1. Integrating Capital and Risk Completing Lecture 21 Student Presentations Unsolved Problems in Finance –#7 of 10 The Insurative Model

2. Measuring and Rewarding Performance Companies get the behavior they reward Companies reward performance they can measure How to you measure effective performance? –Accounting profits –Rates of return –Growth in earnings

3. Economic Value Added® Economic Value Added (EVA) –Earnings after deducting the cost of capital EVA = Residual income = Income earned – (cost of capital x investment) Advantages of EVA –Makes cost of capital visible to managers –Better than accounting income as an incentive Disadvantages of EVA –Biased data

4. A firm has an average investment of $1000 during the year. During the same time the firm has an after tax earnings of $150. If the cost of capital is 10%, calculate the economic value added (EVA) for the firm. A) $0 B) $50 C) $100 D) $120 E) None of the above

5. Biases in Accounting Measures New projects or start-up firms generate accounting losses the first few years Expenses are written off early in the investment process Proposal – measure economic profitability

6. 10 Unsolved Problems in Finance (pages 960-967) #7 What Risks Should a Firm Take? “Financial managers end up managing risk. For example, When a firm expands production, managers often reduce the cost of failure by building in the option to alter the product mix or to bail out of the project altogether By reducing the firm’s borrowing, managers can spread operating risk over a larger equity base Most businesses take out insurance against a variety of specific hazards Managers often use futures or other derivatives to protect against adverse movements in commodity prices, interest rates, and exchange rates”

7. Managing Risk These actions reduce risk Less risk can’t always be better Need for guidance on what bets the firm should place and what the appropriate level of risk is How can a company set a risk management strategy that adds up to a sensible whole?

8. One Proposal by Prakash Shimpi Role of Corporate Capital Capital required = economic capital + signaling capital = operational capital + risk capital + signaling capital Capital required = f {firm risk} Capital Resources firm capital = paid-up capital + off-balance sheet capital firm risk = retained risk + transferred risk

9. Current Approach The Standard Model paid-up capital = f {retained risk) = capital needed to cover retained risk The Insurance Model off-balance sheet capital = f {transferred risk} = capital needed to cover transferred risk

10. The Insurative Model firm capital = f {firm risk} = capital needed to cover firm risk paid-up capital + off-balance sheet capital = f {retained risk} + f {transferred risk} paid-up capital = p x f {retained risk} + q x f {transferred risk} off-balance sheet capital = (1-p) f {retained risk} +(1- q) x f {transferred risk} where p is the proportion of retained risk and q is proportion of transferred risk

11. Total Average Cost of Capital (TACC) where ci = cost of insurance I = insurance value FV = firm value

12. Estimating the Value of Insurance Not directly observable in financial markets Value of insurance is the amount of capital relief insurance provides How much more capital would the firm require if it did not carry insurance Cost of insurance is the insurance premium as a percent of the insurance capital

13. Example D = 500; Cost of debt = 10% E = 500; Cost of equity = 15% I = 500; Cost of insurance = 2%

14. What is TACC if: D = 200; Cost of debt = 6% E = 500; Cost of equity = 14% I = 300; Cost of insurance = 3% A)7.7% B)8.3% C)9.1% D)11.5% E)None of the above

15. Using the Insurative Model Under the Insurative Model, use the TACC for all financing decisions Capital structure and risk management decisions are made on a consistent basis Does Insurative Model work? –Not exactly but the concept is on the right track

16. Next Class Tuesday, April 24 –Enterprise Risk Management –Reading - TBA