BRN 482Corporate Financial PolicyClifford W. Smith, Jr.Summer 2007 Presentation 6 * Covers readings on course outline through Doherty/Smith (1993)

Risk Management Spectrum

Firm Specific Risks

– Fire

– Lawsuit

– Payoffs to R&D projects

Market-wide risks

– Interest rates

– Foreign exchange rates

– Commodity prices

Managing Risk

Bear it

Change it

Hedge it

From Smith (2006)

Risk Management Spectrum

Risk Profiles

ΔP(oil)

ΔVRisk Profile

For an oil producer, rising oil prices [ΔP(oil) >0]

increase revenues and increase firm value.

For an oil user, rising oil prices [ΔP(oil) > 0]

increase costs and decrease firm value.

ΔP(oil)

ΔV

Core Business

Risk Profiles

Impact of Hedging on Core Business Risk

ΔP(oil)

ΔV

Core Business

Hedge

Net Exposure

The Effects of Risk Management

Distribution after risk management

Inherent distribution

Firm Value

Probability

The World has Become A More Risky Place

0.07

0

-0.1

57 61 65 69 73 77 81 85

Futures

Swaps

Options

Options on Futures

Break,Range,ParticipatingForwards

Percent

Corporate Hedging and Insurance

Firm value

The cost of capital (r) depends on the systematic risk of the firm's cash flows.

Insurable risks are generally nonsystematic.

Since insurance purchases do not affect the firm's systematic risk, they do not lower the firm's cost of capital.

Even if the beta of a hedging instrument is not zero, as long as it is fairly price, it will not change the discount rate in a way that would increase value.

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.

Hedging and the Modigliani/Miller Theorem

If hedging affects the current firm value, then it must

– change expected tax liabilities

– change contracting costs

– change future investment decisions.

Hedging and Taxes

A progressive tax scheme provides the government with a call option on the taxable income of the corporation. Reducing the volatility of income reduces the value of this option.

TaxLiability

Income

Y1

Y2E(Y)

E(T(Y))T(E(Y))

LOSS CARRYFORWARDS

are restricted by some revenue-hungry

states.

Federal and most state laws let

corporations carry forward their net

operating losses and deduct them

from taxable income in future years.

But a countertrend may be beginning

at the state level, says James P.

Sweeney of Arthur Andersen & Co.,

CPAs. Pennsylvania not only raised

corporate tax rates this year but also

eliminated the use of loss

carryforwards. California suspended

for tax years started in 1991 and 1992

its partial deduction for

carryforwards.

Texas enacted a corporate levy

that critics call a disguised income

tax. A deduction for carryforwards

isn’t allowed in the first year, 1992,

but is supposed to be after then. In

New York, Sweeney notes, many

companies are required to pay the

state’s alternative minimum tax,

which doesn’t allow deductions for

carryforwards. For that matter the

calculation of the 20% federal mini-

mum tax permits the deduction of

only 90% of a carryforward.

Multistate companies coming out

of the recession will have to plan

carefully for state taxes, Sweeney

declares.

THE WALL STREET JOURNAL WEDNESDAY, NOVEMBER 27, 1991

Hedging and Taxes

TaxLiability

Income

Y1

Y2

Y0

Tax loss carry backs and carry forwards can make your tax

liability concave over some income levels. In this case,

increasing volatility can reduce the expected tax liability.

Using data from COMPUSTAT, Graham/Smith (1998) find

– Major source of convexity arises from statutory rates.

– Carry backs and carry forwards reduce convexity at the kink - spread it over a wider array of taxable incomes.

– ITCs and alternative minimum tax (AMT) provisions have little effect on convexity.

– Firm tax schedules are convex (50%), linear (25%), concave (25%).

Hedging and Taxes

Corporate Insurance

Efficiency in project evaluation

Efficiency in claims settlement

– Claims only policies

– Retroactive Insurance

War Fears, Insurance Costs Curb Air Service to MideastSpecial to The Wall Street Journal

Flights to Israel and other Mideast points are being cut back, the result of war fears and soaring insurance costs.

Pan Am Corp.’s Pan American World Airways said it was suspending all flights to Tel Aviv for a least a week following a rate increase by Lloyd’s of London. The carrier also said it was suspending flights to Saudi Arabia. Insurance rates for Tel Aviv flights increased 10-fold to $102,000 per flight and rates to Riyadh increased 20 times to $65,000 per flight, Pan Am said.

Meanwhile, British Airways and KLM Royal Dutch Airlines said they were reducing flights to Israel. Those two airlines, as well as Swissair, also changed flight plans so crews could avoid flight plans so crews could avoid overnight stays in Israel.

Pan Am previously operating two weekly flights to Riyadh and daily service to Tel Aviv. Pan Am has applied to the

Federal Aviation Administration for war-risk insurance. Under the FAA program, the government provides such insurance to carriers if they can’t get it from commercial insurance companies on reasonable terms.

British Airways is reducing its Tel Aviv service to four weekly flights from six weekly flights, beginning Jan. 15, the deadline given to Iraq to relinquish Ku-wait or face possible force. But an airline spokeswoman said the pull down isn’t related to the Gulf crisis and called it a “seasonal cutback.” She said full service will resume April 1.

Citing security risks and slower traffic to the region, KLM said it is reducing service to Tel Aviv to three weekly flights from four. KLM canceled service to Amman, Jordan, on Wednesday.

Israel’s national airline, El Al, was ordered to accommodated passengers or tourists affected by the cuts.

THE WALL STREET JOURNALPRIDAY, JANUARY 4, 1991

Comparative Advantage inRisk Bearing

Firm

Share-holders

Bond-holders

Board ofDirectors

Managers

Employees

LessorsLessees

Suppliers

Customers

Hedging and the Firm's Employees

To retain the same quality management team, increasing compensation risk requires increasing expected compensation levels.

Thus, higher compensation risk imposes costs on the firm.

These costs will be borne only if there are offsetting benefits.

– tax benefits– incentive benefits

Hedging and the Firm's Employees

Tax Benefits (Miller/Scholes 1982)

– If the marginal personal tax rate exceeds the

marginal corporate tax rate, then there is a

tax deferral benefit to bonus plans, stock

option plans, and restricted stock plans.

Incentive Benefits

– If the compensation risk is related to the managers' actions, then compensation risk improves incentives.

– Thus, it is important to distinguish between controllable risk and uncontrollable risk.

Hedging and the Firm's Employees

In 1989 Du Pont's fiber division instituted an incentive compensation plan for most of its 20,000 employees

– Pay linked to overall profitability of division

– Managers and lineworkers were part of the plan

Du Pont's Incentive Pay Plan

Two years later, the 'incentive' compensation plan was canceled

– Recession reduced sales

– Gulf War raised oil prices

– 'Incentive' pay was very low.

Risks unrelated to incentives dominated the variability of the compensation

– Employees have no control over the state of the economy or world oil prices.

Du Pont's Incentive Pay Plan

The agency costs of debt increase as leverage increases and as financial distress approaches

Hedging can reduce the likelihood of financial distress, and consequently reduce the adverse incentives associated with debt financing

Hedging and the Bondholder–Stockholder Conflict

ΔP(oil)

ΔV

Hedge

Net

Core business

Hedging and the Bondholder–Stockholder Conflict

Hedging and the Bondholder–Stockholder Conflict

BP's Insurance Decision

Benefits

– Taxes

– Contracting Costs

– Investment Incentives

Costs

– Insurance premium

Cost of Insurance

Expected Premium = PV Indemnity + Loading Fees Payment

Loading ExpectedFees = Service + Profit Costs

BP's Insurance Decision

LossRange

Numberper Year

Average Loss

Expected Ann. Loss

LossStd. Dev.

$0 to $10 1845.0 $ 0.03 m $ 52 m $ 12 m

$10 to $500

1.7 40.0 m 70 m 98 m

$500 plus .03 1000.0 m 35 m 233 m

Total 1846.73 $ 0.66 m

$157 m

Loss < $10 Million– Benefits

Claims Administration Taxes Riskshifting

– Costs Competitive Markets → Low Spreads "Common" Claims → Big Reputation

Effects

BP's Insurance Decision

$10 Million < Loss < $500 Million– Benefits

Claims Administration Taxes Riskshifting

– Costs Lloyd's → High Spreads "Uncommon" Claims → Small

Reputation effects

BP's Insurance Decision

$500 Million < Loss

– Benefits

Investment Incentives

Riskshifting

– Costs

Market Virtually Non-Existent

BP's Insurance Decision

"Why?" and "What?" are not independent questions in hedging decisions.

"Why Hedge?" and "What to Hedge?"

Why Hedge?What is Hedged?

Taxes Taxable income

Contracting costs Reported income

Investment incentives Market value

What is hedged?

– Taxable income– Reported income– Market value

How is it hedged?

– Off-balance sheet hedging– On-balance sheet hedging

"What to Hedge?" and "How to Hedge?"

Firm Characteristics Hedging Policy

Growth Options (Merck) ?

Leverage ?

Credence Goods (Eastern) Higher

Product Warranties (Yugo) Higher

Future Product Support (Yugo/Wang) Higher

Supplier Financing (Campeau) Higher

Closely Held Firm Higher

Size ?

Regulation Higher

Firm Specific Assets Higher

Investment Tax Credits Higher

Marginal Corporate Tax Rate ---

Marginal Personal Tax Rate ---

Tax Progressivity Higher