performance measurement and enterprise risk management

Overview and Introduction

Performance Measurement and Enterprise Risk Management

Prof. Antonio Renzi

2

First part: Performance Measurement

Second part: Enterprise Risk Management

3

Information posted on the website:

Course Syllabus; Exam Dates; Slides; Other Materials

Exam: Interview

Midterm tests: Two Midterm Tests (not mandatory)

Contacts:

[email protected]

Department of Statistics (Viale Regina Elena – First Floor -

Room 10)

Office hours: Wednesday at 4,00pm.

To make an appointment, it is recommended to send an email

the day before (Tuesday).

Class schedule:

Tuesday 8am (Class 3); Wednesday 2pm (Class 2)

mailto:[email protected]

General overview

1. Course goals

2. Performance measurement (PM) motivations and

definition

3. Enterprise risk management (ERM) motivations and

definition

4. Course motivations (linkages between PM and ERM)

5. Course topics

6. Details about the exam

Issues of enterprise risk management

Issues of performance measurement

Overview – Title and goals

Performance measurement and enterprise risk management

Goals: 1. Acquisition of basic skills in order to measure firm performances

2. Acquisition of basic skills in order to develop an enterprise risk management

process and measure firm risks in an integrated way.

Performance measurement (PM): motivations and definition

In recent decades, the PM discipline has assumed increasing

importance due to the growing complexity in understanding the

meaning of business results as a consequence of the instability

that occurs both inside and outside organizations.


The main PM task is to connect “dots” of a firm activity by

combining decisions, their operating applications and related

performances according to both a feedback approach and

forecasting approach

A PM process has to be fit expectations of a different

stakeholder kinds


Internal

Instability:

- Propensity to make innovations;

- Dynamic organization processes;

- Accounting noise;

- ….

Environmental

Instability -Price per unit volatility;

- Consumers behavior;

- Changes in the competitors

strategies;

- ….

Unclear current and

expected results of the

company

Need of a PM system able for analyzing: -The real and potential company capacity to achieve performances;

- The interactions between several performance kinds;

- The internal and/or external motivations which are behind company's

performances;

- How to maintain or improve a certain level of company's performances


PM

SYSTEM Firm’s

Managers

Firm’s

Employees

Board

components

Internal stakeholders External stakeholders

Bank(s)

Financial

investors

Public

institutions

Commercial stakeholders:

Customers and suppliers

Unions

The double relationship

between the PM system and firm’s stakeholders, in terms of

information flows, rules about the manner to spread information,

performance goals’ definition, and so on.


Firm’s goals

In the long run

Strategic

decisions

Operating

decisions

Operating

activities

Effective

Results

Measurement Indicators

selection

Feedback analysis Results

motivations

Firm’s stakeholders

pressures


A Broader PM definition :

PM as a coordinated set of quantitative and qualitative

indicators aimed, on the one hand, to asses the capacity of a

firm (or other organization kinds) to achieve desired

objectives, on the other hand to figure out potential new goals.

According to this definition the PM activity is based on two

general indicators kinds:

1) Indicators which focused on the past. They allow to figure

out how earlier plans and their execution affected the

current results;

2) Indicators which focused on the futures. They allow to

figure out, under uncertainty conditions, how current (or

potentially activated) plans could affect expect results.


Past

decisions

and activities

Current

performances

measurement

PM indicators as a set of management control tools

Current

decisions

and activities

Expected

performances

measurement

PM indicators as a set of management planning tools

The PM's activity looks at events already happened; therefore produces

outputs under certainty conditions

The PM's activity inquires potential future scenarios; therefore

gives indications under uncertainty conditions

Enterprise risk management (ERM): motivations and definition

The need of an ERM system is a consequence uncertainty seen as a

threat and an opportunity.

Performance

uncertainty

Economic value creation

Economic value conservation

ER

M S

YS

TE

M


General definition of ERM:

“Enterprise risk management is a process, effected by an

entity’s board of directors, management and other personnel,

applied in strategy setting and across the enterprise, designed

to identify potential events that may affect the entity, and

manage risk to be within its risk appetite, to provide reasonable

assurance regarding the achievement of entity objectives. ”

(Enterprise Risk Management — Integrated Framework, 2004)


The ERM as a multidimensional tool :

1) ERM as a strategic tool to assumes decisions;

2) ERM as a corporate governance and accountability tool;

3) ERM as a tool for managing the double side of risk and

uncertainty;

4) ERM as an organization tool.


Benefits of ERM

A good ERM system:

1) Allows to achieve strategic and operating goals;

2) Brings near managerial decisions and operating processes to

corporate governance rules;

3) Reduces informational inefficiency between companies and their

stakeholders;

4) Fosters “risk culture” and creates a “risk‐aware” across the

organization;

5) Allows to develop new risk models taking into account the

features of a given company and its environmental context.


The strategic side of ERM

Return

expectations and

risk propensity

Strategies Alignment

Strategies’ risk Firm ‘s features Alignment

Change in the

firm ‘s features Strategies’ risk

Dynamic alignment


General representation of the ERM approach

All risk kinds are considered as a part of unique risk

The traditional risk management approach arises a

component of the ERM approach

Source: NYU Enterprise Risk Management

Risk measurement and

capital adequacy

Enterprise risk management (ERM): motivations and definition

The importance of internal risk drivers in ERM

A central aspect in the ERM is the focus on the business risk drivers

that can be managed through managerial decisions.

The main internal risk drivers regard operating and financial

leverages

Course motivations (linkages between PM and ERM)

The motivation for combining PM and ERM appear clear

- The measurement of performance must take into account the

volatility (risk) of company results;

- An ERM system starts from a deep knowledge of linkages between

performances, decisional process and decisions implementation;

- Both PM and ERM produce effects on the relationship between

corporate governance aims and managerial goals;

- The spread of PM and ERM outputs help external actors for

analyzing the firm value in the long run.

Course motivations (linkages between PM and ERM)

PM , ERM and economic value creation/ destruction

Good

PM system

Good

ERM system

Bad

PM system

Bad

ERM system

VALUE CREATION

Mistakes

discovery and

reworking

of decisions

and/or processes

Improvement of

the capacity

to analyze internal and

external phenomena

Improvement of

external relations

VALUE DESTRUCTION

Shadow

mistakes and

lower possibility

to rework decisions

and/or processes

Lower

capacity

to analyze

internal and

external phenomena

Worsening of

external relations

Course topics

First part - Performance measurement

1. Overview on the firm activity and its environmental context.

2. Overview on managerial decisions and firm performances

3. The performance measurement according to the

accounting view: financial statement analysis

4. The performance measurement according to the economic

value view: market value vs. intrinsic value; the present

value analysis according to several methods

5. The Balance Scorecard Model

Course topics

Second part – Enterprise risk management

1. Business risk, uncertainty and ambiguity .

2. Overview on the main firm risks.

3. Unlevered and levered idiosyncratic risk: operating

leverage, financial leverage and economic performances

volatility; the dynamic analysis of unlevered idiosyncratic

risk.

4. The systematic risk according to a managerial perspective:

the bottom up approach

5. Corporate governance pressures, compliance, economic

performances smoothing and inter-temporal risk transfer.

6. Internal risk control according to an integrated approach

Two midterm tests during the course

Midterm tests are not mandatory and can only be taken by

who attending classes

Oral test (Interview) – Formal sessions

Final valuation:

For students who attend lectures and take the first and

second midterm test, the final grade will depend on the

average midterm tests.

You can choose to register (during the a formal session of

exam) the average grade which comes from midterm tests. In

this case the maximum grade is 26/30.

Exam details

In what cases do you have to take the oral test?

1) If you want to improve your average grade on midterm tests.

2) If you don’t get a minimum average grade (18/30) on midterm

tests.

3) If you choose not to take midterm tests.

If you just take one of two midterm tests, the final interview will

not regard all of the syllabus but just a part of it.

Exam details

Exam dates (formal sessions)

•June 10, 2020

•July 20, 2020

•June 10, 2020

•September 16, 2020

Validity period about of both

the first and second midterm test

Midterm tests do not have a formal value. Therefore, all

students must register the final score during one of the

above exam sessions.

Exam details

A brief introduction on fundamentals of

business management


Prof. Antonio Renzi

Agenda

1. The business management discipline

2. The theory of firm: neo-classical theory

3. The theory of firm: neo-institutional theory

4. The theory of firm: Schumpeter theory

5. Entrepreneurship, risk and arbitrage profits

6. Entrepreneurial firms, public companies and decisional

power

7. The business model as logical business design tool

8. The environmental context and firm performance

9. Firm’s performance classifications

The business management subject

Business management arises as sort of evolution of

microeconomics and industrial economics, where the main

focus is on:

-Conceptualization of the firm as an economic entity;

- The relationship between firm and its sector (industrial perspective);

- The relationship between firm and its market (marketing perspective);

- Top management (strategic perspective);

- Firm goals and related decisions (decision making perspective);

- Managerial tools to support firm decisions;

- Managerial tools to measure firm performance;

- Financial tools and methods.

The business management subject

-Strategic management;

- Corporate management;

- Innovation management;

- Knowledge management;

- Strategic and operating marketing;

- Corporate governance;

- Corporate finance;

- Performance measurement;

- Enterprise risk management;

.

- Entrepreneurship;

- Family business

-Total quality management;

- Organization;

- Human resource management

- Supply change management;

- Operations;

- Accounting management;

- Others

From a functional point of view the business

management subject includes a number of specific disciplines:

The theory of firm: Neo-classical theory

Main assumptions:

1) Firms are seen as profits maximizers.

2) In the short run, firms, during the early (or growth) stages of

their lives, have decreasing profits caused by fixed investment.

3) Markets work under equilibrium conditions, therefore, prices will

be determined by competitive pressures.

4) The labor factor arises like a “normal” production input.

5) Neo-classical theory also assumes salaries are flexible: The

salary dynamic depends on demand dynamic.

6) All internal and external actors are rational.

The entrepreneur role

1) According to Neo-Classical Theory the entrepreneur is, on the

on hand a capitalist, on the other hand an organizer of

production inputs;

2) The idea of the entrepreneurs as organizer implies that most

successful entrepreneurs are able to find competitive

advantage in terms of higher efficiency.

3) The entrepreneur is not an innovator.


Weaknesses of Neo-classical theory

1) Normally markets don’t work under equilibrium conditions.

2) Normally goods prices don’t discount all information;

3) The market chaos could be seen as a source of arbitrage

profits.

4) What appears now like a good inputs organization could

implies sunk cost in the future.

5) Often successful entrepreneurs are innovators.

6) Often economic actors think irrationally.


Main assumptions:

1) The firm is seen as an institution with hierarchical structure

2) Property rights and long-term contractual relationships

determine the allocation of resources

3) The ownership of the company must be attributed to a number

of stakeholders.

The theory of firm: Neo-institutional theory

The markets have discontinuous curves, in the sense that the

stability phases (equilibrium) are followed by strong shocks

(disequilibrium).

During the stable periods, the firms that have dominant positions

tend to maximize profits thanks to the inertia of given drivers of

competitive advantage.

On the contrary, during shocks, the success of firm depends on

entrepreneur ability to exploit the chaos through the destruction of

pre-existing factors of success and the creation of new drivers of

competitiveness.

This phenomenon is known as “the process of

creative destruction"

The theory of firm: Schumpeter Theory

The entrepreneur as innovator

36

According to Schumpeter the entrepreneur is able to make the following innovation

activities:

• Product innovation;

• Process innovation;

• Acquisition of a new production factor

• Organizational innovation

Creativity is the main characteristic of entrepreneurs


Some examples of creative destruction

37

1. Innovations about new apps in Internet have destroyed (or decreased in a strong

way) the value of several businesses such as travel agencies, a part of music

industry etc.

2. The born of personal computer sector (1980s) has destroyed the industry of

typewriters

3. The first product of Microsoft (DOS) has destroyed (or decreased in a strong way)

the value of IBM’s software.


The timing of innovation: the strange case of Olivetti

Olivetti was the first firm to develop a personal computer (1960s).

The new product did not succeed because it was not aligned with the

marked needs.

Then, Olivetti decided to abandon the new product for increasing the

investments in the sector of typewriters.

Twenty years later (1980s), the sector of typewriters was destroyed

by the new personal computer.

38


39

The entrepreneurship subject is focused on new small

businesses that promise a potential growth

An new entrepreneurial firm (start up) in not just a young firm,

but a new economic activity based on one or more innovations

Entrepreneurship, risk and arbitrage profits

40

Entrepreneurship

issues

Startups

and new

businesses

Entrepreneurs

Economic

Growth

INNOVATION ISSUES

Entrepreneurial Risk Venture concept

Entrepreneurship, arbitrage profits and risk

An entrepreneurial activity is a venture when it is based on an

innovative project that entails high expected profits and high risk.

Ventures

High probability

to fail

High expected

profits

Ventures imply an extreme risk-return relationship


The entrepreneur as decision maker : arbitrage profit

Mistakes done by other entrepreneurs became the main driver of

arbitrage profits.

The entrepreneur is able to exploit mistakes in terms of arbitrage

profit: he buys (or sells) when the price of a product is lower (of

higher) than its real value.

42

Market efficiency

Arbitrage profit = 0

Intrinsic value Market value (price)

Market inefficiency

Intrinsic value = Market value (price)

Arbitrage profit > 0


The entrepreneur as decision maker: arbitrage activity

43

The higher capacity of successful entrepreneurs to make new strategies in

advance than new phenomena gives them the opportunity to take a large

economic value through arbitrage operations based on the exploitation

of the resources’ intrinsic value.

Inefficiency and instability of the market

Intrinsic value Market values (prices)

Investments in one or more

undervalued resources

Appreciation

of resources

Intrinsic values

=

Market values

(prices)

Arbitrage value = Final Value – Initial Value


44

The decisional power

In an entrepreneurial firm

the decision-making

power belongs to the

entrepreneur.

The managers have a

residual decision power

tied to their skills. The

residual manager power

arises during the phases

of strategies

implementation

Entrepreneurial firms Public companies

The decision-making

power of managers is

higher in the case of

public companies, where

the ownership of the

company is diluted

among many investors.

The power of

shareholders regards the

control activity on

decisions of managers

and their behavior

The transformation of an entrepreneurial firms in a public company causes a change

in relation to the decisional power. This kind of transformation is often due to

dimensional goals. In fact the margin growth of a firm can be amplified by new

financial resources that come from the capital market.

Dimensional

goals

Decisional power

changing

Entrepreneurial firms, public companies and the decisional

power

There are several and heterogeneous definitions of what is a “business

model”

However, there are some general recurring concepts, which are the

following:

• The business model is a logical scheme that connects the dots among

ideas; technologies, and economic results;

• The business model expresses the value proposition;

• The business model is a sort of structural template.

The business model as a logical business design tool

Source: Osterwalder, Pigneur (2010)

Business model “canvas” and revenues/costs formation


Breakdown of canvas

The canvas facilitates both the unification and the breakdown process.

Breakdown process: it allows to extract the four dimensions and the nine

elements of the business.


Right side of Canvas

Value/Customer oriented

(external perspective)


Left side of canvas

Activity/Role oriented (internal perspective)


Up side of canvas

Structural and strategic dimension


Down side of canvas

Economic dimension


The environmental context and firm performance

Internal context

Environmental

context

Decisions

Firm performance


Two main approaches to link environmental

context and firm performance

1) The firm must be consistence with its environmental

context

2) The firm seeks performance drivers inside itself and in

some cases produces external changes


The structure-conduct-performance paradigm

Industry structure:

- Barriers to entry;

- Concentration degree;

- Competitors;

- Clients;

- Suppliers

- Others

Conduct:

- Differentiation strategies

- Cost strategies

- Niche strategies

Competitive

advantage Performance


Resource based view

Strategic resources

Capabilities

Competitive advantage

Strategies

Performance

Possible changes

in

the environmental

context


The business cycle life

Financial need: High; Current Profit: Low;

Potential profit growth: High

Financial need: ?; Current Profit: Low;

Potential profit growth: ?

Financial need: Low ; Current Profit: High;

Potential profit growth: Low

Financial need: Low ; Current Profit: Low;

Potential profit growth: Low

The BCG Matrix


https://www.google.it/url?sa=i&rct=j&q=&esrc=s&frm=1&source=images&cd=&cad=rja&uact=8&ved=0CAcQjRxqFQoTCNaRu9r10MgCFcjSGgodPcUEtQ&url=https://www.haikudeck.com/bcg-matrix-business-presentation-e5n6yQMVjp&psig=AFQjCNHBhtOo034SKQsd8fxPrs__2jYMng&ust=1445422414293446

Relationships between environmental context, decisions and performance


Industry structure

and business cycle life

Firm resources

and managerial capabilities

Strategic, tactical

and operating

decisions

Economic and financial

performance

Ne

w r

eso

urc

es

External

stakeholders

pressure

Internal

stakeholders

pressure

Social

performance

- Quantitative and qualitative performances.

-General and specific performances (divisional performances, .e.g.

marketing performance, production efficiency, organizational performances,

R&D performances, innovation performances etc).

- Strategic and financial/economic performances.

- Accounting and expected performances.

- Corporate Social Responsibility (CSR) performances.

- Growth performances (structural growth, sales growth, market share

growth etc)

At list, the combination of all performance kinds produces the “general firm

performance”

In the short run the above performance kinds are often in contrast to other.

In a long term perspective the above performance kinds tends to be

consistence to other, especially in the case of both a good PM system and a

proper organizational structure .

Firm’s performance classification

Long run vs. short run: the administrative paradox

The current performance maximization may reduce the firm capacity to

provide results in the long run

The performance maximization in the long may reduce the firm capacity to

maximize current results

Firm’s performance classification

Performance measurement according to the

accounting view: financial statement analysis

(First part)


Prof. Antonio Renzi

Agenda

1. Firm, financial system and financial reporting

2. From business activities to financial statements

3. Typical issues about accounting information

4. Financial performance measures and financial

statement structure

5. The net income statement

6. Revenue analysis

7. EBIT analysis

Firm, financial system and financial reporting

- From a financial point of view a firm arises a units in deficit, because

the formation of costs occurs before the achievement of revenues.

- Consequently, each company has as its first market the capital

market which can be acquired in the form of equity or financial debt.

- Therefore, financial reporting system must fit rules and constraints

coming from financial system

Firm, financial system and financial reporting

Financial actors who have interest on firm’s financial reporting

are the following:

- Financial Authorities (e.g., SEC in USA, CONSOB in Italy)

- Financial intermediaries (commercial banks, investment banks,

private equity founds, venture capital founds, insurance companies

etc);

- Informal investors (small investors who do not intermediate capital

flows, business angels, startups accelerators etc.)

- Independent financial analysts (single practitioners, rating agencies)

From Business Activities to Financial Statements

Source: Palepu K.G, Healy P. M. (2012), Business Analysis & Valuation, fourth ed., chapter 1

Typical issues about accounting information

- Accounting information shows just a part of firm dynamic in

economic and financial terms.

-Accounting managers own a certain flexibility in order to make

accounting report.

- The external analysts have to figure out when and how this

managerial discretion was used and its reasons.

- Accruals, or more in general accounting techniques, could create

formal firm's performance which are partially or totally just artificial

results.

- Normally, accounting information coming from public companies are

clearer than the case of private companies.

- Accounting information arise a the initial tool for estimating the past

and present dynamic of the firm. They are not sufficient to asses the

firm’s economic value.

What could lead a manager make accounting information

worse?

- To exploit tax benefits hiding the real firm’s profitability

- To hid the firm risk to failure.

- To exploit personal benefits coming from artificial results.

- A lack of skills and/or mistakes to figure out the real amount of

assets, liabilities, revenues and costs.


What could induce a manager to make accounting information

as correct as possible?

- In the medium to long term, incorrect information worsen the

relationship between the firm and its stakeholders.

- The constant spread of proper accounting information increases the

bankability of the firm.

- Growth-oriented strategies require growing confidence in the

business from many economic players; confidence that could

decrease in the case of shadow accounting information.

- The compliance than accounting rules avoids the risk of penalties

for the company and / or manager.


Financial performance measures and financial statement structure

Financial performance measures aims to analyze values and

drivers about:

- Economic inflows (revenues), economic outflows (costs) and related

net income;

- Balance sheet structure (assets an liabilities);

- Capital structure

- Unlevered profitability and levered profitability

- Cash inflows, cash outflows and related net cash flow

These measure kinds can concern the firm considered as whole, or specific organizational

areas


The economic performance measurement

1) Analyzing the firm capability to cover operating costs through

revenues tied to the core business (operating equilibrium).

2) Identifying of the causes of possible operational losses (negative

operating disequilibrium)

3) Analyzing the firm capability to produce a sufficient operating

profit than non typical managerial areas (general equilibrium)

4) Analyzing the firm capability to produce a positive net income

5) Identifying of the causes of possible negative net income (general

disequilibrium)


The balance sheet performance measurement

1) Analyzing the firm capability to cover the financial need caused by

investment decisions

2) Analyzing the firm capability to balance the assets’ time to

maturity with that of liability ones.

3) To figure out solutions about a potential lack of liquidity

4) To figure out solutions about a potential slack of liquidity


The capital structure measurement

1) Analyzing the firm propensity towards financial debt.

2) Measuring the financial leverage.

3) Analyzing the relationship between leverage and the risk of

financial distress.

4) Analyzing consistency / inconsistency between the firm life

cycle and the equity level


The profitability measurement

1) Measuring the unlevered profitability by combining net operating

profit wit net investments

2) Measuring the levered profitability by combining net income with

net equity

3) Linking profitability and risk in terms of volatility of both unlevered

and levered conditions

4) To figure out a right trade off between profitability and volatility


The cash slow measurement

1) Analyzing the firm capability to cover cash out flows through cash

in flows

2) Analyzing the net cash flows composition taking into account

structural cash flows and economic cash flows

Income statement

Revenues and costs

analysis

Balance sheet

Static and dynamic

analysis of assets and

liabilities

Capital structure and

profitability ratios

Cash flow analysis


Firm

bankability

Survival firm's

degree

Potential

firm’s growth

Failure firm's

risk

First inputs to outline new strategies, investment/financing decisions,

organizational changes etc

The net income

The net income definition

The net income is an accounting document which shows firm’s

economic results concerning a given year.

Revenues linked to the core business, as well as non-typical

revenues (e.g. interest income), achieved in the last administrative

period are the positive side of firm’s profit.

Operating costs, as well as non-typical costs (e.g. financial costs) ,

related to the last administrative period are the negative side of

firm’s profit.

Net income (or net profit) = Total revenues – total costs

The net income

Net income expresses a general result that can be broken

down in several areas:

A) Operating net income (EBIT or operating profits) ;

B) Financial net income;

C) Extraordinary net income;

D) Gross profit

E) Fiscal costs (taxes)

Gross profit = A + B + C

Net income (Net profit) = Gross profit - E

The net income

Revenues

(-) Variable costs (costs of goods sold)

a1) Contribution margin

Salries

(+) Rents

(+) Amortization and depreciation

(+) Other administrative costs

a2) Total fixed costs

a1 - a2 = A) EBIT (earning before interest and taxes)

EBIT (+) Amortization and depreciation = EBITA

(+) Interets income

(-) Financial costs

B) Fianncial income

(+)Extraordinary revenues

(-)Extraordinary costs

C) Extraordinary income

A + C + C = D) Profit before taxes

E) Taxes

D - E = Net income (Net profit or net loss)

Revenues analysis

Revenue Model

Primary Demand Secondary Demand

Competitive

strategies

Customers composition

Marketing

Unit Price

EBIT (or operating profits)

Revenues

-Operating variable costs

= Contribution margin

- Operating fixed costs (including amortization and depreciation)

= EBIT (Earning before interests and taxes)

R = revenues; VC = operating variable costs; p = price per unit;

vc = variable cost per unit; (p – vc) = contribution margin per unit;

Q = quantity of sales; Q(p – vc) = contribution margin;

FC = operating fixed costs.

FC -vc)-(pQFC -VC-REBIT

0EBITFCvc)-(pQ If

0EBITFC vc)-(pQ If 0EBITFC vc)-(pQ If

CM

CMCM

0EBITvc-p

FCQ'Q

Q’ = equilibrium quantity

Q ‘ shows the minimum level of quantity produced and sold below

which the company is unable to cover fixed costs through the

contribution margin


FC

VC

Total operating costs

R

Q’ Q

. Break even point

The break even analysis


Profitable area

Profitable area

Ebit

- FC

FC = 1000

VC = 4000

T. op. costs = 5000

R = 8000

Q’

=

100

Q = 400

. Break even point

The break even analysis (Example with EBIT > 0)

Fixed cost = 1000

Price per unit = 20

Cost per unit = 10

Quantity sold = 400

75%

EBIT = 400(20-10) -1000 = 3000

If DQ = - 75% DEBIT = - 100% EBIT = 0



t0 t1 D

Q 400 100 -75% p 20 20 0% R 8000 2000 -75% vc 10 10 0% VC 4000 1000 -75% CM 4000 1000 -75% FC 1000 1000 0% EBIT 3000 0 -100%

The break even analysis (Example with EBIT > 0)

-75% represents the safety margin compared to the risk of reducing sales


The break even analysis (Example with EBIT < 0)

t0 t1 D

Q 50 100 100% p 20 20 0% R 1000 2000 100% vc 10 10 0% VC 500 1000 100% CM 500 1000 100% FC 1000 1000 0% EBIT -500 0 -100%

+ 100% is the change in sales (Q) which would allow to move from a negative EBIT

to a null EBIT


Profitable revenue (PR), contribution margin rate (cmr) and EBIT

R' - R )p(Q'- p(Q) PR

FCvc-p

pR' )p(Q'

p

vc-p cmr

FC-vc)-(pQFCvc-p

p

p

vc-p-Qp

p

vc-p)R'-cmr(R EBIT


Profitable revenue (PR), contribution margin rate (cmr) and EBIT

(Example with EBIT > 0)

Q 400 p 20 R 8000 vc 10 VC 4000 CM 4000 FC 1000 EBIT 3000

3000PRcmr EBIT

6000PR ;20000,5

1000 R' ;5,0

p

vc-p cmr


Fixed cost, internal resources and production

The fixed costs level and related value of both Q’ and R’ depends

on internal durable resources such as plants, machinery, human

resources, intangible resources (e.g. patents).

Each level of durable resources determines the level of fixed costs

the related values of Q 'and R‘

The fixed costs are stable for a given max production level,

beyond which fixed costs increase. Therefore, fixed costs do not

have a linear trend compared to production, but a "stepped" trend

related to the max production capacity.

Variable costs = (Variable cost per unit) x (Expected sales )

Sales

Technical coefficients Negotiation skills

Distance of potential

suppliers

Number of potential

suppliers

Variable cost per unit

+

+ -

-



Durable resources increasing, current EBIT decreasing

FC

Q Q1 Q2 Q3

Q’1 Q’2 Q’3

Increasing of both expected EBIT and volumes’ risk

Max

production

Increasing 1

Max

production

Increasing 2

Max

production

Increasing 3

Start-up, development and dynamics of total costs

FC = Total costs

Q

Q*

First growth

FC

Q**

VC

TC

VC

Stable

resources

Q

Before production start First stage

Incre

asin

g

reso

urc

es

Increasing

resources

TC

TC

FC

FC


VC

First

stage

First

growth

Stability

Internal

efficiency

Stability

Stability

Stability,

expansion or

downsizing


Q’ =

equili

brium

quantity

DEBIT < 0 DEBIT = 0

DEBIT = 0

Break even point and EBIT dynamic

Ebit

Q

Q’

p - c

FC

First

stage

First

growth

Break

even

Efficiency

Competitiveness

Break even analysis (Q’ ) and entrepreneurial stages


Performance measurement according to the accounting

view: financial statement analysis (Second part – Ratios

analysis)

Prof. Antonio Renzi


Agenda

1. The ratios analysis: general logic

2. Profitability ratios

3. Profitability ratios improvement

4. Capital structure ratios

5. Capital structure ratios and equity profitability

6. The internal (or sustainable) growth rate

7. The net working capital

8. Accounting solvency ratios

9. Liquidity ratios

10.Expected revenues, capital intensive ratio and financial need

estimation

The ratios analysis: general logic

The ratios analysis definition

The ratios analysis is a typical financial statement tool aimed to

connect dots of firm’s performance in a unique framework. The main

kinds of ratios point out the following items:

- Profitability and growth;

- Capital structure and dividend policy;

- Solvency and liquidity;

- Asset management.


Investment

/financing

decisions

t0

Ratios

analysis

t1

The double relationship between Investment/financing

decisions and ratios analysis

t2 t1

Direct relationship

Direct relationship


The ratios inputs

The ratios analysis is based on accounting information coming from:

- Net income statement;

- Balance sheet statement

Net income

statement

Total revenues – Total cots

Balance sheet

statement

Assets Liabilities

Profitability and

growth ratios

Capital structure ratios

Solvency and

liquidity ratios

Assets

management ratios

The profitability ratios aims to point out the economic capacity in

relative terms, therefore allow comparisons in space and/or time.

For example, a big corporation that produces a high profits level

could be less profitable than the case of a small business which

provides lower profits.

The most part of profitability ratios are based on the comparison

between a profit flow and a stock of capital.

Just a little part of them compare two kinds of income flow

The profitability ratios analysis my be used to inquire both specific

profitability areas and the general firm’s profitability (composition and

decomposition of profitability).

Profitability ratios

Composition and

decomposition of profitability

Operating

profitability

Non-operating

profitability

General firm’s

profitability

Operating

profitability

Non-operating

profitability

Composition

process

Decomposition

process

A composition process implies to combine

profitability ratios with capital structure

ratios


Revenues profitability

ROS

(Rerun on sales)

Measures the portion of each

revenue (R) euro that becomes

operating or net income

Turnover


investment euro that becomes

revenue (R)

R

loss)(or profit Net ROS ;

R

EBIT ROS NetOperating

assets Total

R )Turnover(2 ;

sInvestmentNet

R )Turnover(1

Where: Net investments = Equity + Financial debts


ROA

(Return on assets)


asset euro that becomes net

income

ROI

(Return on

investments)


net investment euro that

becomes EBIT

assets Total

loss)net (or profit Net ROA ;

assets Total

EBIT ROA NetOperating

Turnover ROS debts Financial Equity

EBIT

NI

EBIT ROI


Investments profitability

ROI, ROS , Turnover analysis

(Example 1: the effect of price per

unit)

NI = 1.000.000 Equity = 400.000

Debt = 600.000

A

A

B

NI = 1.000.000 Equity = 400.000

Debt = 600.000

B


Combination between investments

profitability and revenues profitability

ROI, ROS , Turnover analysis

(Example 2: the effect of sales)

NI = 1.000.000 Equity = 400.000

Debt = 600.000

A

A

B

NI = 1.000.000 Equity = 400.000

Debt = 600.000

B

Combination between investments

profitability and revenues profitability


Other two kinds of net investment (NI) profitability

NI

onsDepreciati EBIT

NI

EBITA ROI

NI

rate)tax -EBIT(1

NI

NOPAT ROI


The ratios analysis

Equity profitability

ROE

(Rerun on equity)


equity euro that becomes net

income

debts finacial - inv.Net

loss)net (or profit Net

Equity

loss)net (or profit Net ROE


Some ways to improve profitability

- Price premium coming from a differentiation strategy.

- New knowledge creation.

- Economy of scale and/or scope coming from cost strategy.

- Improvement of goods’ portfolio through a correlated

diversification strategy (synergies’ and network benefits).

- Increasing / decreasing of the vertical integration degree.

- disinvestment of unprofitable assets (sunk costs issue).

- Inventory management.

- Capital structure changing

Profitability ratios improvement

The asset profitability improvement in the long run and

new knowledge creation

Both radical and incremental innovations need the exploitation

of new knowledge or a new use of existing knowledge.

Four ways for creating new knowledge as driver of innovation:

-Learning by doing;

-Learning by using;

-R&D investments;

-Acquisition of external knowledge.

Field experiences produce

flows of new knowledge

New investments produce

flows of new knowledge


The asset profitability improvement in the long run

through learning by doing

Learning by doing means to improve products, services and

processes thanks to the constant acquisition of incremental

experience.

Each firm’s worker learns from their own mistakes: the current

mistakes produce new experiences that reduce the probability of

future mistakes.

Constant production improvements allow firms to achieve marginal

innovation in stable conditions.




The focus is on internal experiences.

The firm improves what it is able to produce.

The learning by doing approach is consistent with incremental

innovations.




The application of the learning by doing logic needs choices in relation to

the organizational structure and the information flows.


Strengths and weaknesses of learning by doing

Lower innovation costs

Stability of organizational structure

A higher efficiency

Strong technical interrelations between

top management, managers and workers.

Strengths

Rigidity of organizational structure in

relation to radical innovations.

Rigidity of organizational structure in

relation to strong external changes.

Constant improvement is just based on

an internal perspective.

Weaknesses



through learning by using

"Learning by using" means to improve products, services and processes thanks to the capability to figure out the consumers

needs.

Marketing oriented approach: new market needs drive improvements and innovations over time.



through learning by using

The focus is on user experience.

The firm improves its production in a way that fits with needs and

requests of consumers.

The learning by using approach is mostly consistent with

incremental innovations and only in some cases is it consistent with

radical innovations.


Strengths and weaknesses of learning by using

Dynamism of organizational structure.

A higher propensity to face external

changes.

Higher strategic interrelations between

top management, managers and workers.

Client satisfaction and increase of the

price for sale (price premium).

Strengths

Higher innovation costs.

A higher complexity of organizational

structure.

Risk of internal inefficiency.

Risk to realize wrong innovations linked

to the difficulty to figure out real market

needs.

Weaknesses



Equity

Debts Financial (1) ratioequity Debt

Equity

Liquidity -debts Finacial

Equity

debts finacialNet (2) ratioequity Debt

Debt equity ratio (1) doesn’t take into account liquidity which may

be used to respect (partially or totally) the debt service.

The debt ratio (2) must be analyzed considering the possible

change in liquidity. From this point of view, a prudential approach

is to use as a correction factor for financial debt the average

liquidity stock over a given period, rather than the current level of

liquidity.

NI

Debts Financial (1) ratio inv.net Debt

NI

Liquidity -Debts Financial (2) ratio inv.net Debt

Equity

NI Leverage


Debts Financial

Equity

ratioequity Debt

1 (1) ratio edebt Equity

In the shareholder perspective the equity debt ratio implies an

opportunity cost due to the higher cost of equity in comparison than

debt cost.

At the same time a high level of the equity debt ratio gives the following

advantages : 1) a high protection buffer against the risk of financial

distress; 2) a high bargaining power compared to banks, other lenders

and inputs suppliers; 3) greater opportunities to explore new

opportunity by investing in very risky activities such as R&D activity.

Liquidity -Debts Financial

Equity

(2) ratioequity Debt

1 (2) ratio edebt Equity


Equity debt ratio and business risk

Business risk

Eq

uit

y d

eb

t ra

tio

High

High

Low

Low

Alignment between the

capital structure

and business risk

Relative high

opportunity cost

Misalignment between the

capital structure

and business risk

Relative high

opportunity cost

Misalignment between the

capital structure

and business risk

Relative low

opportunity cost

Alignment between the

capital structure

and business risk

Relative low

opportunity cost

1 2

3 4


Dividend policy, investment growth and capital structure

Residual

dividend policy High propensity to

self financing

InvestmetsNet

InvestmetsNet

Debts Financial

Debts Financial

D

D

0 ratioequity Debt D

First hypothesis


Dividend policy, investment growth and capital structure

Residual

self financing

High dividend

distribution

InvestmetsNet

InvestmetsNet

Debts Financial

Debts Financial

D

D

0 ratioequity Debt D

Second hypothesis


Capital structure and ROE decomposition

)t1(Equity

Debts Fin.i)-(ROI ROIROE

i = interest rate

t = tax rate

)t1(Equity

Costs Fin. -EBIT

Equity

profitnet NormalizedROE

Capital structure ratios and equity profitability

)t1(Equity

Debts Fin.i)-(ROI ROIROE

Equity

profitnet Normalized)t1(

Equity

Cost Fin.-EBIT

)t1(Equity

Cost Fin.-

NI

EBIT

Equity

EBIT

NI

EBIT

)t1(Equity

Cost Fin.-1

Equity

NI

NI

EBIT

NI

EBIT

)t1(Equity

Debts Fin.

Debts Fin.

Cost Fin.-

Equity

Equity-NI

NI

EBIT

NI

EBIT ROE

Algebraic explanation:

Capital structure and ROE decomposition


Levered ROE, unlevered ROE and financial leverage effect

ROE Unlevered

ROE Levered

)t1(ROI)t1(Equity

Debts Fin.i)-(ROI ROI

effect leverage Financial

ROI > i positive financial leverage effect

ROI = i neutral financial leverage effect

ROI < i negative financial leverage effect


Capital structure and Gross ROE decomposition

Equity

Debts Fin.i)-(ROIROI-ROE Gross

Equity

Costs Financial-EBIT

Equity

Debts Fin.i)-(ROI ROI

t-1

ROE ROE Gross

The Gross ROE is bigger than ROI when there are the two

following conditions:

1) Financial debts > 0 (levered condition);

2) ROI > i

When the above conditions arise, the firm can improve the shareholder’s

profitability operating just a financial strategy aimed to maximize the ROE level.

This strategy is known like financial leverage exploitation.


The negative side of financial leverage

A strong use of financial leverage could implies negative

consequences in terms of economic value, due to an increasing of

expected ROE volatility, cost of capital and failure risk:

Debt to

equity ratio

Accounting

ROE

Debt to

equity ratio

Economic

value


The negative side of financial leverage and equity constraints

The negative side of financial leverage explains why there are

constraints about a minimum equity level.

These constraints could come from external authorities such the case

both bank industry and insurance one.

In other cases the firm’s management defines equity constraints to

insure the firm survival.

In addition, in several countries the tax low tends to increase firms’

capitalization through a reduction of fiscal benefits linked to financial

costs.


Internal (or sustainable) growth rate

The internal (or sustainable) growth rate (G), measures the firm

capacity to develop itself without external capital coming from

investors and/or lenders:

G = ROE x Retention Rate

Retention Rate = (Net Income - Dividend) / Net Income

Equity

DivROE

PtofitNet

Div1

Equity

PtofitNet G

ROE and internal (or sustainable) growth rate

Example

Sustainable growth

of new investments

D Financial Debts = 0

D Number of shares = 0


The “G” rate provide the following information:

1) Indentifies the combination between firm’s strategy and its life

cycle;

2) Indentifies the dividend policy (residual or not-residual policy);

3) Provides useful information to analyze the financial side of firm’s

risk and related firm's bankability.


Main accounting solvency ratios

sLiabilitie T.

onDepreciati incomeNet ratiosolvency General

Equity

Debts Financial ratioequity Debt

PaymentsInterest

EBIT (1) coverageInterest

PaymentsInterest

flowcash Operating (2) coverageInterest

Accounting solvency ratios

Repayments CapitalPaymentsInterest

EBIT (1) coverage serviceDebt

Repayments CapitalPaymentsInterest

flowcash Operating (2) coverage serviceDebt

ratiosLiquidity and capital gNet workin

The Net Working Capital (NWC)

Balance sheet equation: CL DFCA FI

NWC = CA – CL = DF - FI

FI DF

CA CL

NWC > 0

FI DF

CA CL

NWC = 0

FI DF

CA CL

NWC < 0

Disequilibrium:

Excess of liquidity

Equilibrium Disequilibrium:

Lack of liquidity

The Net Working Capital (NWC)

Liquidity ratios

The two main liquidity ratios

CL

CAratioCurrent

CL

Iventories-CAratioQuick

Direct and indirect relationship between profitability ratios and

Liquidity ratios

Profitability

ratios

Liquidity

ratios

Direct effect

Indirect effect

A good (or bad) profitability increases (or

decreases) directly potential

and effective liquidity

Liquidity ratios affect in

indirectly profitability

Liquidity ratios

Direct and indirect relationship between economic crisis and

Financial crisis

Economic

crisis Financial

crisis

Constant

losses

Equity

reduction

Liquidity ratios

reduction

Liquidity ratios

Reduction caused

by non-economic factors

Loss of

suppliers and

lenders trust

Higher operating

and financial cost

Liquidity ratios

Expected revenues, capital intensive ratio and financial

need estimation

)(need(FN) Financial 10 REVf 000 SFEFEFN

REV1 = expected revenues

EFN = external financial need

SF = self-financing.

Capital

intensive

Commercial

credits

Management

of inventry

EFN0 +SF0

REV1

The estimation of durable financial need: Synthetic approach

(T0)jj(T1)sj(T0)

n

1i i

is

FI)(REVACI FN

nREV

FIACI

ACIs = Average capital intensive of cluster s

FNj = Financial need of business j

REVj(T1) = Expected j revenues

Fij(T0) = Fixed investments


need estimation

Example of synthetic approach

)FI(FI)REV(REVACI FN j(T0)j(T1)j(T0)j(T1)sT1)j(T0,

Hypothesis: Each expected Euro of revenue requires a durable investment equal to three

Euros

ACIs


need estimation

The estimation of durable financial need: Synthetic approach

The synthetic approach is useful especially in the first stage of analysis,

when the specific business goods are not identified. From this point of

view, the synthetic approach helps the estimation of the general capital

amount necessary to finance the industrial structure of the project.

Moreover the synthetic approach could be useful to analyze the causes

about differences between the capital intensive of a certain industry and

capital intensive of a certain business:

ACIj> ACIs ACIj= ACIs ACIj< ACIs

Lower efficiency than

the average efficiency

of competitors

Efficiency equal to


of competitors

Higher efficiency than


of competitors


need estimation

The case ACIj < ACIs must be analyzed in relation to the business

cycle phase.

Goals of cash flow analysis

1) The Cash flow shows the inflow and outflow of cash between

two balance sheet dates

2) The cash flow analysis aims to list any item that affects

corporate liquidity by increasing or decreasing it .

3) The cash flow analysis is a tool to optimize the liquidity

management

4) The expected cash flows are the final piece of business

design (business plan)

5) The expected cash flows are the positive side of present

value

Performance measurement according to the accounting

view: financial statement analysis (third part – Cash flow

analysis)

Prof. Antonio Renzi


Agenda

1. Goals of cash flow analysis

2. Cash flow kinds

3. General framework of cash flow analysis

4. Economic and structural cash flow

5. Free cash flow concept

6. Free cash flow to firm and free cash flow to equity

Goals of cash flow analysis

1) The Cash flow shows the inflow and outflow of cash between

two balance sheet dates

2) The cash flow analysis aims to list any item that affects

corporate liquidity by increasing or decreasing it .

3) The cash flow analysis is a tool to optimize the liquidity

management

4) The expected cash flows are the final piece of a business

design (business plan)

5) The expected cash flows are the positive side of present

value

Cash flow kinds

1) Operating cash flow

2) Economic cash flow

3) Structural cash flow

4) Free cash flow:

Free cash flow to firm;

Free cash flow to equity.

General framework of cash flow analysis

DLiquidity

=

Casht1 – Casht0

Operational

activities

Non-operational

activities

External

financings

Investments

management

Dividends policy Firm’s growth

Inputs of accounting cash flow analysis


t0 t1

Balance sheet

statement (t0)

Balance sheet

statement (t1)

Income statement(t1)

Variation in assets and

liabilities (including

equity) caused by

revenues and costs

Financing / investments

done in the period t0→t1

At the time t1 all inputs of the cash flow are known

Inputs of forecasting cash flow analysis


t0 t1

Balance sheet

statement (t0)

Forecasting balance

sheet statement (t1)

Forecasting income

statement(t1)

Variation in assets and

liabilities (including

equity) caused by

revenues and costs

Financing / investments

will be done in the

period t0→t1

At the time t0 just the balance sheet (t0) is known

Economic and structural cash flow

Net Income (- ) D Net operative Working Capital (+) Depreciations A) Economic cash flow (+) D Equity – (Net Income +Dividends) (+) Financial debts (-) New Fixed Investments (+) Disinvestments B) Structural cash flow Total Cash flow = A +B

D Net operative Working Capital =

D Accounts receivable + D Inventory D Accounts payable

D Accounts receivable (or D Commercial credits) = revenues without cash inflow DAccounts payable (or D Commercial debts) = operating costs without cash out flow

Economic and structural cash flow

Cash flow analysis

A) Economic cash flow B) Structural cash flow

Goal: maximization

Goal: ?

A positive value of the structural cash flow indicates a surplus of financing

A negative value of structural cash flow could depend on self-financing processes

A null value of the structural cash flow arises when there is a perfect balance between

the acquisition of new equity (and/or new financial debts) and the dynamic of fixed

investments

The free cash flow concept

The free cash flow (FCF) shows the cash flow measured after cash

outflows to support operations and maintain (or development) its

assets.

First, the FCF size depends on the following constraints:

1) The reconstitution constraint of the inputs consumed in the last

administrative period;

2) Remuneration constraints of financial backers.

Secondly, the FCF size depends how the firm uses cash flow that

remains after complying with the above constraints.


The free cash flow (FCF) shows the cash flow measured after cash

outflows to support operations and maintain (or development) its

assets.

First, the FCF size depends on the following constraints:

1) The reconstitution constraint of the inputs consumed in the last

administrative period;

2) Remuneration constraints of financial backers;

Secondly, the FCF size depends how the firm uses cash flow that

remains after complying with the above constraints.

Free Cash Flow

To Firm

It comes just from

investment decisions.

Free Cash Flow

To Equity

It comes from both

investment decisions and

financing choices

Equity

Debt

Assets

The Free Cash Flow

is correlated in negative way with the business dynamic:

Investment growth

Δ Net Fixed Investments + Depreciation > 0


Asset side perspective Equity side Perspective

Revenues Revenues

- Cost of sold goods - Cost of sold goods

- Other operating costs - Other operating costs

- Depreciations -Depreciations

= EBIT = EBIT

- Taxes on Operating Income - Interests

= NOPAT - Taxes

+ Depreciations = Net Profit

- Variation in accounts receivable + Depreciations

- Variation in Inventories - Variation in accounts receivable

+ Variation in commercial liabilities - Variation in Inventories

- New fixed Investments + Variation in commercial liabilities

+ Disinvestments - New fixed Investments

= Free Cash flow to Firm (FCFF) + Disinvestments

= Free Cash Flow to Equity (FCFE)

Free cash flow to firm and to equity

1) Firm’s decisions, strategies, environmental context and accounting measures

2) Revenues and costs drivers

3) Ebit and break even analysis

4) Limits of accounting measures

5) Profitability ratios

6) Capital structure ratios

7) How capital structure affects the equity profitability (the role of financial leverage)

8) Return of equity and internal growth rate

9) The net working capital

10) Solvency and liquidity ratios

11) The double relationship between profitability and liquidity

12) How the weakness of the economic firm determines its financial weakness and vice versa

13) The capital intensity and financial need

14) Economic and structural cash flow analysis

15) Free cash flow analysis

Key points of accounting performance measurement

The economic value measurement : First part – Introduction

to economic value measurement and capital structure

theories


Prof. Antonio Renzi

Agenda

158

The DCF approach: general logic

Intrinsic value vs. market value

Capital structure, Wacc and value: Modigliani and Miller (M.M) theory (I, II)

Capital structure and value: trade off theory

From accounting performance measurement to economic value

measurement

Weighted average cost of capital (Wacc)

Main issues about economic value measurement

Equity cost and capital structure

From accounting performance measurement to economic value

measurement

Accounting performance

measurement

Current and past

firm’s

performances

Economic value

measurement

Present value of

expected firm’s

performances

Set of analysis tools to

check effects on

performances coming from

internal decisions

and external events

General goal:

to figure out strengths and weaknesses

of the decisions already taken

Set of analysis tools to

select current strategies and

related investment/financing

decisions.

General goal:

to maximize the economic value in terms

of market price and/or intrinsic value


• The meaning of economic value according to several perspectives

• The choice about the expected performance kind as the positive side of economic

value

• Technical issues about forecasting analysis

• How to measure risk and uncertainty

• How to use strategic analysis into a quantitative analysis

• Cost of capital (or discount rate) measurement

• The capital structure role than economic value creation

• How to consider the irrational behavior of investors (behavioral finance)

• How to combine micro and macro issues

• The role of managerial flexibility than economic value creation

• How to check over time the quality of a given economic assessment

The need to contextualize the economic value measurement

• Objective contextualization: to link choice about the assessment

model with the valuation object

• Subjective contextualization: to take into account the subject

perspective of who has a specific interest than a valuation.


Intrinsic value:

This kind of estimate is based on the evaluation of flows and risks

linked to future expected performances and their probability.

Market value (stock price): Exogenous variable, defined by the

market.

In other words, the price is an objective factor, emerging from market

transactions. On the converse, the intrinsic value emerges from a

subjective estimation that reflects an opinion about expected

performances, under given hypotheses and risk conditions.



Equilibrium hypothesis

Informational efficiency

Economic rationality Homogeneity

of expectations

Equilibrium: Demand of stocks = Supply of stocks

Market prices = Intrinsic values

No stock is overestimated or underestimated


Disequilibrium hypothesis

Informational inefficiency

Economic irrationality Not homogeneity

of expectations

Equilibrium: Demand of stocks ≠ Supply of stocks

Market prices ≠ Intrinsic values

Stocks may be overestimated or underestimated

Main factors which cause disequilibrium

• Liquidity excess in the financial system that reduces the risk

perception of financial actors.

• Liquidity lack in the financial system that increases the risk

perception of financial actors.

• Changes about the trust in market investments.

• “Noise factor” and irrational behaviors.

• Financial analysts’ inattention to fundamental analysis.

• Value and risk estimation based on pro-cyclical methods.



The asset side and equity side perspectives

Asset side

perspective

Equity side

perspective

Enterprise

Value (EV)

Equity

Value (S)

Debt

Value (D)

EV = Total value = S + D

S= EV - D

The asset side and equity side perspectives

Enterprise value:

present value of

assets

Expected free

cash flow to

firm (FCFF)

Discount rate:

Weighted average

cost of capital

(Wacc)

(+) (-)

Equity value:

present value of

equity

Expected free

cash flow to

equity (FCFE)

Discount rate:

Equity cost

(ke)

(+) (-)


Asset side perspective Equity side Perspective

Revenues Revenues

- Cost of sold goods - Cost of sold goods

- Other operating costs - Other operating costs

-Amortizations -Amortizations

= EBIT = EBIT

- Taxes on Operating Income - Interests

= NOPAT - Taxes

+ Amortizations = Net Profit

- Appreciation in accounts receivable + Amortizations

- Appreciation in Inventories - Appreciation in accounts receivable

+ Appreciation in commercial liabilities - Appreciation in Inventories

- Net Investment flow + Appreciation in commercial liabilities

= Free Cash flow to Firm (FCFF) - Net Investment flow

= Free Cash Flow to Equity (FCFE)

The positive driver of present value: FCF


Discount rate of FCFF (asset side perspective)

τ)(1SD

Dk

SD

SkeWacc

jj

j

ij

jj

j

j

kej= equity cost of j;

kij = debt cost of j;

Sj = equity of j;

Dj = financial debt

The weighted average cost of capital (Wacc)

kej: expected return of equity → the shareholder expectation

kij: expected return of debt → the lender expectation

kej > Wacc > kij

Three important rules

1) Equity financing implies a higher risk premium than the case of debt financing:

2) In the absence of failure risk the debt cost equals the risk free rate (Rf):

3) The equity cost is positively correlated with debt financing, also in the case in

which there is not the failure risk:

Rfkij

kej > Wacc > kij

Increasing

in financial leverage

Higher risk premium

due to a higher

volatility of equity

return

Higher risk premium

due to a higher

failure risk

The weighted average cost of capital (Wacc)

Capital structure, Wacc and value: Modigliani and Miller (M.M)

Theory (I, II)

One of the main issues in corporate finance regards the role of capital structure

than the economic value creation.

The first theory of M.M. aims to demonstrate the irrelevance of the capital

structure than Wacc and therefore enterprise value.

According to M.M. theorem the economic value comes just from risk-return

profile of real assets.


Theory (I, II)

• No frictions about capital market mechanisms

• Competitive capital markets: Individuals and firms are pricetakers.

• Informational efficiency

• No taxes

• No risk of financial distress (or bankruptcy)

Assumptions


Theory (I, II)

1) A firm’s total market value is independent of its capital structure.

2) The equity cost of a firm increases with its debt equity ratio.

3) The economic value of a new firm’s investment doesn’t depend on its capital

structure.

Propositions


Theory (I, II)

First Proposition

Unlevered condition Levered condition DWacc = 0

DEV = 0


Theory (I, II)

First Proposition

s

jj

j

jj

j

jko

SD

DRf

SD

SkeWacc

kej= equity cost of j;

Rf = risk free rate

kos = unlevered cost of capital of the

firms cluster s

The capital structure can’t affect kos

Firms belong to the cluster “s” have the same risk-return profile under unlevered

conditions

Unlevered condition

Unlevered Enterprise

Value (EVu)

Unlevered Equity

Value (Su)


Theory (I, II)

EFCEFEEFE

ValueAsset ko

EFEEV

Lu

s

u

u

EFu= expected unlevered cash flow to

equity

EFL= expected levered cash flow to

equity

ECF= expected financial cost


Theory (I, II)

First Proposition

s

u

su

L

jj

j

jj

jj

ko

EFEEV

koEV

EFE

EV

FCEFE

SD

DRf

SD

SkeWacc


Theory (I, II)

Second Proposition

premiunrisk FinancialS

DRf)-(kokoke

premiumrisk Leverd Rf-ke

premiumrisk UnleverdRf-ko

S

DRf)-(kokoke

sj

j

s

ssj


Theory (I, II)

Second Proposition and value conservation

Unlevered condition Levered condition Dke > 0

DEquity value < 0

DDebt value > 0

DDebt value = - DEquity value


Theory (I, II)

Second Proposition and value conservation


Theory (I, II)

Value conservation

D/S

EV

Unlevered Enterprise Value = Evu

Levered Enterprise Value = EvL

Despite the M.M. it is based on strong simplifications, it expresses two basic truths:

1)The quality of real investments is the main driver of value creation;

2)The debt acts positively on the shareholder expected return and therefore negatively

on the share value.

Evu = EvL


Theory (I, II)

With a second theory M.M focused on how taxes affect the relationship between

capital structure and the enterprise value.

They ague how fiscal benefits linked to financial debts generate a positive

correlation between debt level and e enterprise value:

Levered enterprise value > Unlevered enterprise value

Second theory

j

i

jiτD

k

DτkPVFA

Present value of the fiscal advantage (PVFA):


Theory (I, II)

D/S

EV

EVu

sjj

j

jj

jj ko)1(

SD

DRf

SD

SkeWacc

Second theory

Evu + D

Capital structure, Wacc and value: Trade off Theory

Trade off theory aims to indentify an optimal leverage which maximizes the

firm’s value.

The leverage optimization comes from a proper combination between fiscal

benefits and risks linked both linked to the financial leverage (D/S).

In particular, the increase in leverage corresponds to an initial phase in which

the levered value (EVL) increases, for the same unlevered value (EVu), due to

the tax shield generated by interest expense (fiscal benifits); this until an optimal

leverage point (D / S)* which maximizes EVL.

The increase in debt beyond the optimal leverage causes a proportional

increase in the probability of bankruptcy and the costs associated with it and

consequently a reduction in the EVL.


Therefore according to the trade off theory, given an assts profitability, the value

maximization implies to seek the optimal financial leverage taking into account

two factors:

- Fiscal benefits of financial debts ;

- Costs caused by the financial distress risk.

About the fiscal benefits issue, the trade-off theory uses the same framework of

M.M theory II: the financial leverage acts positively on financial charges and

therefore on the tax shield (1 –).


Financial distress costs

The financial distress (or bankruptcy) risk causes two kinds of costs:

1) Direct financial distress costs: costs to avoid a potential failure or related to

a failure procedure.

2) Indirect financial distress costs: costs related to relationships with internal

and external stakeholder.

Both direct and direct costs determine the non-independence of Ebit with

respect to the financial structure.


Direct financial distress costs

- Asset liquidations

- Legal costs

- Accounting costs

- Loss of fiscal benefits


Indirect financial distress costs

- Increasing of financial debt costs

- Loss of lending from lenders

- Deterioration of the relationship with the inputs suppliers (loss of

inputs quantity, higher cost per unit, lower duration of commercial

debts)

- Deterioration of the relationship with the customers (loss of sales,

lower price per unit, higher duration of commercial debts)

- Less chance of working with the public administration.

190

EV

(D / S)

Unlevered

value

Levered

Value

Fiscal

benefits

E

H

•

Capital structure, Wacc and value: Trade off theory Capital structure, Wacc and value: Trade off theory

EVu

Bankruptcy

costs

Debt financing and cost of Failure

Levered EV < Unlevered EV

(D / S)*

(D / S)*= Optimal debt equity ratio with failure costs

EVu + D (M.M II)

EVL without

bankruptcy costs


Trade off theory and agency theory

According to agency theory the capital structure optimization depends on

agency costs minimization.

Principal:

Shareholder

Agent:

Manager

The shareholder delegates

the company management

The manager could engage in unruly behavior aimed at obtaining personal benefits. This

implies agency costs coming , on the one hand from corporate governance tools for

controlling manager activity, on the other hand from incentives that lead the manager to work

in the interest of the shareholder.

The debt level reduce agency costs, because implies higher remuneration constraints: the

mandatory to respect the debt service reduces the manager decisional margin.


Trade off theory and agency theory

According to agency theory, the debt benefits in terms of lower agency costs

have a limit caused by a possible unruly behavior of the shareholder against

lenders.

Principal:

Lender

Agent:

Shareholder

The lender delegates

the capital structure management

The shareholder could engage in unruly behavior aimed transfer firm’s risk towards

lenders through an increase in the debt equity ratios.

The equity cost according to the CAPM:

The three fundamentals theoretical steps



Rp

sp

Rp= Rf+(Rm –Rf)(sp/ sp)

.

sm

Rf

Rm

Portfolio theory Capital market line

2,11121

2

2

2

2

2

1

2

1p

2211p

ρσσXX2σXσX

RXRXR

:assets Two

s

CAPM

M

The equity cost according to the CAPM


La security market line

mR~

Rf

1

M

βRf)-R~

( Rf m

Premio

β-Rf)(R'm

Security

market line

The equity cost according to the CAPM: equilibrium hypothesis

and the security market line (SML)


Rf

SML Rf + (Rm-Rf)

1

Rm . M

. . . . . . .

The equity cost according to the CAPM: disequilibrium hypothesis

and the security market line (SML)


Rf

SML Rf + (Rm-Rf)

1

Rm . M

.

. .

.

.

.

.

Black points show underestimated stocks

Green points show overestimated stocks

The equity cost according to the CAPM:

Assumptions

• Market equilibrium;

• Diversification as tool for optimizing financial portfolios

• The investor operates just as a take-over and take-risk: He can’t

affect the market prices.

Variables of CAPM:

• Risk free rate (Rf);

• Market return(Rm );

•Beta (j).

kej = f(Rf, Rm, j)


The equity cost according to the CAPM : the beta factor

jmj βRf)-R~

( Rf ke RfR

~Rfke

β m

j

j

2

m

mj,

jσ

σβ

sj,m = covariance j,m; s2j = variance m

Covariance is a measure of how much two random variables change together.

The covariance j,m measures how j return changes for each change of the

average return of market portfolio and vice versa.

Variance m measures the capital market volatility.

sj,m = systematic risk of j

s2j = 100% of systematic risk

j = systematic risk coefficient



The equity cost according to the CAPM : the effect of capital

structure on beta

1) Unlevered beta: coefficient of unlevered systematic risk

Measures how much of the business risk depends on the market portfolio volatility

2) Levered beta: coefficient of levered systematic risk Measures how much of the firm’s total risk (business risk + financial risk) depends on the

market portfolio volatility

Levered beta > Unlevered beta

The equity cost according to CAPM: From unlevered to levered

beta

Sj

τ)1(D1ββ

j

j(u)j(L)

j(u) = unlevered beta (business j)

j(L) = levered beta (business j)

Dj = debt value

Sj = equity value

Dj / Sj = financial leverage

Sj

τ)1(Dβββ

effect Leverage

j

j(u)j(u)j(L)

Sj

D

τ1

11

β

β

Leverage

j

j(u)

j(L)


The equity cost according to CAPM: From levered beta to

unlevered beta

Sj

τ)1(D1

ββ

j

j(L)

j(u)


The equity cost according to CAPM: The levered beta

effect structure Capital

j

j(u)jSj

τ)1(D1Rf)β-(Rm Rfke


The above formula is congruent with M.M. theory (both I, II), where

the financial leverage is a positive driver of equity cost and therefore

negative driver of equity value.

The equity cost according to CAPM: The levered beta

effect structure Capital

j

j(u)jSj

τ)1(D1Rf)β-(Rm Rfke


Given a level of unlevered beta, a firm may reduces its equity cost by changing the capital

structure through the following policies:

-A residual dividend policy;

- Capital increases.

In terms of trade off analysis the analyst has to inquire the change of financial leverage

effect on Wacc and EV.

Du = 0; DFin. leverage <0; Dkej<0; DSj>0

Capital restructuring, Wacc and EV

j

ij

j

j

j(u)jDSj

τ)1(Djk

DSj

Sj

Sj

τ)1(D1Rf)β-(Rm RfWacc


DDj < 0; DSj =- DDj >0

DDj > 0; DSj =- DDj <0

L → - Wacc → +EV

Lower f. distress risk → - Wacc → +EV

Higher weight of equity → + Wacc → -EV

Lower tax shield → + Wacc → -EV

L → + Wacc → -EV

Higher f. distress risk → + Wacc → -EV

Lower weight of equity →-Wacc → + EV

Higher tax shield →-Wacc → +EV

The economic value measurement : Second part –

Basic valuation tools


Prof. Antonio Renzi

Agenda

207

The DCF approach

The APV (Adjusted Present Value) method

The economic value in the venture capital pesrpoective

Market multiples

The equity value according to Gordon’s model

The DCF approach

EqV = Present value of equity

Div = dividend

ke = equity cost

The Gordon’s model consists in a particular application of the DCF framework

where the focus in on expected dividends. The model’s goal is to solve the problem

of teporal indeterminacy of a company's life.

1tt

t

ke)(1

DivEqV

t

1tt

1tt

t

ke1

g1Div

ke)(1

DivEqV

0

g = dividend growth

(1+g)/(1+ke) = geometric progression factor

ke > g


The DCF approach

g - ke

)g1(DivEqv

ke1

g1Div....

ke1

g1Div

ke1

g1DivEqv

0ke1

g1xn

....ke1

g1

ke1

g1

ke1

g1

t0

1x

t0

2

t0t0

x

32


The DCF approach

The DCF approach

g0

1

p

Div ke

Starting from Grdon’s model, some analysts measure both the

equity cost a g rate by using the current price (p0) as the equity

present value.

0

1

p

Div-keg

The DCF approach

Asset side

Equity side

Equity value FCFE = = FCF to equity

Enterprise value EV= Enterprise Value

FCFF= FCF to firm

TV= terminal value

n

nnt

1tt

t

Wacc)(1

TV

Wacc)(1

FCFFEV

n

j

nnt

1tt

j

t

)ke(1

TV

)ke(1

FCFEEqV

The DCF approach

The terminal value without growth

Asset side

Equity side

nnWacc)(1

Wacc

FCFF

TV

n

j

j

n)ke(1

ke

FCFE

TV

The DCF approach

• Stable growth model

• Two-stage growth model

• Three-stage growth model

DCF and different growth (g) hypotheses

The DCF approach

DCF and growth (g) hypotheses

High-Growth

Stable Growth

g

t

Three-Stage Growth

g

Two-Stage Growth

g

Stable High-

Growth Stable Transition

The DCF approach

The terminal value with stable growth

Asset side

Equity side

The DCF approach

njnj

nn

)Wacc)(1g(Wacc

)g(1FCFFTV

njnj

nn

)ke)(1g(ke

)g(1FCFEEqV

DCF and stable growth

b

njnj

nn

a

tj

n

1t)ke)(1g(ke

)g(1FCFE)ke(1FCFEEqV

b

njnj

nn

a

tj

n

1t )Wacc)(1g(Wacc

)g(1FCFF)Wacc(1FCFFEV

Asset side perspective

Equity side perspective

The DCF approach

The APV method (Adjusted Present Value)

The APV method is a specific case of the DCF, and it is adopted when it’s

needed to measure the unlevered value of a venture. The unlevered value

refers to the value of an initiative when it is entirely financed with equity;

while the levered value refers to the value of a venture that is financed

both with equity and debt.

According to APV, financing with debt has both advantages and

disadvantages. As an advantage, there’s the tax shelter. However, more

debt causes more costs; and, therefore, an increased default risk.

Unlevered value

+

Tax advantage of financial debts

–

Default risk due to financial debts

=

Leverage value



g)(ke

g)(1FCFFW

u

o

u

FCFFo= net operating cash flow (operating cash - taxes);

keu= unlevered equity cost (cost of equity in absence of debt);

g= expected growth rate.

Unlevered equity value (Wu)

j

i

jiτD

k

DτkPVFA

Present value of the fiscal advantage (PVFA)

= fiscal rate;

ki = cost of debt;

Dj= debt.


Discounted value of the cost of default (VCF)

p = default probability

BC = discounted default cost

πBCVCF

Levered value (WL)

BCπτDg)(ke

g)(1FCFFW aj

u

0L


The APV method for new ventures

• Normally, in the early years there are no tax benefits

•The financial leverage is lower than the average of existing firms

• The overall risk depends primarily on the operational risk

• For each level of debt, the costs of failure is higher than the

average of existing firms

• The Tobin’s q is used to measure the degree of intangibles of a firm.

This measure is given by the ratio between the market value and the

cost for assets replacement.

• The ratio it is also used as a proxy to measure intangibles

performance. When the value of the ratio goes down, then, this could

be a signal that also the intangibles value is decreasing.

• However, it must be taken into account that, after a market bubble

bursts, investors tend to be more risk adverse and the value of

overall market shares results diminished.

The Tobin’s q

Value and intangibles

Market multiples approach

The estimate of a private firm’s value can be done using the value of public

companies, operating in the same sector and with similar characteristics.

First, there’s the selection of one or more benchmark public companies.

Hence, the ratio among the price of the public company and a reference

parameter is our multiple.

Multiple= Market Value of the comparable/ reference parameter

Target firm value= multiple x reference parameter of the firm

Market multiples and comparable transactions

The so-called market methods are based on the following hypotheses:

Economic value Market value = = Price X number of shares

In case of a private company, it is needed to select some public

firms that can be considered as comparables.


Market multiples approach: Price earning (PE)


)E(PE PV

E

P PE

jSj

PEs = Price earning of cluster s

PVj = Present value of j

Ej = Current earning of j

Comparable transaction approach

This methodology is similar to market multiples ones.

However, in this case there’s the use of a different firms’ panel as

benchmark. In particular, the benchmark value is the one of similar

firms that went under a takeover (as instance, the price of the deal).


The VCM is the forecast of a future value (as instance, by five

years from now). This future value is discounted at a high rate (e.g.

50%).

The VCM allows to determine the pre-money value (before the firm

is financed from a third party) in case of both poor historical data for

making a forecast and high risk-return expectations.

This method can be considered as a variation of the DCF: the

forecast concerns the start up firm value (expected cash flow) at

the external financer’s exit moment (when the backer will sell his

share).

The economic value according to the venture capital perspective

The Venture Capital Method (VCM)

Phases of the VCM

• Determination of the cash flow at the time of the venture capitalist’s exit.

•Future value estimation using comparables: in general, it is adopted the

market multiples method to measure the firm value in the later period. This

last value is considered as the terminal value: it is measured considering

expected revenues after a certain date and using a multiple (as instance

Price/Earnings from exit onward).

•The terminal value is discounted at a high rate, which reflects the high risk

of the initiative. The discount rate is estimated according to the capital gain

expected by the venture capitalist. Usually, this rate is extremely high.

Venture Capital method (VCM)

1-Inv.

FVTR

Inv.

FVTR)(1

TR)(1

FVInv. TR)Inv.(1 FV

1/n

n

n

n

Inv. = Initial investment

FV = Final value

TR = Target return

n = Years between the venture capitalist’s investment and his exit.

VCM: Present value, final value and target return


Multiple of initial investment


Target return and business life

Start up 50-70%

First stage 40-60%

Second stage 35-50%

Bridge / IPO 25-35%

Phase Target Return

Source: Damodaran, 2009.

VCM and price earning

1Inv.

PEFE1-

Inv.

FVTR

PEsFEFV

1/n

sj

1/n

j

Period 0 1 2 3 4 5 Earning -20 0 0 0 0 20 Initial investment 100 P/E (cluster s) 20 20 20 20 20 20 Final Value 400 Target Return 31,95%


Feasibility analysis according to VCM

Assumptions

PE of cluster 15 Maximum Waiting Time 6 years

Minum Return 40%

Portfolio return


The economic value measurement : Third part –

Deepening on beta and equity cost measurement


Prof. Antonio Renzi

Agenda

236

Beta measurement according to the market model

Comparables approach

Specific risk according to bottom up approach

Reworking the CAPM according to bottom up approach

Diversification issue and total beta

Reworking of CAPM according to four correction factors

Beta’s kind

- Top down beta (traditional beta)

- Comparable beta

- Bottom up beta

- Total beta (subjective logic)

Beta’s kinds

Beta’s kinds

Beta kind Model/Approach Field of application

Top down beta

beta Market model Listed firms

Comparable

beta

Comparables

approach Unlisted firms

Bottom up

beta

Fundamentals

approach Unlisted firms

Total beta Subjective

approach

Non-diversified

investor

The CAPM assumes the possibility to measure systematic risk with a

direct correlation between returns of individual stock and returns of

market portfolio. The market equilibrium hypothesis causes

homogeneous expectations.

From the application point of view, analysts use CAPM with strong

compromises, so that the model used in the real world is substantially

different from its the original version


Analysts prefer to build linear regression based on historical data

According to the top-down approach, the historical performances of a

stock are estimated, period by period, as a percentage change of its

market value. Furthermore, the market portfolio is generally

approximated to a sufficiently representative basket of securities

(stock index).


n

1i

2

mim

n

1imimjji

2

m

mj,

j

)R~

(R

)R~

)(Rkeke(

σ

σβ

p

p


n

1i

2

mim

n

1imimjji

2

m

mj,

j

)R(R

)R)(Rkeke(

σ

σβ

Original theory:

Approach based on subjective

probabilities

Market model

Approach based on historical

data (according to the practice

of analysts)

= Regression coefficient

a = Regression intercept

e = Standard error.

εRβα ke mjj

6.2-B 6.2-A

jke jke

j j

a

Rischio

specifico

mR mR

Regression analysis

Reward of

specific risk


2,1 0,0135

0,0161 β j

R-squared (R2) is a measure of how close the

data are to the fitted regression line. 1-R2 is a

measure of specific risk:

1-0,739 = 0,261

a


• The market model is not applicable in direct way in the case of

private firms: absence of data about past prices

• In the case of private companies the valuation problem regards

especially unlevered beta

• In the case of new business, the hypothesis of maximum

diversification is not realistic.

• The CAPM implicitly assumes the absence of liquidity risk of the

securities; risk that, instead, is normally present in the case of private

firms.

Applied problems of the market model in relation to private

firms


The easiest way to estimate the beta of a private firm is to use the

unlevered beta of the sector which the enterprise belongs.

The comparables approach

s(u)j(u) β β :Hypothesis RfR~

)t1(S

D1β Rf ke m

j

j

s(u)j

Nβ β N

1ii(u)j(s)

j(u) = Unlevered beta of the firm j

j(L) = Levered beta of the firm j

s(u) = Average unlevered beta of the

sector s

Dj = Debt of j

Sj = Equity of j

)t1(S

D1β β

j

j

s(u)j(L)

Example of comparables approach: New business in the filed of

Healthcare Support Services


Source:Damodaran, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html

• The equality j(u) = s(u) occurs when, for instance, a large private

company is similar (in terms of size and strategies) - to a certain

cluster of public companies.

• However, such circumstances occur rather infrequently: in most

cases, unlisted companies differ markedly in terms of both structural

and strategic than those listed.

•The problem about a low comparability among companies listed and

unlisted arises even more clearly in the case of start-ups.

• The comparable beta can be assumed as the starting point; the final

result (j(u)) should be estimated taking into account the characteristics

of the new business.

Ipotesi:


According to the bottom-up approach, the risk (specific and

systematic) comes from the combination between firm characteristics

and the volatility degree of a certain core business.

Equity cost = f (firm specific factors, intrinsic business risk, capital market volatility)

The bottom up approach: general framework

Motivations bottom up approach

• Analysis of the risk factors.

•Analysis about the effect of management decisions on risk (for instance

how a growth strategy affects the systematic risk)

• Evaluation of private firms

• Evaluation of market efficiency



Sector's

Volatility

Strategic

investments

Intrinsic

Business risk

Unlevered

Risk

Operating

Leverage

Fixed

Investments

Fixed

Costs Levered

Risk

Financial

Leverage

Levered

Risk = Intrinsic

Business Risk X Operating

Leverage

Financial

Leverage X

Unlevered Risk

Intrinsic business risk


Exogenous volatility

Price and demand volatility

caused by macroeconomic

factors

Endogenous volatility

Price and demand volatility

caused by strategic

decisions

Volatility in

revenues

V~

RE REV IBR2n

1iii

p

n

1iii REV V

~RE p

Degree of operating leverage (DOL)


REV

REV

Ebit

Ebit

REV

REV

Ebit

Ebit DOL

(t0)

(t0)(t0)(t0) D

D

DD

The value of DOL can be positive, null or negative. The use of

DOL in a risk return analysis requires a positive value:

REV

REV

Ebit

EbitDOL

2(t0)

(t0)

D

D

DOL measures that part of intrinsic absorbed by a

specific business

Unlevered risk (su), degree of operating leverage (DOL),

intrinsic business risk (IBR) and unlevered risk (su)


DOL = 1 su = IBR

DOL > 1 su > IBR

I~

ROROI σ2n

1iiiu

p

n

1iii ROII

~RO ;

NI

EBITROI p

Dall’approccio top down all’approccio bottom up (5/7)

Growing unlevered risk due to greater volatility in the competitive environment

Decreasing unlevered risk due to lower volatility in the competitive environment

Unlevered risk with a constant operating leverage

I~

RO I~

RO I~

RO

su = 0,1 su = 0,2 su = 0,4

I~

RO I~

RO I~

RO

Dall’approccio top down all’approccio bottom up (6/7)

Unlevered risk with a constant IBR

Growing unlevered risk due to greater DOL

DOL = 1 DOL = 2 DOL = 5

Decreasing unlevered risk due to lower DOL

DOL and fixed costs


Q(p)REV c);Q(pEbit0)FC 0;c 0;p( DDDDDDD

If price per unit (p), cost per unit (c) and fixed costs (FC) are

constants, the DOL depends on fixed costs:

Ebit

FC1 DOL

2

(t0)

(t0)

(t0)

(t0)

(t0)(t0)(t0)

(t0)(t0)

(t0)

(t0)

(t0) Ebit

FC1

FCVCREV

VCREV

ΔQ(p)

Q(p)

Ebit

c)ΔQ(p

REV

REV

Ebit

Ebit DOL

D

D

The increase endogenous risk depends on the increase in resources (+ FC) and / or

loss of efficiency (- Ebit)

Bottom up analysis of specific unlevered risk: static

approach

Constant values of price per unit, variable cost per unit, fixed

costs and net investments

ROIEBIT

CFO1

V

IBR ROIDOL

V

IBR σ 2

t0

2

t0

t0

t0t0

t0u


Specific unlevered risk: static approach

(Forecasting analysis)

Analysis phases :

;REV)V~

(RE Revenues Expected

;ROI)I~

(RO ROI Expected

i

n

1ii

i

n

1ii

p

p

T~

EBI

FC1)O

~(DL DOL Expected

;t~

Ebi)t~

(EbiEbit Expectedn

1ii

p

I~

ROL~

DOV~

RE

IBR σu



I~

ROL~

DOV~

RE

IBR σ

2

u

Specific unlevered risk: static approach

(Historical analysis)

ROIDOLV~

RE

IBR σ t0t0u



Bottom up analysis of specific levered risk

(sL) and financial risk: static approach

ROE decomposition:

NI

D-1

t1

NI

DiROI

Equity

incomeNet ROE

NI

D-1

t1

NI

DiROI

Equity

incomeNet ROE

Equity

NI

NI

Equity

1

NI

D-NI

1

NI

D-1

1

Equity

incomeNet

)t1(Equity

FC-EBIT)t1(

Equity

NI

NI

FC

NI

EBITROE


Bottom up analysis of specific levered risk

(sL) and financial risk: static approach

NI

D-1

t1ROIROE

DD

With i, t, D and NI constants

NI

D-1

t-1σ

NI

D-1

t-1 ROI

EBIT

CFO1

V

IBR σ u

2t0

2

t0

t0

t0L

1

NI

D-1

t-1 ROI

EBIT

CFO1

V

IBRσ- σrisk Financial 2

t0

2

t0

t0

t0uL

Bottom up analysis of unlevered risk: dynamic approach

In the case of no constant value of price per unit, variable

cost per unit, fixed costs and net investments, the unlevered

risk depends on the following ratios:

j

j

j

j

j

jNI

FCμ ;

NI

CMθ

CM = Contribution margin (Revenues – Variable Costs)

FC = Fixed costs

NI = Net investments


j

j

j

jj

jjjNI

Costs Fixed-

NI

Costs VariableREVμθROI



Independent variables

• Variance of q (volatility of contribution margin). It affects in positive

way the unlevered risk (su).

• Variance of m (structural instability: volatility of the ratio FC/NI). It

affects in positive way the unlevered risk (su).

• Covariance q, m. It affects in negative way the unlevered risk (su).



μθ,

22μj

σ2θj

σσ j(u) s

Managerial interpretation of sq,m

• sq,m >0 shows the managerial capability to compensate the growth

in investment and fixed costs with the increase in contribution

margin. It decreases the unlevered risk linked to growth strategies.

• sq,m 0 amplifies the unlevered risk caused by growth strategies

Combining static and dynamic approach according to a

managerial logic


l =DOLj/DOLs

X

=

sq(j),m(j)/sq(s),m(s)

X > 1 X < 1

l > 1

l < 1

North West North East

South West South East

Stability state: relative high

specific unlevered risk

Dynamic state: relative low


Stability state: relative high


Dynamic state: relative high


Stability state: relative low


Dynamic state: relative low


Stability state: relative low


Dynamic state: relative high

specific unlevered risk Pro

pensity t

o s

tructu

ral gro

wth

Avers

ion

to s

tructu

ral g

row

th

The bottom up approach may be used to rework the CAPM,

starting from the idea that the systematic risk of a specific

company includes an idiosyncratic component. In other words,

internal firm’s features produce an effect on its beta.

As consequence, first the beta level can be correct taking into

account operating and financial leverage; second the firm’s beta

partially depends on managerial decisions.


Assumptions

• Each industrial sector absorbs a share of market volatility

• Each firm absorbs a share of sector volatility

Beta of sector x Correction Factor = Firm’s Beta

Static approach: Correction Factor = f(ROI, DOL)

Dynamic approach: Correction Factor = f(sq, sm, sq,m)


Correction Factor

Static approach: Correction factor comes from the relationship

between the firm DOL and the sector DOL.

Dynamic approach: Correction factor comes from the relationship

between the drivers of firm risk in dynamic conditions (sq, sm, sq,m )

and the same variables referred to the sector.


The correction factor (f: static approach

j(s)

j(u)

2

S

j

s

j

jjj

β

β

I~

RO

I~

RO

L~

DO

L~

DOγλ

f

Constant values of price per unit, variable cost per unit, fixed costs

and net investments . In addition this formula assumes constant the

market quote of j.

S

)τ1(D1β β

j

j

bj(u)

β

js(u)

b

j(L)

f



72,0)69767,0)(0285633936,1()β)((

0285633936,1)8,0)(285704242,1(

8,015125,0

121,0

I~

RO

I~

RO

285704242,1769230,3

846115,4

L~

DO

L~

DO

j

j

S

j

s

j

sf

f


β

β

σ2σσ

σ2σσ

ρ

ρ

j(s)

j(u)

θsμs,

2

μs

2

θs

θjμj,

2

μj

2

θj

ms,

mj,

j

f

The correction factor (f: dynamic approach


The correction factor (f: dynamic approach


Trade-off between growth and conservation

s(u)

μjθj,

2

μj

2

θj

ms,

mj,

jj

sinvestment strategicWith

j(G)

strategicisinvestment

strategicWithout

jσ

σ-

ρ

ργλ

ssff

jj(G)

jj(G)

jj(G)

)

)

)

ff

ff

ff

c

b

a The strategic growth decreases the

unlevered beta

Short-term effects

The strategic growth doesn’t affect

the unlevered beta

The strategic growth increases the

unlevered beta


According to the CAPM the specific risk of a portfolio well diversified

doesn't matter in order to value the expected return.

A rational investor (who exploits the diversification benefits)

measures the risk-return profile of each single stock taking into

account the systematic risk only.

This behavior is really rational when the investor does not seek

control of companies.

The diversification issue and total beta

The CAPM considers pure financial investors. Normally they pay a

little attention to strategic perspectives of firms. Therefore they

consider the “diversification power” like the main way to optimize their

risk-return relationship.

However, there are other types of investors who look at the risk-

return relationship with a logic partially or totally different the

traditional financial logic. This happens when an operators has

interest in a long-term perspective.

For example: Typically the entrepreneur doesn’t diversify. He tends to

invest his capital in one business; The typical venture capitalist

doesn’t exploit the overall diversification benefits. In fact he tends to

combine the diversification benefits with specialization and network

benefits.



Moreover, "Real investors are influenced by where they live and

work. They tend to hold stocks of companies close to where they live

and invest heavily in the stock of their employer. These behaviors

lead to an investment portfolio far from the market portfolio

proscribed by the CAPM and arguably expose investors to

unnecessarily high levels of idiosyncratic risk". (Barber 2011)


The total beta model has been developed by Damodaran and then

it has been deepen by other scholars.

In general, total beta model aims to overcome limits of CAPM in the

case of those investors who tend to concentrate their portfolio in

one or few sectors.


For investors without any diversification, who invest just in firms belonging to a

given industry, the total unlevered beta can be calculated as an inverse function

of the industry correlation coefficient against market portfolio dynamic:

σ

σσβ

ρ

βTβ

ms,

mss(u)

ms,

j(u)

j(u)

rs,m correlation coefficient between the sector s and market portfolio (m)

s(u) average unlevered beta of sector s

ss,m covariance between the between the sector s and market portfolio (m)

ss st. deviation of sector s

sm st. deviation of m

An other way proposed by Damodaran to overcome the

diversification issue is to correct betas through the correlation

coefficient between the investor’s portfolio and market ones.

In the case of perfect correlation, there is no beta’s correction.

In the case a correlation coefficient lower to 1 the beta’s correction

depends on the reciprocal value of the correlation coefficient.


Total Beta (T) – Damodaran’s model

σ

σσβ

ρ

βTβ

mk,

mkj(L)

mk,

j(L)

j

rk,m correlation coefficient between the portfolio of investor (k) and market portfolio (m)

sk,m covariance between the portfolio of investor and market portfolio

sk st. deviation of portfolio k

sm st. deviation of m


Total Beta (T), business life cycle and equity cost


Beta

Total Beta

Equity cost

Diversification grade

of shareholders

Entrepreneurial

firm

Public

company

Risk premium

as function of

specific risk

only

Risk premium

as function of

systematic risk

only

Risk premium

as function of

both specific

and systematic

risk

Strengths and limits of T

• The T is the main model in order to take into account kinds of investors who have a low

propensity to diversify.

• The T formalizes the higher equity cost of private firms.

• The T arises like a powerful way to maximize speculative profits for those investors who

have a dominant position against their firms target

•The T violates the principles of the CAPM (Butler, Schurman, 2011).

• The T causes the transfer of risk due to the characteristics of the investor

(low diversification) towards the firm. This implies that two similar firms in terms of market,

size, intrinsic business risk and so on may operate with a different opportunity cost of

capital.

• The T could be a good tool just in the subjective perspective of the investor.

• The T doesn’t work well in the case of valuation done by an independent professional.


L ρ

1

S

)τ1(D1β RfRmRfke

)4(

j

jTβ

)3(

mk,

anlysis up Bottom

bj(L)

β

)2(

j

j

bj(u)

β

)1(

js(u)j

factorCorrectionfactor

CorrectionfactorCorrection

factorCorrection

f

Lj measures the premium linked to the illiquidity risk


The premium linked to the illiquidity risk comes from the opportunity

cost caused by the wait necessary to demobilize an activity.

The waiting time causes four main disadvantages :

1) Not maximize the capital gain by quickly selling the stock at the

best time;

2) Not exploit new investment opportunities by using cash in flow

coming from the stock selling;

3) Transaction costs;

4) Limitation in order to make personal expenses.


The fourth correction (Lj)

The premium linked to the illiquidity risk comes from the opportunity

cost caused by the wait necessary to demobilize an activity.

The waiting time causes four main disadvantages :

1) Not maximize the capital gain by quickly selling the stock at the

best time;

2) Not exploit new investment opportunities by using cash in flow

coming from the stock selling;

3) Transaction costs;

4) Limitation in order to make personal expenses.

Illiquid assets valuation should imply a higher discount rate against

the case of liquid assets valuation



Tow general ways to face the illiquidity issue:

1) Illiquid assets valuation should imply a higher discount rate

against the case of liquid assets valuation;

2) To value illiquid condition as inability to exploit a sort of put option:

inability to sell when the price of the underlying asset goes up



Basic issues about systemic risk


Prof. Antonio Renzi

Agenda

292

The financial crisis 2007/2008

Real systemic risk

Systemic risk concept

The concept of systemic risk

293

The systemic risk is a macro system “wide-risk” related to financial

and/or real economic instability coming from: interconnections

between economic operators; interconnections between specific

defaults; collapses of macro areas of economic system; etc.

The systemic risk matters at macro and micro level:

• At macro level the systemic risk is the main driver of both

regulations (especially in the financial system) and

macroeconomics analyses about macro economic and financial

instability;

• At micro level the systemic risk awareness should influence the

risk management manners of single units

294

Systemic

risk

Macro level implications:

-News regulations about

systems stability more

based on a holistic view

(emphasis on economic

and financial networks);

- New public policies

against wide- collapses;

- Analyzing micro-risks

as drivers of macro-

risks.

Micro level implications:

-Enlargement of risk

management tools;

- Greater emphasis on

compliance risks;

- Increasing role of

corporate governance

systems in relation to

risk management

processes;

- New challenges in

terms of idiosyncratic

risk assessment.


295

Two kinds of systemic risk

1) The systemic risk coming from a domino effect: a single unit failure

causes a cascade failures

2) The systemic risk coming from correlated disasters: a single event (or

the combination of multiple events) causes the simultaneous collapse of

a macro system in each its components (or in the most part of them).


296

The systemic risk as consequence of network interconnections

The systemic risk coming from both a domino effect and correlated

disasters depends on network interconnections.

Network interconnections have always been the basis of the

transmission mechanisms necessary for the functioning of the

economic and financial systems.

In the last decades, economic and financial interconnections have

increased more and more as a result of the following three phenomena:

1) Diffusion of digital technologies;

2) Globalization of markets;

3) Outsourcing strategies.


297

According to traditional economic and financial studies macro systems based on ring

interconnections are weaker and less efficient against those systems based on network

conjectures. Starting from the financial crisis of 2007/08 an efficient network is seen as a

systemic risk amplifier (Battiston et al., 2009, Blume et al. 2011). “More densely connected

financial systems are more prone systemic risk” (Acemoglu D., 2012, presentation of

“Systemic Risk: Insights From Networks” at The American Finance Association, Chicago).

Ring interconnections , network interconnections and systemic risk

Ring interconnections Network interconnections

Higher efficiency without

strong shocks

Higher systematic

risk exposure


298


“Rings” are stable and incomplete networks. They generate a linear systemic risk

based on interconnections coming from input-output relationships.

Complete networks are unstable. They generate a no-linear systemic risk based

on simultaneous interconnections coming from wider relationships.

Ring interconnections , network interconnections and systemic risk

299

1) The mixing of macro and micro has caused a financial crisis

which was not generated by the stock market. In fact, in the in

the period 2002-2006 there was a gradual reduction in the

average price / earnings ratio.

2) The main macro cause of financial crises has been an excess of

liquidity favored by monetary policy.

3) According to Shiller, the emergence of subprime mortgages is

attributable, on the one hand, to Federal Reserve unawareness

of the real estate bubble risk, on the other to the “contagion” that

characterizes the euphoria phases (behavior economics).

What did we learn from the financial crisis (2007/2008)?

The financial crises (2007/2008)

300

4) According to some scholars, rules aimed to favor financial

stability (e.g. Basel 2) have been a cause of financial instability:

The minimum capital requirements (Basel 2) led financial

institutions to finance activities that in a given period presented

a high market value, thus fueling the formation of speculative

bubbles (pro-cyclic behavior);

The financial stability rules have increased conflict of interests

between banks and rating agencies;

The financial stability rules led financial institutions to externalize

their risks.



301

5) Corporate governance models led managers to aim short run

goals.

6) The end of the time factor: the “profits formalization” before their

actual realization.

7) Financial instrument studied for covering risk have become

drivers of both micro and systemic risk.



302

"We all agree that the technology of new cars has been aimed at

increasing the security level. The problem arises when we don't

use this technological advantage to increase our security but to

increase speed at which we travel or to travel in adverse

weather conditions“ (Synthesis of the Interview with Merton

made by Gianfrate, "Economia e Management“, 2008).

Why did derivatives and other financial engineering instruments amplify

the crisis of 2007/08?


303

The most part of systemic risk studies focused on financial system. It depends on

three main factors: 1) the interconnections inside financial system (or its specific

parts, e.g. bank system) arise in a clearer way against the case of real economy

system; 2) the financial system is governed by authorities (BCE, Federal

Reserve, SEC etc.) which have the task of aiming for macro-financial stability; 3)

In the last decades financial systemic risk occurs with more frequently

(1999/2000; 2001; 2007/2008; 2011/2012)

However, in last years scholars and public decision makers pay a

higher attention real systemic risk in terms of:

-The double relationship between financial systemic risk and real

systemic risk;

- Infra-sector real systemic risk;

- Inter-sector real systemic risk

Real systemic risk

304

Real systemic risk

The double relationship between financial systemic risk and real systemic

risk

Financial

system

collapse

Failure of a

no-financial

firms

number

Real

economic

system

collapse

Real

economic

system

collapse

Failure of a

financial

firms

number

Financial

system

collapse

305

Real systemic risk

Intra and inter-sectors interactions

F1

F4 F2

F3

S1

S4 S2

S3

Intra-sector

interactions

Inter-sectors

interactions

306

Real systemic risk

Leontief’s model: linear inter-sector interactions

Inputs

Outputs

ai,k = technical coefficient which measures the quantity of the product i needed to produce a

unity of the k product.

Industries S1 S2 S3 S4 … Sn

S1 a1,1 a1,2 a1,3 a1,4 … a1,n

S2 a2,1 a2,2 a2,3 a2,3 … a2,n

S3 a3,1 a3,2 a3,3 a3,4 … a3,n

S4 a4,1 a4,2 a4,3 a4,4 … a4,n

… … … … … … …

Sn an,1 an,2 an,3 an,4 … an,n

Vector matrix of the technical coefficients

307

Real systemic risk

Leontief’s matrix: linear inter-sector interactions

Inputs

Outputs

Industries S1 S2 S3 S4 … Sn

S1 a1,1X1 a1,2X2 a1,3X3 a1,4X4 … a1,n Xn S S1

S2 a2,1X1 a2,2X2 a2,3X3 a2,4X4 … a2,nXn S S2



… … … … … … … …

Sn an,1X1 an,2X2 an,3X3 an,4X4 … an,nXn S Sn

Xi = produced quantity of the product i

SSi = Total production of industry i

308

Real systemic risk

How we can use the Leontief’s matrix for analyzing the real systemic risk

-An interruption of one or more input/output interconnections may produce a real economy

collapse.

-Causes of the above interruption may come from a domino effect and correlated disasters

as well.

-For estimating the real systemic risk we need to find a measure about current intensity

sectors interconnections.

- We need to figure out how new technologies may change the intensity sectors

interconnections.

Firm’s risks and enterprise risk management (ERM)


Prof. Antonio Renzi

Agenda

310

Decision making under risk, uncertainty and ambiguity

conditions

The risk management role

The ERM framework

Firm’s risk classification


conditions

311

Main definitions of risk

1. Risk equals the averege expected volatility

2. Risk equals the expected loss (Willis, 2007).

3. Risk equals the expected disutility (Campbell, 2005).

4. Risk is the probability of an adverse outcome (Graham and Weiner, 1995).

5. Risk is a measure of the probability and severity of adverse effects (Lowrance 1976).

6. Risk is the fact that a decision is made under conditions of known probabilities (Knight,

1921).

7. Risk is the combination of probability of an event and its consequences.

8. Risk is defined as a set of scenarios, each of which has a probability and a consequence

(Kaplan and Garrick 1981; Kaplan 1991) Risk Management theory: the integrated

perspective and its application in the public sector 92 ISSN 0717-6759

9. Risk is equal to the two-dimensional combination of events/ consequences and associated

uncertainties (will the events occur, what will be the consequences) (Aven 2007).

10. Risk refers to uncertainty of outcome, of actions and events (Cabinet Office 2002).

11. Risk is an uncertain consequence of an event or an activity with respect to something

that human’s value.

Source: Ignacio Cienfuegos Spikin (2013)


conditions

312

Firm’s decisions and risks

The decision-making process is strongly influenced by the decision maker's

subjective degree of risk appetite. Risk-averse operators (managers,

entrepreneurs, investors, etc.) tend to set low profitability objectives, thus incurring

opportunity costs due to the waiver of high returns on capital.

On the other hand, risk-inclined operators tend towards maximizing expected

profitability and are therefore willing to face particularly uncertain expected

performances.

With specific reference to businesses, the risk appetite also depends on the internal

structural characteristics of the organization and on the financial and equity

capacity to bear economic imbalances induced by particularly risky decisions.


conditions

313

Firm’s decisions and risks

A low propensity to take risk implies taking the risk of "not doing". For example, the

renunciation of investments aimed to make innovation eliminates the risk

associated with innovation processes, but generates the risk of losing development

opportunities.

In recent decades, companies that have not invested in knowledge have often

increased strategic and operational risks.

In the knowledge economy the firm needs find a right trade-off between the

mitigation of the risk linked to complex investments and that caused by their non-

realization.


conditions

314

Business opportunities and the rational behavior against firm’s risk

according to an adaptive logic

No new expected

Business opportunities

Expected stability of the

competitive context

Current stability of the

competitive context

No new current

opportunities Increase in

efficiency and

firm’s risk

minimization

New expected

business opportunities

Expected instability of the

competitive context

Current instability of the

competitive context

New current

opportunities

Temporary efficiency

reduction,

increase of risk

associated to new

strategic

investments,

minimization

of "not do" risk


conditions

315

Business opportunities and the rational behavior against firm’s risk

according to an proactive logic

No new expected


Managerial orientation:

the competitive

environment stabilization

Increase in

efficiency and

firm’s risk

minimization

Temporary efficiency

reduction,

increase of risk

associated to new

strategic

investments,

minimization

of "not do" risk

No new current


Behavior of a leading company operating in a stable market

New expected


Entrepreneurial

orientation:

destructive innovations

New current


The behavior of the innovator: breaking down the existing

competition rules

The risk seen as a danger than consolidated advantages

The risk seen as an opportunity for creating new advantages


conditions

316

Firm’s decisions and risks: the risk culture issue

In the most part of firm’s (especially SMEs) managers and entrepreneurs are not

aware of risk concept and how firm’s risk may be analyzed and managed.

This issue comes from come from risk is intrinsic to each business. In other words

risk is seen as natural condition that each firm can’t face in terms of scietific

management.


conditions

317

Firm’s decisions and uncertainty

The selection of choices based on risk, both in case of an adaptive and proactive

logic, can be formalized through an explicit analysis of the probability distribution

about expected events.

The quantification of the risk, however, is often accompanied by the inadequacy of

the information available, by a poor ability to interpret the observed reality and / or

by an objective indeterminacy of the relevant factors. This causes, in the context of

the forecast estimates, the impossibility of including all possible changes in the

scenario, the set of interpretative variables and the changing relevance that these

can assume over time. Therefore forecast analyzes often cause provisional and

partial or even completely wrong results.

When the subjective and/or objective information and knowledge are not sufficient

to define a probability distribution the decision maker moves for risk conditions to

uncertainty.


conditions

318


According to Knight (1921) risk and uncertainty differ markedly: while the risk expresses

a measurable volatility, the uncertainty concerns unpredictable events, or for which it is

not, in any case, possible to define a probability distribution.

Risk and knowledge: “you don’t know for sure what will happen”

Uncertainty and knowledge: “you don’t even know the odds of what will happen”

(Adams, 2005 in Hermans et al., 2012)


conditions

319


Subjective uncertainty of an individual

or organization:

- Lack of skills;

- Inability accessing relevant information;

- Too much information and inability to

manage big date;

- etc.

Objective

uncertainty:

- Unpredictable events;

- Predictable but too unlikely events;

- Exogenous events than the economic

system;

- etc.


conditions

320

The risk is a complicated issue that may be solved through a set of models and

techniques


The uncertainty is complex issue that can never be completely resolved, because to face

complexity means to generate new complexity.


conditions

321

Business decisions can be optimized, in terms of expected

profitability and the risk they incorporate, only to the extent that it is

possible to attribute weight to future events. This possibility

decreases with increasing environmental instability, to be

understood as rapid changes within the competitive environment in

which the company operates.

In this regard, Stacey (1996) analyzes the relationship between

environmental dynamism and decisional complexity according to

three types of changes:

1) closed change;

2) limited change;

3) open change.



conditions

322

The closed change identifies a variability that has already

occurred in the past and, as such, characterized by a low or even

zero level of decision-making complexity.

The limited change refers to an event that has already happened,

the current manifestation of which, however, presents elements of

differentiation compared to past ones.

Open change occurs when unique situations emerge and have

unpredictable consequences (positive or negative).



conditions

323

The proposed distinction between risky and uncertain phenomena

must not be considered in absolute terms: on the one hand a

phenomenon can include elements of both calculable risk and

pure uncertainty, on the other, it can alternate between high and

low uncertainty over time.



conditions

324

The ambiguity issue arises when the decision maker has more

beliefs (or probabilities) in his/her mind in order to predict future

events.

The decisional ambiguity leads to move from maximization to

minimization goals.

Firm’s decisions and ambiguity


conditions

325

The ambiguity level tends to increase in the case in which the

decision maker is a group of people, as in the case of a firm board,

that assumes strategic decisions . It is a sort of “group ambiguity ”,

in the sense that each member of the decisional group is the

source of a personal beliefs bout expected events.



conditions

326



conditions

327

Combination between uncertainty and ambiguity


conditions

328

According to some scholars, the combination of uncertainty and

ambiguity determines the following two effects: a greater aversion

to undertake innovative initiatives, or in any case, characterized by

discontinuity with respect to the past; the transition from a

maximizing logic, based on the search for the objectively better

solution, on a minimizing logic, based on the search for the best

result in the context of the minimum hypothesis.

However, uncertainty and ambiguity in business decisions also

produce growing opportunities connected with the discontinuity of

the context (Fiocca, 2007, p. 7.). The difficulty in fully quantifying the

risk and the decision-making errors that derive from it amplify, that

is, the spaces for the development of innovative projects and the

emergence of new entrepreneurial subjects devoted to innovation.



conditions

329

For example, the birth and development of Microsoft (in the late 70s

and early 80s) would not have been possible if the main competitor

(IMB) would have owned a set of information and sufficient

knowledge to consider a wide range of future scenarios and to

assign them a unique probability of occurrence.



330

-Financial risks

- Strategic risks (or business risk)

- Investment projects' risk

- Technological risk

- Operational risks

- Compliance risks

- Pure risks


331

- Liquidity risks

- Credit risks

- Market risks

Financial risks are easier to indentify against other risk kinds. Their

evaluation and treatment is partially regulated. The most part of

quantitative risk management models focus on financial risks.

Financial risks


332

Firstly, liquidity risk arises from the illiquidity of one or more assets:

difficulty to sell one or more assets at a price close to the initial

price (low marketability).

Secondly, the liquidity risk depends on the waiting time necessary

to transform one or more assets into cash.

Thirdly, this type of risk relates to the firm's inability to generate

cash flows at the right time.

Financial risks – Liquidity risks


333

The credit risk regards losses due default or insolvency of

commercial or financial borrowers.

Non Performing Loans (NPLs):

NPLs are generally banks' exposures to operators who (due to a

worsening of their economic and financial situation), are unable to

meet their obligations in terms of debt service.

The Bank of Italy divided the NPLs into three main categories:

1) Credits that have expired or exceeded the credit limits for more

than 90 days and beyond a certain threshold;

2) Credits which according to the bank's analysis will not (fully or

partially) be respected;

3) Credits given to operators in a state of insolvency.

Financial risks – Credit risk


334

Financial risks – Strategic resolution of NPLs: Turnaround

NPLs can be due to strategic and/or liquidity causes. Strategic crises and

liquidity crises can affect each other. When according to the financial backer the

firm’s insolvency cannot be solved with a firm’s radical change, the NPL

resolution in based on formal procedures.

Instead, in the case the borrower (firm) has a potential margin to overcome the

crises (strategic/economic crisis and related insolvency), the resolution of a

NPL could be based on a turnaround process. This process leads to a

corporate radical change.

First the turnaround process is based on an assessment aimed to identify the

reasons for failing performance.

Second, the turnaround process needs a planning activity to save the firm in

trouble and returns it to solvency.

Often a turnaround process meets the unwilling of firm’s owner (or

management) and/or problems due organizational rigidity.


335

Financial risks – Strategic resolution of NPLs: Turnaround

The turnaround stages in brief

- Assessment stage: analyzing current weaknesses and current/potential strengths. This

initial stage becomes the final stage if the assessment results show the impossibility to

make a turnaround process.

-Management of change: changing the firm’s philosophy and spread it to financial and

non-financial stakeholders; aligning the change to the expectations of internal and

external stakeholders; tying every internal and external actor to the same set of goals.

- Emergency action stage: focusing on cash and assets/liabilities management to save

the firm’s live in the short period.

-Business restructuring stage: restructuring the business by finding new profitability

sources; adapting the organization structure to new internal processes; implementing an

internal control process.

- Return to normal stage: institutionalizing the changes in corporate culture. Appling

changes to achieve proper level of competitive advantage, profitability, cash flows etc.


336

Market risks depend on fluctuations in the value of aaset/liabilities

caused by:

- stocks’ prices dynamic;

- interest rates dynamic;

- currency exchanges’ dynamic;

- commodities’ prices’ dynamic.

Financial risks – Market risks


337

The strategic risks concern:

- The possibility of losing the current competitive position. A part of

this risk kind depends on potential changes in the specific

competitive environment where the firm is working; an other part

comes from changes in public institutions, laws, macro-economy

etc;

- The irreversibility degree of strategic decisions.

Both the risk of losing the current competitive position and that

coming to irreversibility decisions are negatively correlated with

strategic flexibility.

Strategic risks (or business risk)


338

Strategic risks – Sector risk: 5 competitive forces (Porter 1985)


339

Strategic risks investments – Strategic investments, ex ante and

managerial flexibility

The ex ante flexibility regards the faculty to make strategic investments

before the occurrence of the expected changes. For example, the firm makes

an investment to improve its productivity in the perspective of a demand

growth.

The managerial flexibility regards the possibility to change the investment

strategies after the occurrence of new scenarios. For example, an investment

aimed to improve the productivity could be reduced, when the real growth of

the demand is lower than the potential growth estimated before the

investment decision. The exploitation of managerial flexibility may consist in

an adaptation to changes in the environment, to reduce endogenous

uncertainty and/or to affect the environment to firm’s favor (Sanchez, 1993;

Sanchez & Mahoney, 1996).


340

Strategic risks – Strategic investments, ex ante and managerial flexibility

Drivers of ex-ante

flexibility:

- Prediction capacity;

- Propensity towards changing;

- Innovation propensity;

-Low sunk costs;

- Current economic and financial

strengths;

- Previous knowledge investments;

- Current internal resource;

- etc.

Drivers of

managerial flexibility:

- Intrinsic flexibility of strategic

investments;

-Dynamic capabilities;

- Multi-use resources;

- Low sunk costs;

- Flexible knowledge;

- No-linear strategic plans;

- etc.

Increasing in

symmetrical

volatility

Increasing in up side

volatility; decreasing in

down side volatility


341

Strategic risks – Strategic investments, ex ante and managerial flexibility

The combination of these two flexibility kinds (ex ante and

managerial flexibility) allows:

• To realize investments aimed to exploit expected changes

• To correct investment decisions, once verified the effective

dynamic of several independent variables.


342

Technological risks

• Risks linked to the existing technologies

• Risk of switching costs of new technologies

• Risk linked to new technologies adoption


343

Technological risks - Switching costs

Often, the adoption of a new technology requires further investments, as

those one made for compatibility among products.

For instance :

• A new software could require further investments to update already

existing software;

• A new plant could require additional investments for human resources

training

• There could be penalties due to previous suppliers in case of switching.

Moreover, the innovative technology could increase the supply risk, if it’s

a real risk or just a difference in risk perception.


344

Technological risks – Technology adoption Two drivers:

1)Intrinsic value: the adoption degree is linked to the economic dimension of a specific innovation (e,g. new machinery that allows lower production costs)

1)“Bandwagon” behavior: the adoption degree of an individual (or a firm) depends on the behavior of other individuals (or firms)


345

Technological risks – Technology adoption

Innovation Users

Value

maximization

To be similar

to the others

Adoption

motivation Adoption

Behavior

Rational

Imitation

Intrinsic value

Bandwagon


346

Technological risks – Technology adoption

Intrinsic value logic

Risk of possible

mistakes about

effective economic

utility

Bandwagon logic

Risk of unawareness

about effects coming

from a new technology


347

Operational risks

Operational risks are the risks of losses

inherent in business operations, arising

from:

• Human errors;

• Incorrect functioning of processes;

• Illegal behavior connected with

fraudulent conduct of managers, of

employees or external subjects;

• Risk of change in one or more laws;

• Risk of legal disputes

• Inadequate in conduct with customers and suppliers; etc..


348

Compliance risks

• The risks of conformity deriving from failure compliance with laws, internal

regulations and external regulations.

• These risks can give rise to effects negatives related to penalties, penalties,

fines, economic losses and, in cases more serious, to damage to reputation

corporate with consequent losses, compensation claims etc.


349

Compliance risk: the role of corporate governance

Compliance risks and corporate governance framework are closely connected.

This produces two effects:

-A decisive role of firm’s board in order to define risk management goals;

- Standardization of risk management process


350

Compliance risk: the role of corporate governance

Compliance

risk

mitigation

Ensuring compliance

with funders terms

and conditions

Compliance with

current

legislation

Corporate governance

rules and actions


351

Pure risks

Pure risks are linked to external events that can negatively influence company.

They are "insurable" risks fall into this category, that is associated with events

such as natural disasters, damage, injuries or accidents that in generally they

can cause damage to third parties, as well as terrorist acts, robberies, thefts,

etc..


352

• The implementation of Risk Management (RM) allows the

company to make informed decisions, mitigating the effects of

potential negative events.

• The RM activity is one of the 2 level controls

• The RM activity plays a cross-cutting role in the organization as

whole.


353

Risk management process

Step 1 Step 2

Risk

Identification

Risks

quantification

Risks

management

Step 3

Risks

monitoring

Define and

identify all

sources of

risk; actual,

anticipated,

and perceived

Estimate the

financial

impact on the

firm of all

pure and

speculative

risks identified

Decide how

to manage

pure and

speculative

risks (through

loss control,

loss financing,

risk reduction)

Track and

assess the

performance

of the risk

management

strategy in

light of actual

experience)

Step 4

Feedback Source: Erik Banks, Chapter 3


354

External role of risk management

Risk

Identification

Risks

quantification

Risks

management

Risks

monitoring

Communication about: -the risk profile of the company;

- the ways adopted to face the risk;

- the effectiveness of the RM process;

- how to improve the MRI process.

Financial and

non-financial

stakeholders


355

Firm's reaction than its risks

-Avoid risk by rejecting risky actions as much as possible.

- Loss prevention.

- Separation.

- Diversification.

- Risk financing through mechanisms of transfer or retention.


356

Thre

e leve

ls o

f R

M

Risk pooling Risk transfer

Hedging: Risks are not pooled as

such, but transactions undertaken

which have the economic effect of

selling (or transferring) the risk.

Risks are exchanged (transferred)

from one party to another

Diversification: Risks are placed into

portfolios and the aggregated risk is

less than the sum of the individual

risks

Insurance: Assumed risks, as in the

case of insurance, may be pooled at

the aggregate level and hence risk

taker may get benefits of

diversification

No risks are transferred: risk

reduction is obtained through portfolio

effects

Risks are sold (transferred) from the

buyer to the seller. Seller assumes all

future uncertainty about value

Source: Moles P. (2016)

Risk pooling and risk transfer


357

An enlargement of risk transfer concept

-Risk transfer through insurance companies

- Risk transfer through hedging operations

- Risk transfer through risk sharing agreements

- Risk transfer through unilateral changes of remuneration of employees and /

or suppliers.


358

Causes of risk management failure

- Weak transmission mechanisms between corporate governance and the risk management

area.

- Poor involvement of internal and external stakeholders in order to define strategies and

goals of RM.

- Each risk kind is considered in a stand alone way.

- Lack of management supports.

- Different ways of considering risk.

- Different levels of risk appetite.

- Failure to share information.

- Low level of risk culture.

- Aversion to RM: RM is considered as a set of mandatory but not useful procedures.

- The entrepreneur (or the management) looks at risk as an inevitable thing inherent in the

life of a company.

- Difficulties to combine quantitative and qualitative risk assessment tools.

359

The corporate governance concept

Corporate Governance Management

Corporate governance definition:

“The corporate governance is the action, the way, the fact or the function to

dominating and controlling the firm” (Oxford Dictionary)

The risk management and corporate governance

360

How and when start the Corporate Governance:

- the firm acquire legal personality (Corporation of capital or partnership of individual. In this way there is a separation of responsibilities between the ownership and the firm. The legal personality introduced the firm’s constitutions

- the increase of the firm’s size. The growth of the size determined the born of delegation mechanism. The owner delegates some functions to manager. For this reasons It becomes necessary to monitor the actions of managers.


An example of presence of the delegation mechanism between owner and manager in the public company: large companies with a growing number of shareholders interested only equity return.

The shareholders delegate their governance rights to managers.

The manager becomes the “King”. Perfect Management firm

The managers aim to provide returns for shareholders increasing the price of the shares.

It 'important to identify the mechanisms witch protect the ownership of opportunism manager. (Agency theory)

Delegation mechanism


362

The Independent Directors role

The Independent Directors

The importance of

the independent directors is

affirmed with the rules of

good governance

related to the reform of

company law

It establishes a minimum

limit of presence of independent

board member

In 2012 the average

proportion of independent directors on the boards is

36% (Assonime,

2013). Today the percentage is much higher


363

The reform provides the formation of the internal Board Committees (Nomination, Remuneration Committee, and Risk Control Committee).

The Corporate Governance Code recommends that the office of President of Control Risks and Remuneration Committees is covered by an independent director.

The legislation says that committees have a majority of independent directors.

The international literature suggests an exclusive presence of independent directors on committees

The growing importance of risk management in the corporate governance

system


The growing importance of risk management in the corporate governance

system

Shareholders

meeting

Board of

directors or

single

administrator

Control and risk

committee

Remuneration

committee

Appointment

committee


365

Internal control and risk management system (Corporate Governance

Code)

-The Corporate Governance Code is a set of principles and recommendations

that can be voluntarily adopted by companies listed on the main stock markets.

-The adoption of the Corporate Governance Code entails a specific report. This

report must be spread, so it is public document usable by internal and external

stakeholders.

- The principles and recommendations Corporate Governance Code are the

base on which the above report is built taking into account characteristics of

each individual company in terms of strategic objectives, organizational

structure, operational processes and so on.

A part of Corporate Governance Code regards issues about internal

control and risk management system.


366


Code)

“Controls system is one of the critical issues of a listed company governance.

Its components are rather diversified and range over from the so-called “line

control” (or “first level control”) carried out by persons in charge of operational

areas to the so-called “management control”, relating to business planning and

controlling, up to internal auditing, that is the global assurance on design and

functioning of internal controls” Banca D’Italia 2018.


367


Code):

- Each issuer shall adopt an internal control and risk management system

consisting of policies, procedures and organizational structures aimed at

identifying, measuring, managing and monitoring the main risks. Such a system

shall be integral to the organizational and corporate governance framework

adopted by the issuer and shall take into consideration the reference model and

the best practices that are applied both at national and international level.

- An effective internal control and risk management system contributes to the

management of the company in a manner consistent with the objectives defined

by the Board of Directors, promoting an informed decision-making process. It

contributes to ensuring the safeguarding of corporate assets, the efficiency and

effectiveness of management procedures, the reliability of the information

provided to the corporate bodies and to the market and the compliance with

laws and regulations, including the by-laws and internal procedures.


368


Code):

The internal control and risk management system involves each of the following

corporate bodies depending on their related responsibilities:

a) the Board of Directors;

b) The Internal Audit;

c) the other roles and business functions having specific tasks with regard to

internal control and risk management, depending on the company’s size,

complexity and risk profile;

d) the Board of statutory auditors.

Each issuer must provide for coordination methods between the above

mentioned bodies in order to enhance the efficiency of the internal control and

risk management system and reduce activities overlapping.


369


Code):

In order to control the firm’s risks and implement a risk management system,

The Board of Directors (BD) acts according the following principles and

recommendations:

- BD defines the general rules in order to align the internal control and risk

management system with the company's strategies;

- BD defines principles aimed at maximizing the effectiveness of the system

itself, reducing duplication of control activities and ensuring proper system's

functioning;

- BD indicates manners to check and assess functioning of internal control and

risk management system ;

- the CEO (chief executive officer) is responsible for establishing and

maintaining the internal risk control and management system.


370


Code)

The BD establishes the Control and Risk Committee , whose task is that to

support the assessments and decisions of the BD relating to the internal risk

control and management system and approval of the financial and non-financial

periodical reports.


371

The Internal Audit (IA) :

- the IA office is responsible for verifying that the internal control and risk

management system is functional and in line with what is defined as defined at

DB level.

- the IA verifies the compliance system than both specific characteristics of the

company and international best practices, through continuous checks and

periodic analyzes.

- the IA defines the audit plan, based on a risk analysis process and

identification of the most significant risks. This plan to be approved by the BD.


372

Expected

shocks in

revenues

Unlevered

Risk: volatility

of operating

profit

Degree of

operating

leverage

Decreasing

of enterprise value

Risk management, corporate governance and income smoothing

Income

smoothing

Avoid


373

Risk management, corporate governance and income smoothing

Expected

shocks in

revenues

Potential volatility

of operating profits

caused by

operating leverage

degree

Corporate

governance

Risk

management

Unlevered Risk

transfer towards

suppliers and

employs

Operating income

smoothing

Compliance of risk

management with corporate

governance rules

Creation or stabilization

of enterprise

value

De

cre

ase

s

of e

ffectiv

e

op

era

ting

leve

rag

e


374

Income smoothing and inter-temporal risk transfer

A firm can achieve the income smoothing by accounting techniques (artificial

smoothing) and/or by real changes in its operations (real smoothing).

Both real and artificial smoothing imply an inter-temporal transfer of unlevered risk,

considered as a one period risk externalization which may increase and reduce

symmetrically the remuneration of both suppliers and employees. Risks that a firm

cannot eliminate by diversifying its sales activities can be “averaged over time in a way

that reduces their impact on individual welfare. One hedging strategy for non-

diversifiable risks is the use of the intergenerational risk sharing, which spreads the

risks associated with a given stock of assets across generations with heterogeneous

experiences” (Allen & Gale, 1997, p. 525).


375


The extent of income smoothing that is achieved by managers of firms by acting on the

cost of goods purchased, which implies a transfer of unlevered risk linked to revenue

volatility towards suppliers, is likely to be greater in the cases of larger-sized

corporations affiliated with a business group than in smaller-sized corporation

unaffiliated with a business group.

On the one hand the firm’s size allows income in terms of contractual power, belong to

a business allows the risk transfer inter-group on other hand, thanks technological,

financial and/or commercial interactions.


376


Big

com

panie

s

Sm

all

com

panie

s

Groups Single companies

Structural interactions

North West

High inter-temporal transfer of

unlevered risk towards

suppliers

Low/Medium inter-temporal transfer of


employees

North East

High /Medium inter-temporal transfer of


suppliers

Low inter-temporal transfer of


employees

South West

Low/ Medium inter-temporal transfer of


suppliers

Medium inter-temporal transfer of


employees

South East

Low intertemporal transfer of


suppliers

Medium inter-temporal transfer of


employees

Firm

siz

e

Source: Renzi, Vagnani, 2020


377



Big

com

panie

s

Sm

all

com

panie

s

Groups Single companies

Structural interactions

North West

Transfer of


Suppliers: 76,2%

Transfer of


employs: 7,90%

North East

South West South East

Transfer of


Suppliers: 71,17%

Transfer of

idiosyncratic risk toward

employs : 3,62%

Transfer of


Suppliers: 68,14%

Transfer of


employs : 8,51%

Transfer of


Suppliers: 11,55%

Transfer of


employs : 5,96%

Firm

siz

e

Source: Renzi, Vagnani, working in progress


At the individual companies level, strategies aimed for reducing unlevered risk could

become sources of systemic risk in the real economy. This paradox could be

amplified when the constraint to be compliant with corporate governance rules leads

risk managers for finding an operating incomes smoothing through a transfer of

unlevered risk.

Conclusion and research perspectives

Income smoothing, inter-temporal risk transfer and systemic risk

380

Income smoothing, inter-temporal risk transfer and systemic risk: linear

process


Real systemic risk

381

Income smoothing, inter-temporal risk transfer and systemic risk:

network process


Real systemic risk

The enterprise risk management (ERM) framework

382

Definition and motivations of ERM

The ERM arises as a “natural” evolution of traditional RM.

The ERM is defined as wide approach to risk management where the main focus is

to figure out ways for integrating risks’ analysis and their treatment, taking into

account the firm’s vision and risk appetite according to guidelines coming from

corporate governance and external institution.

The ERM aims to achieve two interacted general goals:

1) Making actions to protect the firm against adverse conditions;

2) Maximizing firm’s value in the long run.


383

From a silo approach and systemic approach

Financial

risks Strategic

risks

Operat.

risks

Comp.

risks

Tech.

risks

Pure

risks

ERM

Financial

risks

Strategic

risks

Comp.

risks

Pure

risks

Tech.

risks

Operat.

risks

Silo approach Systemic approach


384

Definition and motivations of ERM

The need of a higher integration depends on:

• compliance issues;

• the growing role of corporate governance than RM processes;

• the need to fit strategies with the firm's vision and its risk appetite;

• finding ways to combine qualitative and quantitative approaches in risk analysis;

• providing risk management reports that allow internal and external analysts to link

"points" of risk and their drivers deriving from the company's decisions,

characteristics of the internal structure and those of the external environment.


385

The ERM challenge

The ERM is a challenge that has not yet been completely overcome. Its basic idea

is to combine several managerial issues in a holistic manner. It entails to analyze

each risk like a part of a unique risk.

From a theoretical viewpoint, this risk management challenge is in contrast with the

traditional scientific management and fits those studies which looks at organizations

like a complex set of dynamic and interrelated components.

The implementation of a ERM system causes transversal changes across all

organization and imposes new ways of making strategic as well as operating

decisions.


386

The ERM challenge

The ERM challenge fails when:

-There is a lack of risk culture;

- The culture of risk is too specialized and fragmented;

- The investment in ERM is too low;

- Organizational routines prevent a higher interactions between several firm’s areas;

- The ERM implementation is just done in formal terms and/or aims to improve the

firm’s imagine only;

- The firm doesn’t own a proper information system;

- The several firm’s areas are adverse for sharing information to each other;

- The complexity of ERM is a source of entropy, rather than a value driver.


387

Reducing the ERM complexity and the flexibility issue

Typically holistic managerial approaches and models are based on a too high

complexity. This often causes a gap between theoretical principles and their real

application.

Therefore the ERM becomes as an effective risk management tool by framing its

holistic view into a defined framework of actions.

To maintain the holistic view it is necessary to enlarge as much as possible the

ERM framework in terms of its contents.

Anyway, the application of each managerial approach or model needs a given level

of standardization degree.

The best hypothesis arises when a set of ERM standards may be used with a

flexibility margin in order to adapt the ERM actions to new events, emerging

knowledge, new technologies, etc.


388

Reducing the ERM complexity

In the last years public and private institutions tried to reduce the ERM complexity

through easy to understand models (but not always easy to apply), based first on a

“visual” representation of what ERM is about, second by framing in a sequential

way the crucial steps of an ERM process.

The most popular ERM models come from the following organizations :

-ISO: International Organization for Standardization;

- CoSO: Committee of Sponsoring Organizations of the Treadway Commission,

private organization.


389

ISO 31000

ISO 31000 provides general principles and guidelines about risk management. It

can be used by any kind of organizations (firms, public institutions, associations etc)

belonging in any sectors.


390

ISO 31000

General principles of ISO 31000:

- The risk management must aim not only to avoid (or mitigate) risks but also to

create value;

-The analysis and treatment of risk must be integrated in the all organization;

- The risk management acts as a support and constrain than firm’s decisions;

- The risk management process must be adapted to characteristics of each

organization, even taking into account human and culture factors;

- The risk management actions must be transparent;

- The risk management must be faced according to the logic of continuous

improvement (similarity with Total Quality Management logic).

The enterprise risk management framework

391

Committee of Sponsoring Organizations of the Treadway Commission

(CoSO) report

"A process, activated by the Board, management and the entire corporate

structure, oriented to the application of the strategy defined by the company,

aimed at identifying potential events that could compromise

company performance and risk management within the defined

risk appetite, and who provides reasonable insurance of

achievement of business objectives "


392

Committee of Sponsoring Organizations of the Treadway Commission

(CoSO) report

The CoSO ERM framework implies a multi-discipline logic. According to CoSO

the ERM considers the firm as whole:


393

Internal environment

The internal environment depends on the tone of an organization

which determines: how risk is viewed by managers and workers;

the risk appetite and risk management philosophy; ethical values.

The organizational tone may be defined as the atmosphere that is

created in the workplace by the organization's leadership.


394

Internal environment

Internal

environment

↓

Organizational

tone

Risk appetite

Propensity

towards risk

management

Ethical values


395

Objective strategy-setting according to CoSO ERM

The ERM helps in alignment risks linked to potential alternative strategies as well as

already adopted strategy with decisions taken at higher level coming from the board of

directors.

Risks

alignment

ERM Principles and rules

Ex a

nte

support

Ex post control

Select one or more strategies

among several alternatives


396

Objective strategy-setting according to CoSO ERM

Risk misalignment and strategy rejecting

According to CoSO ERM a risk misalignment must lead the management to

reject a strategy, even when it achieves its goals.


397

Identification of risk events

-Identification of events capable of influencing company performance positively

or negatively.

-Analysis of interdependencies between events.

Typical techniques for identifying:

-Brainstorming;

- Event inventories and loss event data;

- Interviews and self-assessment;

- SWOT analysis;

- Scenario analysis


398

Identification of risk events – Brainstorming

The brainstorming allows to combine different a knowledge flows among teams with

specific skills about organization’s areas and related risks.

Facilitating a brainstorming session takes special leadership skills, and, in some

organizations, members of the internal audit and ERM

In general, a brainstorming is not simple meeting to achieve opinions and idea.

Therefore, participants have been trained and certified to conduct risk brainstorming

sessions.


399

Identification of risk events – Event inventories and loss event data

This techniques is often used into risk brainstorming. It improves the brainstorming

quality.

For instance event inventories and loss event data may regard the industry where

the firm works.


400

Identification of risk events – Event inventories and loss event data


401

Identification of risk events – Interviews and self-assessment

“This technique combines two different processes. Each individual of the

organizational or operating units is given a template with instructions to list the key

strategies and/or objectives within his or her area of responsibility and the risks that

could impede the achievement of the objectives. … Each unit is also asked to

assess its risk management capability using practical framework categories such as

those contained in the CoSo ERM framework” (Institute of Managment Account).


402

Identification of risk events – SWOT analysis

SWOT analysis is a traditional tool used in strategic planning to identify the

strengths, weaknesses, opportunities and threats associated with a business or a

specific strategy.


403

Identification of risk events – Scenario analysis

Four types of scenario

• Exploration scenarios

• Forecast scenarios

• Descriptive scenarios

• Normative scenarios


404


Exploration scenarios vs. forecast scenarios

•Exploration scenarios are based on past and current phenomena.

They assume, on the one hand, the recurrence of phenomena, on the

other, stable relationships between the independent variables and

dependent variables. It’s possible to associate to each cause one or

more effects: causes effects.

• Forecast scenarios are based on the hypothesis of strong spread

between past phenomena and future phenomena. This spread could

be depend on new phenomena and/or new relationships between the

independent variables and dependent variables: effects causes


405


Exploration scenarios vs. forecast scenarios

CAUSE EFFECT

For instance, the analysis of past

has demonstrated that the primary

demand of a certain product

changes of - 20% than oil price

changes

EFFECT CAUSE

For instance, each target about

expected market share requires

a specific change in price


406


Descriptive scenarios vs. normative scenarios

Descriptive scenarios have no contsrains: there are not limits in relation to positive

or negative correlations. The analyst simply describes causal relationships.

In the case of normative scenarios the causal relationships are limited within

constraints system: For instance, a change in demand can be assumed as scenario

taking into account constraints that come from internal resources.


407


Descriptive

Normative

Given the causes,

what will be the

effects?

Exploration Forecast

Given the effect,

what will be the

causes?

Given the resources,

which target can be

reached ?

Given the targets ,

what resources target

can be mobilised?

Source: Martelli A. (2014), Model of scenario, Palgrave


408

Risk assessment: Qualitative and quantitative assessment

Normally the risk assessment is based on two stages:

1) Qualitative risk assessment;

2) Quantitative risk assessment.

Qualitative risk assessment focuses on each risk and opportunity according

to descriptive scales.

The output of qualitative risk assessment is often used as the input of

quantitative risk assessment aimed to achieve impact and likelihood of potential

events. Moreover, quantitative risk assessment regards both the risks

correlation analysis and, especially in the case of financial risks, the VaR (value

at risk) measurement.

In many cases, non-financial firms can’t make a quantitative risk assessment. It

depends on a lack about data.


409

Strengths Weaknesses

- Enlarge the analysis field beyond measurable

risks.

- Are easy to learn from a conceptual viewpoint.

- Facilitate collaboration between different

business areas.

- Allow to pay more attention on strategic risks.

- Allow to exploit better experiences gained

working (learning by doing).

- Allow a bigger flexibility to face new risk issues.

-Make shadow the relationship between risk and

economic value.

- Provide limited differentiation between levels of

risk.

- Make difficult to measure the correlations

between different types of risk

- Are influenced by a high subjectivity.

- Are not fit with the financial culture and mindset

of financial backers . Qualit

ative a

naly

sis

te

chniq

ues

Quantita

tive a

naly

sis

te

chniq

ues

- Numerically explain the relationship between

risk-opportunity and value

- Fit the financial culture and mindset of financial

backers.

- Their results are less subjective.

- Summarize a direct way the results of the

assessment process.

- Are fit with the goal to analyze correlations

between risks.

-They are not easily understood by most

members of an organization.

- Reduce collaboration between different

business areas.

- Don’t take into account experiences of

managers and workers.

- Often are based on rigid assumptions.

- Only in part can be used to assess strategic

risks


410

Risk assessment: : Impact/probability matrix

The probability and impact matrix helps define priorities in terms of treatment

and risk response


411

Risk assessment: risks correlation matrix

Source: Makky, 2013

Dynamic risk/value analysis of new projects: real

option approach


Prof. Antonio Renzi

Agenda

413

The Real Option Approach: general logic

The real options classification

The extended NPV

The real options and ERM

Binomial model assessing strategic investments

The certainty equivalent method

Differences between financial options and real options

Contextualize the evaluation of real options than the firm's

structural characteristics

During the 70s, several studies highlighted the inadequacy of the

DCF logic.

These studies have shown that the traditional approach based on a

linear actualization implies an underestimation of investment

decisions. This phenomenon is due to several factors.

An important factor about the underestimation phenomenon is that

the DCF result doesn’t include the component of managerial flexibility

value.

The Real Options Approach (ROA): general logic

The role of managerial flexibility is double:

• It is a "cushion" on the negative side of the uncertainty;

• It is a leverage to exploit the positive side of the uncertainty.

This implies asymmetric risk conditions, in the sense that the investor

has the faculty to give up on a given investment when its real

performance is lower than the initial expectations. At the same time,

the investor has the possibility to exploit as much as possible the

benefits linked to a positive volatility, when the real performance is

higher than the average expected return.


The idea that the decision maker has the faculty to change strategies

in place, after the observation of one or more phenomena, has led to

the development of non linear models.

This has entailed new ways to capture the value


Risk and value of flexibility

The value of managerial flexibility is positively correlated with the risk:

The increase in the risk of investment increases the utility

function of the managerial flexibility.

This positive correlation is similar to that between risky securities and

the value of financial options.


Risk and value of flexibility

This similarity (between the managerial flexibility related to

investments in real assets and flexibility produced by financial

options) has resulted in the ROA.

The main goal of the ROA is to enlarge the logic of DCF, thanks

to a dynamic risk valuation linked to the possibility to defer

decisions to the future or modify those already approved.


General definition

Real options represent elements of managerial flexibility that allow the

correction, the postponement or abandonment of investment, after the

observation of one or more events.


Real option and market discipline

In the traditional financial perspective of the allocative efficiency of

resources is seen as necessary to create value.

Instead, according to a strategic perspective the strategic resources

potentially exploitable in future assume the role of positive drivers of

value.

The ROA can be an important tool, to bring out, even in the eyes

of financial investors, the shadow value related to a portfolio of

strategic resources.


The real options classifications

Options tied to the time factor:

• Options to defer

• Options to temporarily suspend

Options tied to the investment size:

• Expansion Options

• Reduction Options

• Growth Options

Options tied to opportunities to change:

• Switching Options;

• Options to abandon

First Classification:

Real options and flexibilities

Second Classification:

Real options assimilated to financial options

European Real Options:

• European call options;

• European put options

American Real Options:

• American call options;

• American put options

• The option to defer the start of a project reduces the sunk cost

problems

• The option to delay the investment decision is a real call option.

• The strike price is equal to the initial investment

• This real option implies an opportunity cost equal to the profits lost in

the waiting period. So that if the entrepreneur (or the investor) is

certain to realize the new business, the late entry only produces

economic damage.


Options to defer and new business

The decision to realize the business under any circumstance

could depend on:

• Non rationality of the entrepreneur;

• Negative observations (down side market) , in a limited period, could

be insufficient to tell if the business will fail.


Why do some new entrepreneurs reject options

to defer?

“By formulating an integrated strategy that combines the creation and exercise of real options

together with other risk management techniques, management can reduce risk and thereby

increase firm value.

For example, a company that is in a position to delay investing without losing its competitive

edge, to abandon a project that becomes unprofitable, or to adjust its operating strategy at

low cost can avoid risks and exploit profitable opportunities. …. An integrated risk

management approach requires a careful process of diagnosing a company's risk exposure.”

(Triantis, 2000)

The Real Options and ERM

A real option (or a portfolio of real options) can:

- change the risk appetite;

- change the risks identification;

- enlarge strategies that are compliant with the ERM framework

- improve the flexibility in the risk assessment;

- show the relationship between internal resources, value and risk;

- improve the sustainability of the risk.

The Real Options and ERM

The extended NPV (NPVE)

ueOption val

NPV

10E OPWacc1FCFFINPV

N

t

n

t

Symmetrical distribution of NPV and asymmetrical distribution of

NPVE

Expected

Average

NPV

Option value

OPVANVAN0E

The possibility of exploiting risk asymmetric conditions allows

a risk immunization process

Expected

Average

NPVE


The double effect of the risk on NPVE

The volatility of the expected cash flows increases both the

cost of capital and the value of real options.


Present value as

discounted cash

flows

Real

option

value Risk

(+) (-)

(+)

Cost of capital

(+)

Utility of flexibility

s

The double effect of the risk on NPVE


Value

NPV

NPVE

Manag

erial

fle

xib

ility

= Value of real option j


Both in the case of forward contracts and in the financial options for

each expected value in uncertainty conditions there is a certainty

equivalent:

Present value of j in uncertainty conditions

=

Present value of j in certainty conditions .

This logic is the base to estimate both financial and real options

One period analysis

(QJ1)(1+ RJ)-1 = QJ0 = (S1)(1+ Rf)-1 = S0

QJ1 - S1 = (QJ0)(1+ RJ) - (S0)(1+ Rf)

(QJ1) = Expected value in uncertainty conditions

QJ0 = Present value of QJ1

RJ = Risk free rate + risk premiun

S1 = Forward price

S0 = Present value of forward price

Rf = Risk free rate


One period analysis


p = objective probability in the up state

1- p = objective probability in the down state

q = intrinsic probability in the up state

1- q = intrinsic probability in the down state

Tempo 0 1 Probabilità oggettive Probabilità soggettive

QJ1u 100 0,5 0,409

QJ1d 60 0,5 0,591

RJ = 0,1

QJ0 = 0,5(100 + 60)(1,1)-1

72,727

Rf = 0,05

QJ0 = (0,409(100) + 0,591(60))(1,05)-1

72,727

Objective

probabilities

Intrinsic

probabilities

One period analysis


Binomial Model for assessing strategic investments

The binomial model is based on discrete process, where the price of

underlying asset could become period by period one of two values:

• Up state value;

• Down state value.

The up state value depends on a multiplying factor (u)

The down state value depends on a reductive factor (d)

Factors “u” and “d”

u = multiplying factor> 1

d = reductive factor = 1/u

u = es

d = e -s

s = ln(u)

ln = Natural logarithm

e = Base of natural logarithm

s = standard deviation of underlying asset

Binomial Model

One period analysis - Discrete discounting


Continuous discounting

Binomial Model

Base of natural logarithms

Discounting factor

Binomial Model

Multiple period analysis – “Tree" dynamics of the underlying asset

Multiple period analysis and reverse analysis


Multiple period analysis and reverse process (three stages)

Stage

3


Stage

3

Stage

2

Stage

1

Multiple period analysis


Q0 = Present value 1000

u 1,0617966

d 0,9418

q 0,5198

1 – q 0,4802

E = Initilal investment 900

Rf (per year) 0,05

Rf (per month) 0,0042

Months

Reverse process


The binomial tree as a decisional tool

Decision during

the option life (T > 0)

Decision at the end of

the option life (T= 0)

Waiting

Waiting Waiting

Waiting

Yes

Yes

Yes Yes

Yes

Yes

Exploitation

Abandon

Waiting

Waiting


Equivalent Portfolio

The equivalent portfolio model allows to identify equivalences

between the option payoff and a virtual financial portfolio of the

underlying asset, partially financed with a riskless debt.

For each future scenario the option value is given by:

Option Value

=

Amount invested in the underlying asset x

Price of the underlying asset

–

Riskless debt

Equivalent Portfolio

Amount invested in the underlying asset

Amount of riskless debt

Dis

cre

te d

isco

un

ting

Co

ntin

uo

us d

isco

un

ting

Differences between real options and financial options

Time to maturity

Volatility

Price of und.

asset

Interest rate

Strike price

Dividends

It is contractually

defined

Volatility about the

underlying financial

asset

Price of the


asset

Risk free

rate

Value of the


asset

Dividends lost during the

waiting period

Time required for the

knowledge formation

Volatility about the

underlying real

asset

Present value

as summation of

discounted cash flows

Risk free

rate

Initial

investment

Cash flows lost during

the waiting period

Financial options (Call) Real options (Call) The 6 variables of

the call option value

Differences between real options and financial options

Financial options Real options

They are contractually

defined

They are traded on regulated

markets

They are easy to

classify

Their margin of exploitation does not

depend on the quality of individual

operators

Their value tends to change

in a continuous way

Normally they are not contractually

defined

They can’t traded on regulated

markets

They are not easy to

classify

Their margin of exploitation could

depend on firm

characteristics

Their value tends to change

in a discrete way

Real options value, direct and indirect costs

The value of real options come from observing what happens in the real world

and adapting the firm’s behavior to increase its potential upside from the

investment and to decrease the possible downside.

Normally, flexible investments involve a higher initial cost compared to rigid

investments (option premium).

Exploiting the flexibility of one or more investment projects requires adequate

strategic resources. This explains why the strategic flexibility of investments

made by small businesses is often exploited by other companies especially

through M&A operations.

Contextualize the evaluation of real options and the firm's


Real options according to a path dependence logic



New flexible

investments

Exiting strategic

resources

Real

options

Potential managerial

flexibility

Exploitation degree

of flexibility

New strategic

resources

Slack and options according to a path dependence logic

Three slack’s definitions



Slack “A cushion of actual or potential resources which allows an organization to

adapt to internal pressures for change in policy, as well as

to initiate changes in strategy with respect to external environment” (Bourgeois,

1981)

Slack “As resource intentionally kept by a firm beyond those needed by an organization to meet its known commitments” (Sharfman et al., 1998, Sharfman

and Dean, 1997)

Slack “as pool of resorces in an organization that is in excess of the minimum necessary to produce a given level of organizational output” (Nohria,

Gulati, 1997).


Kinds of slack



-Financial slack;

-Relational slack;

-Human resource slack;

-Knowledge slack;

-Operative slack;

-…

Inefficiency in

short run

Agency costs

Potential strategic

reserve in long run

Potential

innovation

driver


Financial and knowledge surplus as unabsorbed slack and multi-source of real options



Op(n)

Financial slack

Knowledge slack

Op(1)

Op(2)

Op(3)

Op(4)

…


Absorbed/unabsorbed slack



Absorbed slack Flexible conservative

investments

Operating

real

options Exploitation of managerial flexibility

through a reduction of absorbed slack

Potential managerial flexibility

Unabsorbed slack Flexible strategic

investments

Strategic

real

options Exploitation of managerial flexibility

through a reduction of unabsorbed slack

Potential managerial flexibility

Consistency

Consistency

Potential NPVE and actual NPVE: A path dependence

logic

Potential NPVE

Actual NPVE

Potential real

option value

Actual real

option value

NPV

Inconsistency of internal resources

s

Value



In

trin

sic

fle

xib

ility

of a

New

str

ate

gic

investm

ent

Availability

of strategic resources

H L

L

H

A

Low NPVE

High efficiency before

the new investment

B

High NPVE

Low efficiency before

the new investment

C

NPVE NPV

High efficiency before

the new investment

NPVE NPV

Low efficiency before

and after

the new investment

D

The maximization of the NPVE causes a risk of inefficiency



Real options and internal risk drivers

Analysis of real options

Shadow options mapping

Analysis of managerial flexibility Internal Risk drivers

Intrinsic business risk

Degree of operating leverage

Degree of financial leverage



Real options and internal risk drivers



For example: measuring the multiplying factor and reductive

as functions of intrinsic risk and DOL

d

u

t0t0

t0t0

ROIDOLV

IBR

ROIDOLV

IBR

e

eMultiplying factor

Reductive factor

Normally the DOL size in positively correlated with both absorbed and

unabsorbed slack

Shadow options



A shadow option is an option that a firm already holds, but it is not aware of

it.

In other terms, it hasn’t discovered the option, yet.

To discover the already existent option, a firm need to focus or re-focus its

attention.

A shadow option is a real option which is not in being. Hence, it is its

antecedent.

Beside attention (for the opportunities to be discovered), an option

requires resources for its execution.

Those resources are slack resources, that act as knowledge

inventories: "to create inventories of competencies that might be used

later without knowing precisely what future demands will be"

(Levinthal, March, 1993).

Shadow options



A shadow option is latent because of:

•Lack of additional resources required for option execution;

•Lack of market opportunity;

•Lack of awareness;

The process for what an option passes from shadow to real follows some

steps, that are:

• noticing, thanks to focusing attention;

•matching with relevant strategies;

• commitment through Investments.

At this point, the options becomes real.

performance measurement and enterprise risk management

Documents