1. McGraw-Hill/Irwin Copyright © 2004 by the McGraw-Hill Companies, Inc. All rights reserved. Chapter 2 Objective and Risk Management

2. T2.2 H&N, Ch. 2 Need for a RM Objective Risk imposes costs on businesses and individuals Risk Management (e.g., loss control and insurance) also is costly  Tradeoffs must be made Need a criteria for making choices about how much risk management should be undertaken Appropriate Criteria: Minimize Cost of Risk

3. T2.3 H&N, Ch. 2 Components of the Cost of Risk

4. T2.4 H&N, Ch. 2 Tradeoffs in the Cost of Risk Decreasing one component of the cost of risk usually is associated with an increase in another component Examples: Decreasing expected direct losses (worker injury costs) by increasing loss control costs (increased workplace safety) Decreasing expected indirect losses (bankruptcy costs) by increasing loss financing costs (insurance costs ) Decreasing cost of residual uncertainty by increasing loss financing costs (insurance costs)

5. T2.5 H&N, Ch. 2 Cost of Risk Example Firm value in ideal world of no risk = $100,000. Issues to be examined: What is firm value with risk of worker injuries? What is relation between firm value and cost of risk?

6. T2.6 H&N, Ch. 2 Cost of Risk Example Business is faced with one source of risk: Probability of worker injury = 1/10 Losses from a worker injury: medical expenses $10,000 lost pay $50,000 total $60,000 Expected loss = $_________

7. T2.7 H&N, Ch. 2 Cost of Risk Example Option 1: Do Nothing Cost of risk: Expected loss = $________ Cost of residual uncertainty = $4,000 (assumed) Cost of loss control = $0 Cost of loss financing = $0 Cost of internal risk reduction = $0 Total cost of risk = $__________ Firm value = $100,000 - $________ = $_________

8. T2.8 H&N, Ch. 2 Cost of Risk Example Option 2: Loss control Spend $2,000 to reduce probability of loss to 1/20 Cost of risk: Expected loss = $_________ Cost of residual uncertainty = $3,000 (assumed) Cost of loss control = $2,000 Cost of loss financing = $0 Cost of internal risk reduction = $0 Total cost of risk = $_________ Firm value = $100,000 - $________ = $_________

9. T2.9 H&N, Ch. 2 Cost of Risk Example Option 3: Additional Loss control Spend an additional $2,000 to reduce probability of loss to 1/40 Cost of risk: Expected loss = $________ Cost of residual uncertainty = $2,700 (assumed) Cost of loss control = $4,000 Cost of loss financing = $0 Cost of internal risk reduction = $0 Total cost of risk = $__________ Firm value = $100,000 - $_________= $___________

10. T2.10 H&N, Ch. 2 Cost of Risk Example Option 4: No loss control, but full insurance Premium = $7,500 Loading = premium - expected loss = $7,500 - $6,000 = $1,500 Cost of risk: Expected loss = $6,000 Cost of residual uncertainty = $0 Cost of loss control = $0 Cost of loss financing = $1,500 Cost of internal risk reduction = $0 Total cost of risk = $7,500 Firm value = $100,000 -$7,500 = $92,500

11. T2.11 H&N, Ch. 2 Cost of Risk Example Key points from example: Do NOT minimize risk, Minimize cost of risk There are cost tradeoffs: Increase insurance coverage ==> Increase loading paid Decrease residual uncertainty Additional loss control ==> Decrease expected losses Increase loss control costs

12. T2.12 H&N, Ch. 2 Determinants of Value Firm Value depends on Magnitude of expected net cash flows Timing of expected net cash flows Risk of expected net cash flows Net cash flows = cash inflows – cash outflows

13. T2.13 H&N, Ch. 2 Firm Value Maximization & the Cost of Risk Maximizing Value by Minimizing Cost of Risk Define: Cost of risk = Value without risk – Value with risk Rearrange: Value with risk = Value without risk – Cost of risk Implication: Maximize Value  Minimize Cost of Risk Hypothetical construct

14. T2.14 H&N, Ch. 2 Do Managers Maximize Shareholder Value? In practice, there are several factors that motivate managers to maximize shareholder value Management compensation contracts (e.g., bonuses) Market for corporate control (e.g., hostile takeovers) Product market competition Monitoring by shareholders with large stakes Legal duty of managers

15. T2.15 H&N, Ch. 2 Individual RM and the Cost of Risk Cost of risk concept applies to individual RM An individual’s cost of residual uncertainty depends on the person’s degree of risk aversion Risk aversion  Pay extra to reduce risk (buy insurance even though premium exceeds expected claim costs) Require higher expected returns to take on more risk (demand higher expected returns on riskier stocks)

16. T2.16 H&N, Ch. 2 Risk Management & Societal Welfare Minimizing the cost of risk is also an appropriate objective for society, because doing so generally results in an efficient level of risk for society Efficiency ==> risky activities are pursued until the marginal costs exceed the marginal benefits Implication: public policies should consider the cost tradeoffs Example: greater safety regulation  lower expected losses, but higher loss control costs

17. T2.17 H&N, Ch. 2 Conflict between Private & Societal Objectives Issue: Will individuals and businesses acting to minimize their own cost of risk result in the minimization of society’s cost of risk? Observe: For a business to maximize value (minimize its own cost of risk), the business must consider the effect of its decisions on other parties (even in the absence of regulation and legal liability) Why – b/c decisions affect the terms at which other parties contract with the firm Example: riskier workplace  higher wages

18. T2.18 H&N, Ch. 2 What if business cost of risk < societal cost of risk? Example: workers are uninformed about injury risk Then, a business might engage in excessively risky behavior (they may not consider the effects of risk on other claimants) Thus, there is a potential role for regulation and legal liability. Regulation and legal liability should induce managers to make decisions that minimize society’s cost of risk Conflict between Private & Societal Objectives