The management of risk is a key area within a number of ACCA exams, and exam

questions related to this area are common. It is vital that students are able to
apply risk management techniques, such as using derivative instruments to
hedge against risk, and offer advice and recommendations as required by the
scenario in the question. It is also equally important that students understand
why corporations manage risk in theory and in practice, because risk
management costs money but does it actually add more value to a corporation?
This article explores the circumstances where the management of risk may lead
to an increase in the value of a corporation.

Risk, in this context, refers to the volatility of returns (both positive and negative) that
can be quantified through statistical measures such as probabilities, standard deviations
and correlations between different returns. Its management is about decisions made to
change the volatility of returns a corporation is exposed to, for example changing a
company’s exposure to floating interest rates by swapping them to fixed rates for a fee.
Since business is about generating higher returns by undertaking risky projects,
important management decisions revolve around which projects to undertake, how they
should be financed and whether the volatility of a project’s returns (its risk) should be
managed.

The volatility of returns of a project should be managed if it results in increasing the

value to a corporation. Given that the market value of a corporation is the net present
value (NPV) of its future cash flows discounted by the return required by its investors,
then higher market value can either be generated by increasing the future cash flows or
by reducing investors’ required rate of return (or both). A risk management strategy that
increases the NPV at a lower comparative cost would benefit the corporation.

The return required by investors is the sum of the risk free rate and a premium for the
risk they undertake. If investors hold well-diversified portfolios of investments then they
are only exposed to systematic risk as their exposure to firm-specific risk has been
diversified away. Therefore, the risk premium of their required return is based on the
capital asset pricing model (CAPM). Research suggests companies with diverse equity
holdings do not increase value by diversifying company specific risk, as their equity
holders have already achieved this level of risk diversification. Moreover, risk
management activity designed to transfer systematic risk would not provide additional
benefits to a corporation because, in perfect markets, the benefits achieved from risk
management activity would at most equal the costs of undertaking such activity.
Therefore, in a situation of perfect markets, it may be argued that risk management
activity is at best neutral or at worst detrimental because costs would either equal or be
more than the benefits accrued.

Such an argument would not apply to smaller companies which have concentrated,
non-diversified equity holdings. In this case the equity holders, because they are
exposed to both specific and systematic risk, would benefit from risk diversification by
the company. Therefore, whereas larger companies may not create value from risk
management activity, smaller companies can and should undertake risk management.
However, empirical research studies have found that risk management is undertaken
mostly by larger companies with diverse equity holdings and not by the smaller
companies. The accepted reason for this is that the costs related to risk management
are large and mostly fixed. Small companies simply cannot afford these costs nor can
they benefit from the economies of scale that large companies can.

In addition to the ability of larger companies to undertake risk management, market

imperfections may provide the motivation for them to do so. Market imperfections that
exist in the real world, as opposed to the perfect world conditions assumed by finance
or economic theory, may provide opportunities to reduce volatility in cash flows and
thereby reduce the costs imposed on a corporation. The following discussion considers
the circumstances which may result in providing such opportunities.

Taxation

Risk management may help in reducing the amount of tax that a corporation pays by
reducing the volatility of the corporation’s earnings. Where a corporation faces taxation
schedules that are progressive (that is the corporation pays proportionally higher
amounts of tax as its profits increase), by reducing the variability of that corporation’s
earnings and thereby staying in the same low tax bracket will reduce the tax payable.

According to academics, corporations could often find themselves in situations where

they face progressive tax functions, for example, when they have previous losses which
are not written off or, in the case of multinational corporations, due to the taxation
treaties which exist between different countries. The amount of taxation that can be
saved depends upon the corporation’s individual circumstances.

Insolvency and financial distress

A corporation may find itself in a situation of being insolvent when it cannot meet its
financial obligations as they fall due. Financial distress is a situation that is less severe
than insolvency in that a corporation can operate on a day-to-day basis, but it finds that
these operations are difficult to conduct because the parties dealing with it are
concerned that it may become insolvent in the future. When facing financial distress a
corporation will incur additional costs, both direct and indirect, due to the situation it is
facing.

The main indirect costs of financial distress relate to the higher costs of contracting with
the corporation’s stakeholders, such as customers, employees and suppliers. For
example, customers may demand better warranty schemes or may be reluctant to buy a
product due to concerns about the corporation’s ability to fulfil its warranty; employees
may demand higher salaries; senior management may ask for golden hellos before
agreeing to work for the corporation; and suppliers may be unwilling to offer favourable
credit terms.

Academics exploring this area postulate that because stakeholders are subject to the
corporation’s full risk, as opposed to only systematic risk, which is faced by the
corporation’s equity holders, the stakeholders would demand greater compensation for
their participation. Where an organisation actively manages its risk and prevents (or
reduces the possibility of) situations of financial distress, it will find it easier to contract
with its stakeholders and at a lower cost. Hence, the more volatile the cash flows of a
corporation, the more likely the need to manage its risk in order to reduce the costs
related to financial distress.

External funding and agency costs

Another consequence of financial distress is the impact this may have on the
corporation’s ability to undertake profitable future investment. Financial distress may
make the cost of external debt and equity funding so expensive that a corporation and
its management may be forced reject profitable projects. Academics refer to this as the
under investment problem.

Equity holders in effect hold a call option on a corporation’s assets and debt holders can
be considered to have written the option. In cases of low financial distress the company
may be considered to be similar to an at-the-money option for its equity holders, and,
therefore, they would be more willing to undertake risky projects as they would benefit
from any increase in profitability, but the impact of any loss is limited. In the case of
substantial financial distress, the option could be considered to be well out-of-money. In
this situation there is little (or no) benefit to equity holders of undertaking new projects,
as the benefits of these will pass to the debt holders initially. However, debt holders
would be reluctant to lend to a severely distressed company in any case.

Therefore, when raising debt capital, a corporation that is subject to low levels of
financial distress would face higher agency costs, with lenders imposing higher
borrowing costs and more restrictive covenants. Whereas debt holders get a fixed
return on their investment, any additional benefit due to higher profits would go to the
equity holders. This would make the debt holders reluctant to allow the corporation to
undertake risky projects or to lend more finance to the corporation because they would
not gain any benefit from the risky projects.

A corporation that faces high levels of financial distress would find it difficult to raise
equity capital in order to undertake new investments. If corporations try to raise equity
finance for relatively less risky projects then the profits earned from such projects would
initially go to the debt holders and the equity holders will gain only residual profits.
Therefore equity holders would put pressure on the corporation and its management to
reject good, low risk projects, which may have been acceptable to the bondholders.

Therefore, risk management in reducing financial distress by reducing the volatility of

the corporation’s cash inflows may help the management to obtain an optimal mix of
debt and equity, and to undertake profitable projects.

Capital structure and information asymmetry

Risk management can help a corporation obtain an optimal capital structure of debt and
equity to maximise its value. Since risk management stabilises the variability of cash
inflows, this would enable a corporation to take more debt finance in its capital structure.
Stable cash flows indicate less risk and therefore debt holders would become more
willing to lend to the corporation. Since debt is cheaper to finance than equity because
of lower required rates of return and the tax shield, taking on more debt should increase
the value of the corporation. Risk management can help achieve this.

Academics have observed that managers would prefer to use internally generated funds
rather than going to the external markets for funds because it is cheaper and less
intrusive on the corporation. They suggest that borrowing money from the external
markets, whether equity or debt, would involve parties who do not have the complete
information about the corporation. This information asymmetry would make the external
sources of funds more expensive. If risk management stabilises the cash flows that the
corporation receives from year to year, then this would enable managers to plan when
the necessary internal funds will become available for future investments with greater
accuracy. They will then be able to align their investment policies with the availability of
funding.

Manager behaviour towards risk management

In his seminal paper, Rene Stulz suggests that managers, whose performance reward
structure includes large equity stakes in a corporation, are more likely to reduce the
corporation’s risk, as opposed to managers whose performance reward structure is
based primarily on equity options. Managers who hold concentrated equity stakes in a
corporation face increased levels of risk when compared to other equity holders. As
discussed previously, investors hold well-diversified portfolios and face exposure to
systematic risk only. But managers with concentrated equity stakes would face both
systematic and unsystematic risk. Therefore, they have a greater propensity to reduce
the unsystematic risk.
However, if investors do not reward corporations that are reducing unsystematic risk,
because they have diversified this risk away themselves. And if a corporation’s
managers use the corporation’s resources to reduce unsystematic risk, thereby
reducing the corporation’s value. Then it is worth exploring under what circumstances
would equity investors allow managers to act to reduce unsystematic risk and whether
such actions could actually result in the value of the corporation increasing.

Stulz argues that encouraging managers to hold concentrated equity positions but
allowing them to reduce unsystematic risk at the same time, may enable them to act in
the best interests of the corporation and the result may be an increase in the corporate
value. He explains that managers, who do not have to worry about risks that are not
under their control (because they have hedged them away), would be able to focus their
time, expertise and experience on the strategies and operations that they can control.
This focus may result in the increase in the value of the corporation, although the impact
of this increase in value is not easily measurable or directly attributable to risk
management activity.

As an aside, one could pose the question, why don’t managers, who are rewarded by
equity, diversify the risk of concentrated equity investments themselves? They could sell
equity in their own corporation and replace it by buying equity in other corporations. In
this way they do not have to hold concentrated equity positions and then would be like
the normal equity holders facing only systematic risk. A research study on wealth
management, which looked at concentrated equity positions and risk management,
found that senior managers are reluctant to reduce their concentrated equity positions
because any attempt to sell the equity would send negative signals to the markets, and
cause their corporation’s value to decrease unnecessarily.

Contrary to the behaviour of managers who hold concentrated equity stakes, managers
who own equity options, which will be converted into equity at a future date, will actively
seek to increase the risk of a corporation rather than reduce it. Managers who hold
equity options are interested in maximising the future price of the equity. Therefore in
order to maximise future profits and the price of the equity, they will be more inclined to
undertake risky projects (and less inclined to manage risk). Equity options, as a form of
reward, have been often criticised because they do not necessarily make managers
behave in the best interests of the corporation or its equity investors, but encourage
them to act in an overly risky manner.

A number of empirical studies looking at manager behaviour support the above

discussion (see for example Tufano’s study published in 1996 in the Journal of
Finance).

Testing the impact of risk management

In addition to the above, empirical research studies have looked at the risk management
policies and actions pursued by corporations and their impact on corporate value.
Although the studies have provided varying results when studying each area of market
imperfections and their impact, the overarching conclusion from these studies is that:
corporations manage their risks in the belief that this would create or increase corporate
value, although a direct link between risk management and a corresponding increase in
corporate value has not been established.

Hence the belief held among managers is that the management of risk does create
value, and certainly corporations and their senior managers seem to believe and act in
a manner that it does. However, the jury is still out on whether risk management actually
does lead to increased corporate value. There seem to be strong theoretical reasons for
managing risk, but empirical research has not proven the impact of risk management
activity on corporate value.