fail
· Worsening of terms offered by suppliers because the firm is more likely to fail (failing business are last in line for goods and services)
Direct and indirect costs of financial distress are in addition to loss due to the poor performance of the business. Furthermore, the financial distress (which arises because of the use of debt) can also intensify the loss of customers, employees and suppliers. To illustrate, suppose that United Bakers has suffered a decline in its business and a series of losses. If United were all equity, it would avoid the added costs of financial distress. But if United has debt, some or all of the above costs may be present. Debt makes a bad situation worse, sometimes much worse.
Hedging to Improve Management Decisions
Greater cash flow predictability facilitates analysis, planning and decision-making. For example, reducing (through hedging) the risk of a proposed project’s future cash flow will usually enable a more accurate estimate of the discount rate to be used in computing the present value of that cash flow. The more accurate discount rate estimate implies greater confidence in the present value figure and the resulting decision as to whether to adopt the project. The outcome is likely to be fewer mistakes in accepting and rejecting projects.
The forward or futures markets can be used to hedge and to improve decisions. A forward or futures contract is an agreement now to buy, or sell, a particular good or service at some date in future. For example, using futures contracts, farmers agree now to deliver wheat in the future for a price that is set now (the “futures price”). Since the currently prevailing wheat futures price reflects the market’s current expectation about future demand for wheat, the use of futures prices can help a farmer make better-informed production decisions (whether or not the farmer actually sells any wheat in the futures markets).
Insurance companies provide a hedge (insurance) and in the process gain specialized expertise in the costs of, and methods of preventing, the various categories of loss-creating events. There are economies of scale in gaining this specialized knowledge. To exploit this comparative advantage, British Petroleum insures against relatively frequent and common events such as on-the-job injuries, fire damage, and natural disasters. BP management believes that insurance companies have a better understanding of the probabilities and magnitudes of these potential losses (including knowledge of the cost of settling lawsuits). On the other hand, BP self-insures against very unusual losses about which it has the better understanding.
Hedging is also used to improve performance evaluation so that effective managers can be properly rewarded. For example, Disney Corporation hedges exchange rate risk and other sources of hedgeable risk in order to isolate those aspects of performance that are produced by management decisions, rather than by forces outside the control of the manager.
Hedging to Reduce Taxes
Gains and losses are usually treated asymmetrically under U.S. tax law. The tax on $100 million of taxable income might be $35 million, whereas the present value of the tax rebate on a $100 million tax-deductible loss might be only $25 million. This asymmetry produces the possibility of an advantage to reducing the uncertainty of taxable income.
Assume Exhibit 1a for Roy, Inc. There is a 50% probability of strong performance and 50% probability of weak performance over the coming year. If Roy does not hedge, its pretax income will be $100 million (strong) or - $20 million (weak). If Roy hedges, pretax income will be $35 million for certain. We assume here that transaction costs of hedging are $5 million, so expected (average) pretax income is $5 million less with hedging than without hedging ($35 million versus $40 million). Exhibit 1b shows after-tax income. For simplicity, assume a 40 percent tax rate on positive taxable income, but no tax rebate if the firm incurs a loss. Expected (average) after-tax income is $20 million with no hedging and $21 million with hedging. This is so even taking into account the lower expected pretax income with hedging.
Exhibit 1a. Pretax Income for Two Equally Likely Outcomes (in $millions)
Strong Performance / Weak Performance / AverageUnhedged / $100 / - $20 / $40
Hedged / $35 / $35 / $35
Exhibit 1b. After-tax Income for Two Equally Likely Outcomes (in $millions)a
Strong Performance / Weak Performance / AverageUnhedged / $60 / - $20 / $20
Hedged / $21 / $21 / $21
a Assume that pre-tax income is taxed at a 40 percent tax rate (Federal, state and local tax combined), and that a loss produces no tax benefit.
WHICH FIRMS ENGAGE IN HEDGING?
Virtually every company, large and small, uses various kinds of insurance to “hedge” against insurable risks. Property and casualty insurance, and life insurance (e.g., to cover key employees), credit insurance, and health insurance for employees are all available at a price.
Non-insurance hedging includes hedging against input and output price fluctuations, financial hedging to reduce uncertainty about the rates on borrowing and lending, and currency hedging to protect against exchange rate changes. The use of hedging through means other than insurance depends on the type of firm. Large firms are more likely than are smaller firms to hedge, both because establishing the risk management function involves large fixed costs, and because sophistication of management practices and firm size are positively correlated. However, of those firms that do hedge, small firms tend to hedge more completely; this is likely because the small firms that hedge tend to be riskier than the large firms that hedge (and so have a greater need to hedge in order to prevent financial distress).
Hedging is also more common among companies with exceptional growth opportunities, particularly those with large R&D budgets. It appears that these companies hedge in order to ensure that they have sufficient internal funds to finance their capital outlays. Furthermore, high growth firms often have high business risk and have assets that are very susceptible to value shrinkage in the event of financial distress. Such companies have high potential financial distress costs and therefore benefit disproportionately from hedging activities that reduce the likelihood of financial distress.
The extent of hedging, and the type of hedging, depends on industry. Companies that produce or purchase basic commodities (oil, metals, and agricultural products) commonly hedge the price risk of those commodities through commodity futures contracts. Issuers and holders of debt instruments hedge interest rate risk through interest rate futures. For example, banks and other lenders that lend long term and borrow short-term hedge interest rate risk. Firms that have international operations (virtually every large company) usually hedge in the foreign exchange markets.
TECHNIQUES FOR RISK-MANAGEMENT
INSURANCE
Insurance is a contractual arrangement with an outside party, almost always an insurance company, who agrees to cover a particular kind of loss in exchange for a fixed payment, or premium. Insurance companies offer two kinds of coverage, life and health insurance and property and liability insurance. Health insurance covers some or all of the medical, prescription drugs, disability, etc.. Property and liability insurance protects against a multitude of risks, including loss due to natural disaster, fire, accidents, or theft, and legal liability arising from property damage, bodily injury or financial loss to others. Business firms purchase both, and the range of offerings within these two categories has proliferated over time. If a company does not purchase insurance to protect against a risk, it is “self insuring” against that risk.
Benefits of Firm-Provided Life and Health Insurance: Businesses provide or subsidize employee life and health insurance plans primarily for three reasons.
· Lower After-Tax Cost: Group plans are cheaper than individual policies to administer, and a tax benefit may result if the company purchases insurance for the employee (rather than the employee buying the insurance individually).
· Reduction of Absenteeism: The risk of employee health-related absenteeism is reduced if employees are diligent in obtaining needed medical examinations and treatment. Insurance makes this behavior more likely; in fact, some employees might not purchase adequate insurance coverage unless it is provided by the company.
The Decision to Insure or Self-Insure: In evaluating a particular risk, a good start is to ascertain whether to insure through an insurance company or to self-insure. Here are some reasons to purchase the insurance from an insurance company.
· For many risks, insurance companies have the greatest knowledge and expertise. They may have a comparative advantage in estimating the likelihood and potential level of loss, and they may be helpful in providing advice on how to control and limit risk.
· Purchasing insurance reduces cash flow risk and the likelihood of financial distress costs for the insured. If a company self-insures a large risk, it may face significant probability of financial distress and financial distress costs. If it purchases insurance from an insurance company, it pays a premium but knows that it will be compensated if the loss occurs. Furthermore, an insurance company has the benefit of diversification; the risk of a large theft may be high for an individual, but the average theft loss for 10,000 individuals may be highly predictable. This means that the risk does not expose the insurance company to financial distress, and can charge a relatively low premium. Outside insurance is a way of reducing the overall bankruptcy costs in the economy. Large risks that jeopardize the survival of the insured are good candidates for insurance.
· Insurance companies have lower in processing claims. Insurance companies process a far larger volume of claims than would most insureds. They have the benefits of economies of scale. Moreover, they better understand insurance management, and consequently are likely to have a lower cost for any given volume of claims.
Insurance also has several drawbacks relative to self-insurance.
· Insurance companies have additional costs. Insurance companies incur a multitude of costs (marketing, claims management, etc.) that must be covered by the premiums paid by the insured. Self-insurance avoids some of those costs (e.g., marketing and advertising).