Notes on risk management (II)
This feature is a continuation of an earlier publication on theoretical explanations proffered by Brigham, Ehrhardt and Stulz on risk management. Discussions in the previous write-up ended on forms of risk.
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Importance of risk management
It is a known fact that investors are always interested in channeling their financial resources into “secure” areas of the economy; most investors prefer to diversify their investments, that is, hold a diversified portfolio. This implies investors abhor risk, and corporate executives may have to focus on a systematic risk or beta. Interestingly, corporate executives think otherwise. They perceive investment risk as the tendency for the stream of future cash flows from investment to be significantly lower than expected. If the firm’s expenses during the life of a project exceed the estimated cost, the returns would decrease.
However, returns on the project would increase if estimated cost decreases, or remains the same during the life of the investment. Thus, variations in the estimated cost of investment would either maximise or minimise shareholders’ wealth. To illustrate, suppose Mensco Company, a furniture manufacturer, has a contract to supply Eden School with 1000 sets of furniture each year for the next four years. The school is expected to pay $150 for each set of furniture. The major raw material required for this project is lumber. The cost of lumber per furniture set during contract signing is $60 and expected to remain unchanged for the next four years. If the price of lumber falls below $60 during the contract period, Mensco Company’s returns would increase more than expected; if the price of lumber increases during the period, the company’s profit would be less than expected.
Mensco Company can control the fluctuations in lumber prices during the contract period through hedging. Even if the cost of hedging is zero, it is difficult to conclude that the wealth of shareholders would be maximised. This is because shareholders’ wealth is determined as the “present value of [the] expected future free cash flows, discounted at the weighted average cost of capital (WACC)” (Brigham and Ehrhardt, 2008, p. 820). Thus, hedging would maximise the wealth of shareholders only when it results in an increase in the streams of cash flows expected in future; and only when it leads to a fall in the weighted average cost of capital.
An increase in WACC would lead to an increase in the cost of equity, debt, or the firm’s capital structure; and an eventual decrease in profit. Hedging against the price of lumber assures investors of expected future free cash flows, and minimises risk. If the company experiences unexpected decrease in cash flows, then its operational activities would be disrupted; and its free cash flows would be negatively affected.
Although hedging comes at a cost, it is necessary for companies to hedge to minimise or prevent risk. This explains why companies attach much premium to risk management. A study conducted by Bodnar, Hayt, and Marston (1998) reveals about eighty-three percent of large companies (that is, companies with values in excess of $1.2 billion) are actively committed to risk management; only seventeen percent of small companies utilise risk management.
According to Stulz (as cited in Chew, 2001) the theoretical development of corporate risk management is at variance with contemporary practice: the theoretical underpinning of the risk management theory is to help reduce the strategic risk of companies to ensure stability in their stream of free cash flows by using derivative securities. The author argues, since smaller companies are more vulnerable and more prone to risk, they should be making use of risk management, not larger companies.
Unfortunately, large companies with relatively low risk are the dominant users of risk management. Stulz (as cited in Chew, 2001) believes most companies use risk management for purposes other than minimising variations in cash flows. The author observes that most corporate executives engage in selective (p. 411) hedging rather than full-cover (p. 411) hedging. This means only few managers constantly use derivatives in taking clear speculative position on commodity prices or foreign exchange rates whereas most managers allow their personal future views on strategic risk to influence their hedging positions.
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This notwithstanding, financial experts such as Brigham and Ehrhardt (2008) and Stulz (as cited in Chew, 2001 ) have identified several factors which encourage the use of risk management in companies: financial distress, comparative advantages in hedging, capacity of debt, maintenance of optimal capital budget over a given period, effects of tax, compensation systems, and costs of borrowing.
Financial Distress: Financial distress occurs when the firm is embroiled in bankruptcy costs, higher interest rate payments on debt, or when its customers defect to other firms. Although most shareholders hold well-diversified portfolios to secure their investments, they will be concerned if the firm’s operations exhibit the probability of a financial distress. Effective and active risk management techniques help to eliminate or reduce the perceived probability of financial distress to the company, it ensures stability in the company’s cash flows.
Stulz (as cited in Chew, 2001) affirms the elimination of bankruptcy costs through risk management helps the company to increase the value of its shares “by an amount roughly equal to Bc (bankruptcy costs) multiplied by the probability of bankruptcy if the firm remains unhedged (pBU)” (p. 416).
Assume the market value of Company A’s equity is $50 million, bankruptcy costs are estimated at $12 million (or 24% of current company value), and the probability of bankruptcy in the absence of hedging is 5%.
In this example, Company A’s adoption of risk management would lead to an increase in the current value of its equity by $600,000 (5% x $12 million), or 1.2% [($600,000 / $50 million) x 100%].
This argument holds strongly for companies with healthy financial conditions. When companies are experiencing decrease in cash flows, the value that risk management adds to equity may be measured in percentage terms or in absolute monetary terms or value.
Comparative advantages in hedging: The efficiency of companies in hedging against risk is higher than that of most individual investors. A company’s comparative advantage in hedging over its shareholders could be attributed to several factors, such as the company’s involvement in many hedging transactions, the company’s access to inside information which makes effective hedging possible, and the firm’s possession of skilled and knowledgeable professionals who could effectively analyse hedging than individual investors.
Capacity of debt: As mentioned earlier, effective risk management techniques ensure stability in the company’s stream of cash flows. A company that is financially stable may not be more prone to risk; it may be economically profitable to finance its operations mainly through debt. The interest payments on debt result in tax savings for the company and this could in turn maximise the wealth of shareholders.
Maintenance of optimal capital budget over a given period: Due to market pressures and high flotation costs, most companies are unwilling to raise funds through external shares. The implication is the firm would have to rely heavily on internally generated funds and debt to finance its optimal capital budget. In most cases, the company is able to generate funds internally through deductions for depreciation and earnings retained over the years. The company’s reliance on internally generated funds may not be effective, especially when cash flows from operations are inconsistent: high stream of cash flows in some years and low in others.
Low cash flows mean the company may not be able to adequately finance its projects; it may be compelled to raise funds through external shares. The major technique that helps companies to avert this problem is risk management. Through risk management, companies are able to insure constant cash flows. There is a direct relationship between risk management and capital structure: the company’s ability to maintain an optimal capital budget depends on its risk management.
Effects of tax: One of the economic “weapons” of risk management is its ability to minimise fluctuations in the firm’s reported income. By ensuring stability in reported earnings, the firm is able to ensure a significant proportion of its annual taxable income falls within the desired tax payment range. Thus, effective risk management method leads to lower tax payments. Firms without risk management are likely to experience income instability, and higher tax payments; they may file bankruptcy and eventually lose the tax benefits associated with losses (tax loss carry forwards).