Chapter OutlineChapter Outline2.1 RISK, VALUE, AND VALUE MAXIMIZATION 2.2 VALUE MAXIMIZATION AND THE COST OF RISK Determinants of Value Maximizing Value by Minimizing the Cost of Risk 2.3 UNDERSTANDING THE COST OF RISK Components of the Cost of Risk Expected Cost of Losses Cost of Loss Control Cost of Loss Financing Cost of Internal Risk Reduction Methods Cost of Residual Uncertainty Cost Tradeoffs Measuring the Cost of Pure Risk Cost of Other Types of Risk 2.4 OTHER GOALS OF BUSINESS RISK MANAGEMENT Subsidiary Goals Objectives for Non-profit Firms and Government Entities 2.5 RISK MANAGEMENT AND SOCIETAL WELFARE Risk Management Objectives and Societal Welfare Conflict Between Business and Societal Objectives

Cost of Risk and Value Maximization - Cost of Risk and Value Maximization - The Big PictureThe Big Picture

Do Managers Maximize Shareholder Value?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 ValueDeterminants of Value

Firm value depends on net cash flows

Value Maximization and Minimizing the Value Maximization and Minimizing the Cost of RiskCost of Risk

Define

– Cost of Risk

Then

– Value with risk

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

Direct Losses

Ind irect Losses

Expected Costof Losses

Increased Precautions

Reduced Activity

Cost of LossContol

Reten tion / Self-Insu rance

Insurance

Hedg ing

O ther Risk Transfers

Cost of LossFinancing

Diversification

Investments in In form ation

Cost of In ternalRisk Reduction

Effects on Shareholders

Effects on O ther Stakeholders

Cost of ResidualUncertain ty

Cost of Risk ExampleCost of Risk Example

– Value of firm in ideal world of no risk = $100,000.

– Issues to be examined:

Cost of Risk ExampleCost 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 ExampleCost of Risk Example Option 1: Do Nothing

– 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 ExampleCost of Risk ExampleOption 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 ExampleCost of Risk ExampleOption 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 ExampleCost of Risk ExampleOption 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 ExampleCost of Risk Example– Key Points:

Do NOT minimize risk

There are tradeoffs:

– Increase insurance ==>

•

– Additional loss control ==>

•

Cost Tradeoffs in Risk ManagementCost 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 ManagementCost Tradeoffs in Risk Management

– Cost of loss financing & internal risk reduction vs. cost of residual uncertainty

Risk Management & Societal WelfareRisk Management & Societal Welfare

– Minimizing the Cost of Risk is an appropriate objective for

Individuals Businesses Society

Business Objectives and Other ClaimantsBusiness 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 ObjectivesConflicts 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”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