Chapter Outline

Cost of Risk and Value Maximization - The Big Picture

Do Managers Maximize Shareholder Value? In practice, there are several factors that motivate managers to maximize shareholder value Should Managers Maximize Shareholder Value? Discussed later

Determinants of Value Firm value depends on net cash flows

Value Maximization and Minimizing the Cost of Risk Define Cost of Risk Then Value with risk

Components of the Cost of Risk (Figure 2-1)

Cost of Risk Example Value of firm in ideal world of no risk = $100,000. Issues to be examined:

Cost of Risk Example Business is faced with the following risk: Probability of worker injury = 1/10 Losses from a worker injury: medical expenses lost pay total Expected loss = $

Cost of Risk Example Option 1: Do Nothing Firm value = Cost of risk: Expected loss = Cost of residual uncertainty = $4,000 (assumed) Cost of loss control = Cost of loss financing = Cost of internal risk reduction = Total cost of risk = Firm value =

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 = Cost of loss financing = Cost of internal risk reduction = Total cost of risk = Firm value =

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 = Cost of loss financing = Cost of internal risk reduction = Total cost of risk = Firm value =

Cost of Risk Example Option 4: No loss control, but full insurance Premium = $7,500 Loading = Premium - expected loss = $ Cost of risk: Expected loss = Cost of residual uncertainty = Cost of loss control = Cost of loss financing = Cost of internal risk reduction = Total cost of risk = Firm value =

Cost of Risk Example Key Points: Do NOT minimize risk There are tradeoffs: Increase insurance ==> Additional loss control ==>

Cost Tradeoffs in Risk Management Loss control costs vs. expected cost of losses (direct and indirect) Cost of loss financing & internal risk reduction vs. expected cost of indirect losses

Cost Tradeoffs in Risk Management Cost of loss financing & internal risk reduction vs. cost of residual uncertainty

Risk Management & Societal Welfare Minimizing the Cost of Risk is an appropriate objective for Individuals Businesses Society

Business Objectives and Other Claimants Does maximizing shareholder wealth imply that you ignore the effect of risk on employees, customers, etc.(ignoring regulation and legal liability)? Not necessarily, because Thus, risk management decisions that shareholder wealth generally also consider the effect of risk on other claimants

Conflicts between Business & Societal Objectives What if business cost of risk < societal cost of risk? Possible scenarios: Thus, there is a potential role for regulation and legal liability

“An Integrated Approach to Risk Management” A. Setting CRM Policy 1. Decision Areas 2. Guidance 3. Problem 4. Conclusion 5. Implementation 6. Modern Finance Theory 7. Why Total Risk Matters

B. Adverse Incentive Effects 1. Project Selection 2. Exit or Liquidation 3. Quality and Safety

C. Effects on Sales and Costs 1. Product Quality 2. Service 3. Operating Costs 4. Financing Costs

D. Methods of Reducing Total Risk 1. Capital Structure 2. Futures Contracts 3. Insurance 4. Projects 5. Operating Leverage