CHAPTER

How RIsKMANAGEMENT CAN

INCREASE THE VALUE

OF THE FIRM #

If a firm manages its financial price risk, it follows that the volatility of the valueof the firm or of the firm's real cash flows will decline. This general relation is illus-

trated in Figure 4-1.

FIGURE 4–1 The Impact of Risk Management Hedging Is to Reduce the Variancein the Distribution of Firm Value

Distribution after riskmanagement

Inherent distribution

Value of the firm or ofpre-tax cash flows

Since the value of a firm is sensitive to movements in interest rates, foreignexchange rates, or commodity prices, a tantalizing conclusion is that the value of

the firm will necessarily rise if this exposure is managed . But however appealing,

this conclusion does not follow directly . That a firm is confronted with strategic

*This chapter is adapted from Rawls and Smithson (1990) .

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213

102

Chapter 4

risk is a necessary condition for the firm to manage that risk. The sufficient condi-tion for a firm to manage risk is that the strategy increase the present value of theexpected net cash flows, E(NCFjt), where r t, is the discounted rate.

V~ — E(NCFFt)(1 + rat).

This equation provides the insight that if the market value of the firm is to increase,the gain must result from either an increase in expected net cash flows or a decreasein the discount rate.

Whether risk management will have an impact on the discount rate—the firm'scost of capital—is an issue we defer until Chapter 19 . One special case should bementioned now, however . For firms in which the owners do not hold well-diversified portfolios (such as proprietorships, partnerships, and closely held cor-porations) the risk aversion of the firm's owners can provide an important riskmanagement incentive. At this point, we want to focus on how risk managementcould increase the value of the firm by increasing the firm's expected net cashflows. Hence, the question that must be answered is, how can hedging, or any otherfinancial policy, have any impact on the real cash flows of the organization?

The relation between the firm's real cash flows and its financial policies wasestablished by Franco Modigliani and Merton Miller in 1958 in what has come tobe called the M&M proposition . The M&M proposition would imply that in aworld with no taxes, no transaction costs, and a fixed investment policy, investorscan create their own "homemade" risk management by holding diversified portfo-lios .' However, the message of the M&M proposition for practitioners becomesevident only when the argument is turned upside down:

Iffinancial policies matter . . . if risk management policies are going to have an impact

on the value of the firm,

then risk management must have an impact on the firm's taxes, transaction costs, or

investment decisions.

Risk Management Can Add Value by Decreasing TaxesFor risk management to produce tax benefits, the firm's effective tax schedule mustbe convex. As illustrated in Figure 4-2, a convex tax schedule is one in which thefirm's average effective tax rate rises as pretax (financial statement) income rises.If the firm's effective tax function is convex and if the firm is subject to financialprice-induced volatility in its pretax income, it is a mathematical certainty that hedg-ing will reduce the firm's expected taxes . 2 However, instead of resorting to a math-ematical proof, we think that this point is demonstrated in the following illustration.

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How Risk Management Can Increase the Value of the Firm

103

FIGURE 4—2 Hedging and Financial Distress

Illustration 4–1

Unhedged company

Inherent distribution

Probability ofencounteringfinancial distress

Income

Distribution afterHedged company

risk management

Probability ofencounteringfinancial distress

Income

/

Inherent distribution

/

Reducing Taxes with Risk Management

Consider a firm that is exposed to financial

price risk; its pretax income is related to

interest rates, foreign exchange rates, or

some commodity price . Suppose that if the

firm does not hedge, the distribution of its

pretax income will be as shown below : for

any given year, the firm's pretax income

might be low or high, either with a probabil-

ity of 50 percent.

'ra

0

0.5

Low

HighPre-tax income

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104

Chapter 4

216

Reducing Taxes with Risk Management continued

T(HIGH)

Year-on-yeartax

T(LOW)

Low

HighPre-tax income

If the firm implements an effective riskmanagement program, the volatility in itspretax income will decline . In the context ofour simple distribution, a reduction in volatil-ity means that the pretax income LOW andpretax income HIGH will both move towardthe mean. For purposes of illustration, sup-pose that the firm hedges completely ; in sucha case the distribution of the firm's pretaxincome would be a single point, MEAN.

If the firm has the low pretax income, it willpay tax T(LOW) ; if the firm's pretax incomeis high, the tax will be T(HIGH) . Hence if thefirm does not hedge, its expected tax will bethe average of these two taxes. In otherwords, the firm's year-on-year taxes wouldbe on the straight line connecting T(LOW)and T(HIGH), halfway between T(LOW) andT(HIGH).And as the next illustration shows, the firmwill pay a tax that is strictly less if it hedgesthan if it does not hedge.

Year-on-yeartax (Unhedged)

Year-on-yeartax (Hedged)

1 f )►Mean

Pre-tax income

A

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How Risk Management Can Increase the Value of the Firm

105

If the firm's effective tax function is convex, risk management can reduce thefirm's expected taxes . And the more convex the tax schedule is, the greater the taxbenefits are . The obvious question then is, why would my firm's effective tax func-tion be convex?

The obvious factor that would make a tax schedule convex is progressivity, a taxschedule in which the statutory tax rate rises as income rises . Greater progressivityresults in a more convex tax schedule . However, since the range of progressivityfor corporate income taxes in the United States is relatively small, this factor wouldnot be a significant source of convexity for most large, public industrial corporations.

Another cause of convexity in the effective tax function is the existence of taxpreference items—for example, tax loss carryforwards and investment tax credits(ITC). Since a firm will always be induced to use the most valuable tax preferenceitems firms, these tax shields will result in the firm's effective tax function beingconvex.'

Finally, in the United States, firms that are subject to the alternate minimumtax (AMT) provision face convex effective tax functions. The AMT gives the taxauthorities a claim that is similar to a call option on the pretax income of the firm,so the AMT puts a "kink" in the effective tax function, making it convex.

While the impact of hedging on the firm's taxes is driven by a mathematicalrelation—the convexity of the effective tax function—the underlying logic is sim-ple, perhaps easiest to see in the case of the tax preference items . If the firm doesnot hedge, there will be some years in which the firm's income is too low to use (oruse completely) the tax preference items, so the firm would lose a benefit . Byreducing volatility in pretax income, hedging reduces the probability that the firmwill not be able to take advantage of its tax preference items . In a similar fashion,hedging reduces the probability that the firm pays the higher tax rates specifiedunder a progressive tax schedule or AMT provision.

Risk Management Can Add Value by Decreasing Transaction CostsAs illustrated in Figure 4-1, risk management reduces the volatility of the value ofthe firm. Figure 4–3 goes further to show that by reducing volatility, risk manage-ment reduces the probability of the firm's encountering financial distress and theconsequent costs.

How much risk management can reduce these costs depends on two obviousfactors: the probability of encountering distress if the firm does not hedge and thecosts if distress occurs. The greater the probability of distress or distress-inducedcosts, the greater the firm's benefit from risk management through the reduction inthese expected cost.

Default results when a firm's income is insufficient to cover its fixed claims.The probability of financial distress and subsequent default, therefore, is deter-

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Chapter 4

FIGURE 4-3 Convexity in the Tax Function

Pre-tax Income

mined by two factors : fixed-claims coverage (because the probability of defaultrises as the coverage of fixed claims declines) and income volatility (because theprobability of default rises as the firm's income becomes more volatile).

The cost of financial distress has two major components . The first is the directexpense of dealing with a default, bankruptcy, reorganization, or liquidation . Thesecond is the indirect costs arising from the changes in incentives of the firm's var-ious claim holders . For example, if the firm files for bankruptcy and attempts toreorganize its business under Chapter 11, the bankruptcy court judge overseeingthe case is unlikely to approve nonroutine expenditures. The judge receives littlecredit if the activities turn out well, but is criticized by creditors with impairedclaims if the efforts turn out badly . Thus, firms undergoing reorganizations arelikely to pass up positive net-present-value projects systematically because of thenature of the oversight by the bankruptcy court.

But even short of bankruptcy, financial distress can impose substantial indirectcosts on the firm .' These indirect costs include higher costs to the firm in contract-ing with its customers, employees, and suppliers.

The impact of financial distress on the cost of contracting with customers isperhaps the easiest to observe . Firms that provide service agreements or warrantiesmake long-term contracts with their customers . As illustrated in the followingexample, if the firm is less viable, consumers place less value on the service agree-ments and warranties and are more likely to turn to a competitor.

If the firm can convince potential consumers that the likelihood of financial dis-tress has been reduced, the firm can increase consumers' valuation of its service;agreements and warranties . And this perceived increase in value will be reflected iri

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How Risk Management Can Increase the Value of the Firm

107

Illustration 4—2

the cash flows to the firm and in the price the consumers will be willing to pay for theproduct. These potential benefits of risk management are likely to be greater for firmsthat produce "credence goods" and firms whose future existence is more uncertain.

A credence good is one wherein quality is important but is difficult (and insome cases impossible) to determine prior to consumption . A good example is air-line travel: quality is crucial, but until the trip is complete and baggage is recov-ered, there is no way for the consumer to judge the quality level . (In contrast, whenfirms purchase materials—for example, refined copper—they can determine thequality prior to use by assaying a sample .) Thus, firms that produce credence goodswould receive a larger benefit from hedging and being able to assure potential cus-tomers that they will not depreciate quality.

Consumers are aware that firms approaching financial distress are more likelyto cheat on quality than financially healthy firms . So the benefit from hedging wouldbe larger for firms that have a higher probability of encountering financial distress.

Risk Management Can Add Value by AvoidingInvestment Decision Errors

The M&M proposition implies that if hedging policy increases firm value, it doesso by reducing contracting costs, by reducing taxes, or by controlling investmentincentives. We now turn to this last general motive for corporate hedging—dys-functional investment incentives.

The Impact of Financial Risk on Sales : The Case of Wang*

As reported in The Wall Street Journal, "Thebiggest challenge any marketer can face [is]selling the products of a company that is onthe ropes ."

For purchasers of computers, manufactur-ers' guarantees and warranties (both explicitand implicit) are extremely important . As theJournal put it, "Customers . . . want to besure that their suppliers . . . will be around tofix bugs and upgrade computers for years tocome." Not surprisingly, when Wang'sleverage got to the point that earnings volatil-

ity could put the firm into financial distress,sales turned down. A potential Wang cus-tomer put it best when she noted that "beforethe really bad news, we were looking atWang fairly seriously [but] their presentfinancial condition means that I'd have a hardtime convincing the vice president in chargeof purchasing . . . . At some point we'd haveto ask `How do we know that in three yearsyou won't be in Chapter 11?'

*This illustration is from Bulkeley (1989).

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108

Chapter 4

Incentives to turn down positive net present value projects also can arise in firmsthat avoid bankruptcy. These incentives arise because of the conflict between thebondholders and the shareholders resulting from differences in the kind of claims eachhold.' Bondholders hold fixed claims, while shareholders hold claims that are equiv-alent to a call option on the value of the firm. The conflict results in a constraint on thedebt capacity of the firm (or in the firm's having to pay a higher coupon on its debt).

The severity of the conflict between the shareholders and bondholders is deter-mined primarily by the debt-equity ratio . As debt level in the capital structure rises,the conflict becomes more significant . But other factors, such as the range of invest-ment projects available to the firm, also affect the severity of the bondholder—shareholder conflict . As with any other option, the value of shareholders' equityrises as the variance in the returns to the underlying asset increases . If sharehold-ers switch from low-variance investment projects to high-variance projects, theycould transfer wealth from the bondholders to themselves .'

Basically, bondholders, or rather, potential bondholders, are concerned aboutthe probability that they will be left holding the bag, that the value of the firm's assetswill be insufficient to cover the promised payments in the indenture . In addition toconcerns about future market conditions, potential bondholders are concerned aboutopportunistic behavior on the part of shareholders who might declare a liquidatingdividend, burden'the firm with extra debt, or select risky investments. Potentialbondholders, however, recognize the possibility of opportunistic behavior and pro-tect themselves by lowering the price they are willing to pay for the firm's bonds.

To convince potential bondholders to pay more for bonds, shareholders mustassure them that wealth transfers will not occur . These assurances frequently havebeen given by attaching restrictive covenants to debt issues (restrictions on divi-dends and debt coverage ratios), issuing a mortgage bond (to preclude asset sub-stitution), making the debt convertible (to align the interest of bondholders withthose of the shareholders), and issuing preferred stock instead of debt (to reduce theprobability that future market conditions will lead to default).

The shareholder—bondholder conflict can also be reduced through risk man-agement. Figure 4—2 shows that risk management reduces the probability ofdefault, so potential bondholders will be willing to pay more for the bond . Hence,risk management can increase the debt capacity of the firm. Likewise, risk man-agement can decrease the coupon the firm will have to pay on its debt.

In addition to increasing the financing cost for investment projects undertaken,volatility in the firm's earnings can even cause the firm to pass up positive net-present-value projects . Textbook "underinvestment" occurs when the firm is highlylevered and the value of the firm's assets is volatile : shareholders may opt not toundertake a positive NPV project because the gains accrue to the bondholders .' Per-haps the simplest way to understand this rather complex theoretical argument iswith an example .

220

)

How Risk Management Can Increase the Value of the Firm

109

Illustration 4–3

Illustration 4–4

The Impact of Volatility on Debt Capacity*

As Corporate Finance reported, a number offirms realize that "hedging techniques canstabilize a company's net worth and keep itfrom tripping into technical default . . . " andby doing so, the firm can increase its debtcapacity. As a case in point, "Kaiser haseffectively increased its debt-carrying capac-

ity by removing volatility from its cost andrevenue stream. . ..

*This illustration is based on "Kaiser andUnion Carbide Hedge Their Bets With TheirBanks," which appeared in the June 1991 issueof Corporate Finance.

Cutting Rate Risk on Buyout Debt:Reducing Shareholder-Debtholder Conflict on the

RJR Nabisco Deal*

When Kohlberg, Kravis, Roberts and Co.got ready to issue the senior bank debt forthe RJR Nabisco deal, they ran into theshareholder–debtholder conflict head-on.But by using risk management, they wereable to reduce the conflict and increase theirdebt capacity.

The market was concerned about theinterest rate risk such a large amount of debtwould entail . If the debt carried a floating-rate coupon, and if rates rose substantially,the probability of default would rise dramat-ically. Therefore, to reduce the shareholder-debtholder conflict, KKR was required to

purchase interest-rate insurance . As the vicechairman of Chase Manhattan explained,before committing any money to finance acorporate takeover, Chase insists that stepsbe taken to reduce the interest rate risk.

Consequently, KKR agreed to keep interestrate protection (in the form of swaps or caps)on half the outstanding balance of its bankdebt. In this way, KKR was able to borrow$13 billion. Without the rate insurance, theamount the banks would have been willing tolend would have been substantially less.

*Based on Quint (1989).

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110

Chapter 4

Illustration 4-5

Controlling Underinvestment with Hedging*

Let's consider a 100 percent equity firmwhose value is positively related to oilprices—a small oil producer, for example.The value of the firm in the initial period,Period 1, will be higher if oil prices are highthan if they are low. For simplicity, let's sup-pose that there are only two outcomes, eachwith a 50 percent probability .'

Value of FinnOutcome

Probability

in Period I

Price of oil high

.5

1000Price of oil low

.5

200

While this initial value belongs completely tothe shareholders—our simple firm begins asall equity—suppose that the shareholders planto issue, in Period 1, bonds with face value of

$500. All the proceeds of the debt issue willbe passed directly to the shareholders.

Now suppose that the shareholders of thefirm are presented with a riskless investmentopportunity : if the shareholders make an out-lay of $600 in Period 1 (before the issue of

the debt), the investment project will result inan income to the firm of $800 in Period 2 with

certainty . Logic would suggest that share-holders will always accept a riskless oppor-tunity with a return above the riskless rate,but that's not necessarily how it will work.

As shown in Table 4–1, if the price of oilis low, the shareholders of this firm will passup this positive NPV project . In other words,if the value of the firm in Period 1 is $200, theshareholders will not undertake the risklessinvestment project.

The reason for this surprising result is that thevolatility in the value of the firm, coupledwith a large debt-equity ratio, could transferwealth from the shareholders to the bond-holders if the shareholders elect to undertakethe positive NPV project.

The total value of the shareholders' wealthposition is the sum of their equity value in thefirm at Period 2 plus the monies they receivefrom the debt issue . Note that while the face

value of the debt is $500, the market value ofthe debt—what the potential bondholders willactually pay the shareholders for the debt—isequal to the expected value of the debt,

112($500) + 1/2($200) = $350.

The expected value of the shareholder'sequity in the firm is 1/2($700) + 1/2(0) =-$350; the total value of the shareholders'holdings—the value of shareholders' equityin the firm plus the monies they receivedfrom the debt issue, is $350 + $350 = $700.

Now let's look at the impact of risk man-agement on this situation . Suppose the share-holders of the firm hedged its exposure to theprice of oil by entering into a simplified com-modity swap agreement:

Price of oil high : This firm pays $400.

Price of oil low: This firm receives $400.

Now the value of the firm is hedged againstoil price fluctuations . No matter what happensto oil prices, the value of the firm is $600.

As Table 4–2 indicates, with the value ofthe firm hedged against oil price fluctuations,the positive NPV project will always beundertaken.

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How Risk Management Can Increase the Value of the Firm

111

Controlling Underinvestment with Hedging continued

TABLE

Period 1 Period 2

Value of Firm Value of Firm Value of Debt Value of EquityWill the Positive NPV

Project Be Undertaken?

Undertake $1200 $500 $700

$1,000project

YesDo not 1000 500 500undertakeproject

Undertake 400* 500' -100$

$200project

NoDo not 200 200 0undertakeproject

*If the firm is worth only $200 initially, the shareholders would have to put up another $400 to get the $600 neces-sary to invest in the riskless project . In Period 2, the firm's treasury would contain the $800 proceeds from the invest-ment project ; but, $400 of these dollars would be earmarked for return to the shareholders.tEven though the firm would be worth only $400, the treasury would contain the $800 proceeds from the investment(see * note above) . Since the bondholders would have the senior claim, they can take the full $500 face value of thebond from the treasury.The treasury would "owe" $400 to the shareholders (see * note above) ; but, after the bondholders took their $500

from the treasury, only $300 is left.

TABLE 4—2

Period 1 Period 2

Value of Firm Value of Firm Value of Debt Value of EquityProject Be Undertaken?

Will the Positive NPV

Undertake $800 $500 $300

$600 Jproject

YesDo not 600 500 100undertakeproject

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112

Chapter 4

Controlling Underinvestment with Hedging continued

With the hedge against oil prices, the give them a total of $800 . By hedging, thetotal value of the shareholders' wealth is shareholders would increase the value of$500 (the proceeds of the debt issue), plus their wealth by $100.$300 (the value of their equity at Period 2) to

*This illustration is based on Mayers and

risk-free interest rate equal to zero_ These simpli-

Smith (1987) .

fying assumptions in no way influence the quali-

tFor tractability, we have created this exam-

tative outcome of the example ; but they make the

ple with no transactions costs and no taxes and a

exposition immensely more simple.

An instance in which risk management can avoid this type of underinvestmentproblem occurs in the long-term debt market. As we have noted, if a firm issueslong-term debt, its shareholders have the incentive to pass up positive net-present-value projects or to shift from low-risk to high-risk projects . Recognizing thisincentive, bondholders demand a large premium on long-term debt . However, this"opportunistic-behavior premium" is lower for firms with higher bond ratings, pre-sumably because higher-rated firms have established reputations . Lower-ratedfirms can avoid this premium by issuing short-term debt . But short-term debt couldexpose the firm to interest rate risk . If. however, the firm issues short-term debt andthen swaps the debt into a fixed-rate, the lower-rated firm can control the agencyproblem while avoiding interest rate risk .'

Illustration 4—6

The Impact of Earnings Volatility on Investment:The Case of Merck*

Since Merck's earnings are denominated in impacted its investment decision . When theU.S. dollars, its pretax income fluctuates with dollar was strong and pretax income was low,the value of the dollar . If the dollar is weak, Merck had cut back the rate of growth ofthe dollar value of net income received from R&D spending.foreign operations will be high; if the dollaris strong, Merck's dollar income will be low .

*This illustration is based on Lewent and

Looking at its behavior in the past, Merck Kearney (1990).

discovered that this volatility in earnings had

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How Risk Management Can Increase the Value of the Firm

113

But even without excessive leverage, volatility in earnings can lead to a formof underinvestment.

Since there is a well-established relation between R&D activity and value forpharmaceutical firms, there was a clear reason Merck would want to manage itsforeign exchange risk . However, this form of the underinvestment problem is onethat a number of firms have encountered . And if risk management permits the firmto undertake positive NPV projects that would otherwise be deferred, its net cashflows will necessarily rise.

Notes1. The original M&M proposition focused on the firm's

debt/equity ratio [Modigliani and Miller (1958)] . Therationale is that, because (under their assumptions)leverage by an individual is a perfect substitute forcorporate leverage, an investor will not pay the firmfor corporate leverage. The M&M proposition wasextended to dividends in Modigliani and Miller(1961), with the argument that "homemade" dividendscan be created as the investor sells the firm's stock.

2. Indeed, the mathematical paradigm that makes thishappens even has a name: Jensen's Inequality.

3. A substantial body of evidence demonstrates that taxpreference items will result in the effective tax func-tion being convex . For example, see Siegfried (1974),Zimmerman (1983), and Wilkie (1988).

4. The work of Jerry Warner suggests that the direct costsof bankruptcy are small in relation to the value of the

firm (Warner 197Th) . However, his evidence suggeststhat there are scale economies in this cost function, soavoiding these costs is potentially more important forsmaller firms.

5. This conflict has been discussed under the rubric ofagency problems . The agency problem refers to theconflicts of interest that occur in virtually all coopera-tive activities among self-interested individuals . Theagency problem was introduced by Jensen and Meck-ling (1976).

6. The problem referred to as asset substitution is a casein point. A firm can increase the wealth of its share-holders at the expense of its bondholders by issuingdebt with the promise of investing in low-risk projectsand then investing the proceeds in high-risk projects.

7. Myers (1977).8. Wall (1989).

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