L 04.05 CRM Strategy

7/29/2019 L 04.05 CRM Strategy

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Corporate Risk ManagementStrategy

Lecture 4/5Dr. Tahir Khan Durrani

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

A Meditation For The Week:

“The tools of learning are the same for any and every subject; and the personwho knows how to use them will at any age, get the mastery of a new subjectin half the time and with a quarter of the effort expended by the person whohad not the tools at his command.” Dorothy L Sayers (1893-1957)



Topic Objectives

Integrate risk classification andmanagement.

Review classical finance theory on why risk is a problem.

Lay out generic risk management strategies:

risk elimination risk accommodation

Dr. Tahir Khan Durrani 2


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Managing Risk

Bear it

Change it

Hedge it




“Why Hedge”, “What to Hedge”, and “How toHedge?”

“Why?” and “How?”are not independent questions in hedgingdecisions.

Why Hedge? Taxes

Contracting costs

Investment incentives

What is Hedged? Taxable income

Reported income

Market value.

How is it hedged? Off-balance sheet

hedging

On-balance sheet hedging




Hedging Corporate Risk Risk is diversifiable in capital markets. Even if risk is not diversifiable within the capital

market, its sale will command an appropriate risk premium.

Therefore, hedging the risk at this price will not add value but will merely change the risk-returncombination available to investors.

This reasoning suggests that, if risk is costly, it isnot because that risk causes a problem for thefirm’s investors directly.

Rather, it is because it gives rise to a set of transaction costs that lower the expected value of the form’s cash flows.




Hedging Corporate Risk These transaction costs include;

increased tax burden from risky cash flows,

increased expected costs of bankruptcy,

agency costs that arise from potential financialdistress and lead to inefficient investment decision,

crowding out of new investment by unchanged

losses, and inefficiencies that arise from managerial risk

aversion.




Hedging Corporate Risk If risk causes costs to firm, one can either remove

the risk or one can accommodate the risk andarrange the affairs of the firm so that the risk does not cause a problem.

But to do this, one must understand exactly whyrisk is a problem.

This is the principle of duality, which asserts that

for every type of cost that risk imposes on thefirm, there are two generic risk management strategies: either removes the risk or accommodate the risk but reduce the cost.


D li i i k



Duality in risk management strategy The essence of duality is that one can

address the cause or the effect. One can remove the risk if one can adapt

the firm so that the risk is not a problem.

Following table lists the various reasonswhy risk is costly to publically ownedfirms.

The table also shows that for each type of risk cost there are two potentialstrategies.




Duality of Risk Management Strategies

Type of Risk Cost Strategy

Non-linear taxes Hedge Tax arbitrage

Expected bankruptcy costs Hedge Change leverage

Contingent leverage

Agency cost:

Dysfunctional investment

Crowding-out new investment

Hedge

Hedge

Change leverage

Contingent leverage

Contingent financing

Contingent leverage

Managerial risk aversion Hedge Change comp. Scheme

Stakeholder risk aversion Hedge Change s/hr contracts




Duality of Risk Management Strategies First, the cause of the problem can be removed;

risk can be hedged.

Second, the risk can be retained but the firm or itsactivities can be structured so that the risk causes

less of a problem; this strategy is labeled“accommodate.”

This dual principle is important for identifying the

menu of strategies available for dealing with risk. The task now is to take each risk cost in turn and

flesh out the types of hedging and accommodationstrategies that are available.




Tax arbitrage When taxpayers exploit facets of the tax

code to increase their incomes, this istax arbitrage.

One example comes from thecombination of the deductibility of interest combined with the exemption

of certain types of capital income fromtaxation.


b “l k f



Tax Arbitrage i.e., a “lack of symmetry”

What is “tax arbitrage”? Consider:

1) deduction (e.g., contribution to retirement plan) available when using borrowed money.

2) tax exempt income received and (a) the investment is funded with borrowing &

(b)the interest expense is deductible. E.g., a

personal residence is acquired with borrowedfunds (no income from occupancy right but interest expense deduction).




Tax arbitrage example

In the US interest is tax deductible but rent is not • This creates a significant incentive to turn rent

payments into tax deductible interest payments

• This is what 100% mortgages do The buyer doesn’t own the house, the bank does

• The user of the house makes a fixed payment

each month to cover the interest

• This is just like paying rent except it is tax

deductible




Tax arbitrage Dennis has a marginal rate of 31%. He

borrows money from the bank at a 15%interest rate. As long as this interest satisfiesdeductibility criteria, Dennis’s effective

interest rate is 10.4%. If the going rate of return on tax-exempt state

& local bonds is 11%, then Dennis can borrowfrom the bank, invest in state and local bonds

and make money. Dennis has used the tax system as a money-

making machine.




Leasing A lease is a contractual agreement between a

lessee and lessor. The agreement establishes that the lessee has the

right to use an asset and in return must makeperiodic payments to the lessor.

The lessor is either the asset’s manufacturer or anindependent leasing company.

Two types:

Operating lease Financial lease

Sale and lease-back

Leverage lease




Buying versus Leasing

Buy LeaseFirm U buys asset and uses asset;financed by debt and equity.

Lessor buys asset, Firm U leases it.

Manufacturer

of asset

Equity

shareholders

Firm U

1. Uses asset

2. Owns asset

Creditors

Manufacturer

of asset

Lessor 1. Owns asset

2. Does not use asset

Equity

shareholders Creditors

Lessee (Firm U ) 1. Uses asset

2. Does not own asset



Taxes and Leases The principal benefit of long-term

leasing is tax reduction. Leasing allows the transfer of tax

benefits from those who need

equipment but cannot take fulladvantage of the tax benefits of ownership to a party who can.

Naturally, the IRS seeks to limit this,especially if the lease appears to be set up solely to avoid taxes.




Duality and Non-linear Taxes

A firm purchases a capital asset at a cost of £1bn,which will generate an income stream over a 5-yr.period. The annual income is risky, with: 0.5 chance of £132m 0.5 chance of £532m Expected annual earnings = £332m

The firm is allowed to depreciate the asset in equalinstalments over its 5-yr. life. Thus, the firm canshield £200m from tax each year. The tax rate is

34%. What is the expected tax liability? Find the expected value of this investment assuming a

discount rate of zero.




Hedge Strategy

Let us now assume that our firm can hedge to fix itsearnings at the expected value of £332m. What now is the expected tax liability?

Calculate the expected NPV of the investment.

Please note that the hedge strategy depends on thesource of risk: Insurable,

interest rate fluctuations Demand curve risk

Exchange rate fluctuations.




Non-linear Taxes: Computations

Unhedged Position:

Exp. Annual Earnings = 0.5(132) + 0.5(532) = 332

Exp. Tax Liab. = [0.5x 0 + 0.5 x (532 -200)] x 0.34 =

56.44ENPV = -1,000 + [332 -56.44] x 5 = 377.8m

Hedge Position:Exp. Tax Liab. = [332 – 200] x 0.34 = 44.88ENPV = -1,000 + 5 x [332 -44.88] = 435.6m




Tax Arbitrage strategy Consider that there is another firm, whose expected

earnings are either £1billion or £2billion. This firm isguaranteed to earn more than £200m always.Therefore the firm will enjoy the full benefit of £200m depreciation every year (0.34 x £200m =

£68m). The annual cost of buying the machine is(£200m - £68m = £132m).

Suppose the second firm buys the machine and lease it back to the first firm at an annual charge of £132m.

What is the first firm’s expected after-tax income withthe lease?

What will be the annual after-tax income if the cost of the lease is not tax deductible?




Tax Arbitrage Strategy: Computation

Exp. Taxable Earnings = 0.5(532 -132) + 0.5(132 - 132) = 200m

Exp. Taxes = 0.5 x 0.34 (532 -132) + 0.5 x (0) x 0.34 = 68mENPV = 5 x [200m – 68m] = 660m

Which is even higher when the firm hedges.The reason for the extra gain is that depreciation has been givendouble tax advantage (Firm 2 deducts the full $200m annually,

then firm 1 deducts lease cost i.e. After tax cost to firm)If the company is unable to deduct its lease cost:Exp. Net Income = 0.5(532 – 132) + 0.5(132 – 132) –

0.34[0.5(532) + 0.5(132)]= 87.12m

ENPV = 5 x 87.12m = 435.6m

Lease and hedge are equivalent ways of securing full taxadvantage of depreciation.

Difference in tax rates provides arbitrage opportunities




Tax Arbitrage Strategy If earnings turn out to be $532m, the tax liability

is $112.88m, as shown. If earnings are only $132m, then taxes will be

zero. If we bear in mind the 50-50 chances of the two

earnings levels, expected taxes are $56.44m. Notice that the firm gets the full benefit of

depreciation if earnings are $532m (i.e., taxes fallby 0.34*$200m). but if earnings are only $132m,

then the depreciation has no effect on taxes. Thus, the depreciation allowance can be wasted

(this lost deduction can sometimes be partlyrecovered with carry forwards, but this is

uncertain and does not accrue interest).Dr. Tahir Khan Durrani 38




112.88

56.44

200 132

0

44.88

332 532

Tax due $m

Earning $m



Tax Arbitrage Strategy: Hedge Strategy Compared with the unhedged value of

$377.8m.

Note that expected taxes have changed

even though expected earnings have not. How this hedge strategy would be

achieved would depend on the source of

risk.




Tax Arbitrage Strategy: Hedge Strategy One firm needs purchase to purchase equipment

but faces a large probability that its potential taxshield will go unsound. Another firm does not need to make such a

capital investment for production purposes, but

its earnings profile is such that it could nearlyalways fully use any depreciation. This configuration yields opportunities for the

latter to take full tax advantage of capital

expenditures and then lease the equipment to thefirm that needs to use it. The tax advantage afforded to the leasing

company can be shared with the lessee in the

price of the lease. Dr. Tahir Khan Durrani 41



Tax Arbitrage Strategy: Hedge Strategy Other forms of tax arbitrage might be used in

conjunction with risk management. A particularly interesting one is reinsurance.

Insurers routinely purchase reinsurance as ameans of limiting their portfolio exposure onthe book of insurance policies they have sold totheir clients.

Thus, reinsurance is clearly used as a hedging

strategy. However, there is some evidencesuggesting that reinsurance is also used as aform of tax arbitrage.




Tax Arbitrage Strategy: Hedge Strategy Insurers can deduct additions to loss reserves

from taxable income.

The value of this deduction to an insurer dependsupon how much taxable income that insurer has

that determines its marginal tax rate. Insurers with low marginal tax rates (and who

therefore gained little from more deductions)

were transferring business to insurers withhigher marginal rates.

This suggest that reinsurance is being used forboth hedging and tax arbitrage.




The Cash Flows of Leasing

Consider a firm, ClumZee Movers, that wishesto acquire a delivery truck.

The truck is expected to reduce costs by$4,500 per year.

The truck costs $25,000 and has a useful life of 5 years.

If the firm buys the truck, they will depreciate

it straight-line to zero. They can lease it for 5 years from Tiger

Leasing with an annual lease payment of $6,250.




21-45


Cash Flows: Buy

Year 0 Years 1-5Cost of truck –$25,000

After-tax savings 4,500×(1-.34) = $2,970

Depreciation Tax Shield 5,000×(.34) = $1,700

–$25,000 $4,670

Cash Flows: LeaseYear 0 Years 1-5

Lease Payments –6,250×(1-.34) = –$4,125After-tax savings 4,500×(1-.34) = $2,970

–$1,155

Cash Flows: Leasing Instead of BuyingYear 0 Years 1-5

$25,000 –$1,155 – $4,670 = $5,825



21-46


Cash Flows: Leasing Instead of BuyingYear 0 Years 1-5

$25,000 –$1,155 – $4,670 = –$5,825

Cash Flows: Buying Instead of Leasing

Year 0 Years 1-5 –$25,000 $4,670 –$1,155 = $5,825

However we wish to conceptualize this, weneed to have an interest rate at which to

discount the future cash flows. That rate is the after-tax rate on the firm’s

secured debt.



21-47

Reasons for Leasing

Good Reasons Taxes may be reduced by leasing.

The lease contract may reduce certain types of

uncertainty. Transactions costs can be higher for buying an

asset and financing it with debt or equity thanfor leasing the asset.

Bad Reasons

Accounting

Hedging and the Bondholder-Stockholder



Hedging and the Bondholder StockholderConflict


V

P (Oil)

Loss due to increasedagency costs from debt

As firm value declines (with rising oil prices for an oil user)economic leverage increase, and the firm faces greateragency costs from its debt, such as underinvestment andasset substitution.

d d h dh ld



Hedging and the Bondholder-Stockholder Conflict

The agency cost of debt increase asleverage increases and as financialdistress approaches.

Hedging can reduce the likelihood of financial distress, and consequently

reduce the adverse incentivesassociated with debt financing.




Duality and bankruptcy Costs

A firm has an expected value of £500m, but this is risky.The firm’s cash flow distribution is given as follows:

The firm has debt with a face value of £200m, withbankruptcy costs assumed to be £50m.

What is the value of debt and equity? Find the firm’s new value.

Value (£m) 100 300 500 700 900

Probability 0.1 0.2 0.4 0.2 0.1




Computation: Bankruptcy Costs

If firm is bankrupt, bondholder receive only 50, but in all othersituation he receive full face value of 200VoD = 0.1[100-50] + 0.2[200] + 0.4[200] + 0.2[200] + 0.1[200]

= 185

VoE = 0.1(0) + 0.2(100) + 0.4(300) + 0.2(500) + 0.1(700)= 310

Value of the Firm = 185 + 310 = 495

Exp. Bankruptcy Cost = 50 x 0.1 = 5VoF = 500 – 5 = 495




Duality and bankruptcy Costs:Hedge Strategy

Suppose the firm is now able to hedge and compress thefirm value to its expected value £500m - T, where T is thetransaction cost associated with the hedge.

We already know that the expected loss is £400m. If transaction costs over and above the expected loss is £2m,what are the values of both equity and debt?

Note: The result from above seem to suggest that shareholders are better off without the hedge. How can weresolve this?




Bankruptcy Costs: Hedge strategy

Exp. Loss = 0.1(800) + 0.2(600) +0.4(400) + 0.2(200) +0.1(0) = 400

VOF = 500 -2 = 498

There is an overall gain from hedging

VOD = 200 > 185 (without hedge)

VOE = 298 < 310 (without hedge)

(with hedge) 498 > 495 (without hedge)

Insurer may charge 400 to insure this loss with aloading, above expected loss. This if premium is 410,then T=10.




Resolving the problemEx Post Analysis:

Imagine that bondholders had alreadypurchased bonds at aprice of £200m.

Shareholders will prefer

not to hedge (equityvalue £310m vs. £298m. Risk is attractive to

shareholders as theykeep the upside of risk

and can default on debt. Heads I win, tail you

loose strategy.

Ex Ante Analysis:

Bondholders usually anticipate suchex-propriative actions, and haveforeknowledge of an unhedged valueof £185m.

Shareholders have to send a crediblesignal that they will commit to the

hedge to bondholders, so that theypay the £200m for the bonds. Shareholders will benefit by

receiving an additional £15m in theproceeds of the bond issue, whereasthe equity is £298m compared with£310m.

Additional proceed of bond issueoutweigh the fall in share price,share holders may use additional 15as dividend or may fund newinvestments without having to diluteequity.


D lit d b k t C t



Duality and bankruptcy Costs:Leverage Strategy

Suppose that the firm simply funded its operations at alower level of leverage. In this case imagine that debt has now a face value of only £100m.

Do you notice that the lowest value of the firm is

sufficient to pay off debt in full and there is nopossibility of default.

The effect of such a strategy is to reduce the expectedvalue of bankruptcy costs.

One can never really reduce the probability of

bankruptcy to zero, but can reduce the expected valueof bankruptcy cost by lowering level of debt in capitalstructure.




Bankruptcy Costs: Leverage Strategy

VoD = 0.1(100) + 0.2(100) + 0.4(100) + 0.2(100) +0.1(100)

= 100

VoE = 0.1(0) +0.2(200) +0.4(400) + 0.2(600) +0.1(800)

= 400

VoF = 400 + 100 = 500


C i l d



Contingent leverage strategy andpost -loss financing

It might not be beneficial to reduce leverage because: the cost of debt and equity differ,

there are different tax effects for debt and equity,

leverage influences agency costs,

the CFO and not the risk manager chooses the capital structure.

Strategy:

Keep the firm’s current capital structure, but put in place some

facility so that the capital structure changes should somepredetermined event occur.




Duality: Agency Cost: Underinvestment

Consider a banking firmwith operations that generate value of either50 or 200, each with a

50% probability. The variations depends

on interest rates.

The firm has debt of 140.

A new investment opportunity exist that willcost 100 to shareholdersand will generate a c/f

with a PV of 120; Thus, the NPV is 20.

The bank makes itsdecision on the new

project after it knows what the interest rate will be.




Duality: Agency Cost: Underinvestment

ExistingValue

PotentialDecision

Value of Firm

Value of Debt

Value of Equity

Decision

200 Accept /

Reject

220

200

140

140

80

60

Accept

50 Accept /

Reject

70*

50

140*

50

-70* Reject

• Hedge effect on value of debt: When debt is issued, bond holder anticipateuncertainty in interest rates and that firm is worth ½(200) + ½(50) = 135and debt is worth ½(140) + ½(50) = 95. Firm only receives 95 for debt issued with a face value of 140.




Hedge Strategy: Underinvestment

ExistingValue

PotentialDecision

Value of Firm

Value of Debt

Value of Equity

Decision

125 Accept /Reject 145125 140125 50Accept

If interest rate risk is hedged, fixing value to 125 The hedge leads to the full capture of the NPV of the new

project and it also yields a higher price for the issue of debt (140), as downside risk is covered




Leverage Strategy: Underinvestment

ExistingValue

PotentialDecision

Value of Firm

Value of Debt

Value of Equity

Decision

200 accept/

reject

220

200

0

0

220

200

accept

50 accept/

reject

70

50

0

0

70

50

accept

• Reduction of leverage leads to correct investment decision.


D lit d th C di t f N



Duality and the Crowding out of New Investments

Sudden large and unhedged losses tend to absorb internalfunds and crowd-out new investments. A firm identifies five investment opportunities, each having a

capital cost of £10m but having different NPVs as shownbelow. Suppose the firm has £50m in funds available, so that it can undertake all the 5 projects

Project CapitalCost

NPV NPV less Cost of externalCapital

1

2

3

4

5

10

10

10

10

10

3

2

1

1

1

0.5

0.5

-0.5

-0.5

-0.5


l d h d f



Duality and the Crowding out of New Investments

Now suppose that the firm takes a sudden hit toliquidity from an unhedged loss of £30m,reducing the cash from £50m to £20m.

If the transaction cost associated with externalcapital is 1.5m for each 10m raised, then theadjusted NPV shown in the final column reveals

that projects 3, 4, and 5 will be lost.




Strategies

Hedge Strategy: By hedging the total NPV of

£3m is secured from projects3, 4, and 5.

But is it worth it, given that insurance has its owntransaction costs.

The optimal hedge involvesbalancing between the actualtransaction costs incurredwith the hedge, and the exp.

Loss of NPV from thedisplacement of investment opportunities.

Leverage and contingent leverage strategies:

By changing leverage, one canmanipulate the conditional cost of external capital.

If the firm lowers its leverage

before any loss, lowering its fixedobligations from earnings willraise retained earnings to, say,£80.

The firm may also set in placesome contingent financing facilitythat is triggered by the unhedgedloss.

Remember to do a CBA.




Classifying Risk Management strategies

Strategy Risk cost AddressedHedging Tax nonlinearities, bankruptcy costs

Asset substitution and underinvestment

Crowding out of new investments

Managerial & Stakeholder risk aversion

Tax arbitrage Tax nonlinearities

Changing leverage bankruptcy costs

Asset substitution and underinvestment

Crowding out of new investments

Re-design executive comp. Managerial risk aversion

Design of other stakeholder contracts

Stakeholder risk aversion




Hedging Strategies

A hedge is a focused risk management tool in that it addresses a specific form of risk.

A hedge instrument is a pair of two cash flows withoffsetting risk.

It starts with some pre-existing asset

The value of this asset is risk because it can be damaged.

Risk of the asset can be hedged on both sides of the balancesheet.




Leverage and Financing Strategies

Leverage Management: Reduction in leverage in

anticipation of a possiblefuture loss.

Reduces agency costs

reduces expected value of bankruptcy costs.

Dividend policy

Post-loss Financing: Raising of funds after a loss.

Amount raised and termsdepends on severity of event, franchise value of the firm and perception of the financial market.

Money is needed forinvestment needs

Redressing post-lossleverage.


L d Fi i S i



Leverage and Financing Strategies

Contingent Financing: Terms under which new

money is raised agreed inadvance of loss.

Line of credit (LOC)

put options on firm's shareprice linked to a predefined

event [These equity puts(CatEputs)]

Converting debt into equity Un-levers the firm

Exchange of less valuableshares to retire morevaluable debt provides a

partial hedge.

We call these reverseconvertible debt - option to

convert lies with the firmand not the debt holders.




Other strategies

Compensation Mgt.

Risk management formulafor compensation design

can be envisioned that balances the need toincentivise managers withperformance related payand the risk premianeeded in suchcompensation schedules.

Tax Mgt.

Linearise the taxschedule by:

leasing reinsurance

captive formation




Learning Outcomes

We established that if risk is costly, the costs can bereduced by removing the risk/hedging

restructuring the firm to accommodate the risk.

Risk management strategies should be co-ordinated

We looked at integrated risk management strategies The hedge strategies focus on specific risk that is reduced of

transferred to another party.

Various dual strategies are not specific to the source of risk and arenaturally integrated.

L 04.05 CRM Strategy

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