1. Chapter Outline

2. Cost of Risk and Value Maximization - The Big Picture

3. 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

4. Determinants of Value
Firm value depends on net cash flows

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

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

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

8. 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 = $

9. 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 =

10. 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 =

11. 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 =

12. 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 =

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

14. 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

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

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

17. 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

18. 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

19. “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

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

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

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