L 02.03 Strategic Hedging.ppt

Lecture 2 Lecture 2

Dr. Tahir Khan DurraniDr. Tahir Khan DurraniCEngr, MCIT, ACII, MSc, MPhil, CMBA, PhD

Meditation For the Week:

The day you fall in love with what you are doing is the last day you will ever have to work.

Integrate risk classification and management.

Review classical finance theory on why risk is a problem.

Lay out generic risk management strategies:

risk elimination risk accommodation

Dr. Tahir Khan Durrani

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Does this mean that hedging does not increase firm value?

If risk management increases firm value, it must increase expected net cash flows.


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If hedging affects the current firm value, then it must

Change expected tax liabilities Change contracting costs Change future investment decisions.


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While firms can change their level of risk by hedging, investors can change their level of risk in the choice of portfolios.

If firma do not hedge, investors can achieve same risk-return level simply by holding more assets.

Investor is a substitute of corporate hedging and insurance.


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C

rf

E (r)

SML

β

AB

A firm stock is valued according to expected earnings and systematic risk (β).

Losses are cash outflow in a diversified portfolio and tend to increase systematic risk (holding negative beta liability has same effect on portfolio risk as holding a positive beta asset).

If firm insures this risk this is like riding itself of a positive beta asset, and firm’s beta will fall.

If insurer sell insurance for a premium equal to the expected value of loss, then firm’s expected income will not change, but its beta is lowered.

As shown at point B.


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Firm’s beta and expected return are shown at point A.

Firm buys insurance and assumes that insurable losses are less likely when market index is high.

Lowering beta is attractive proposition for investor.


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Form’s stock is now underpriced and high in demand, bidding its price up

Expected return would fall to “C” Rise in price is a capital gain for existing

shareholders and would signal a reward for insuring risk.

Insurance transaction shifts the firm earnings from A to C

Firm shareholders find the firm correctly priced Insurance policy would reduce expected

earnings (insurer demand risk premium), and reduce beta.


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Tax functions facing Firms are convex Higher corporate earnings encounter

higher rates of marginal taxation. convexity also arises from allowances

for expenditures such as depreciation and loss carry forwards.

This increases the range of income which attracts a zero marginal tax rate.

The nonlinearity in tax functions gives rise to a relationship between risk and expected tax liability.


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Tax Function

Corporate EarningsCBA

T(A)

T(B)

E(tax)

Tax Liability

T(C)

= (0.5)T(A) + (0.5)T(C)

A firm has earnings that follow the distribution:

Earnings Probability0 0.2100 0.3200 0.3300 0.2Expected Value = 150 The firm faces a 34%

marginal tax rate but, due to progressivity of the code and to tax shelters such as depreciation, the first 120 of earnings is free of tax.

The firm’s expected after tax income is (E denotes before tax earnings, S is earnings shielded:

E-Max{0.34(E-S);0} ATE

0-0 = 0100 - 0 =

100200-0.34(200-120) = 172.8300-0.34(300-120) = 238.8

Expected Value = 129.6

If the risk is hedged, replacing risky earnings stream with expected value of 150.

The firm’s ATE is 150-0.34(150-120) = 139.8.

What's the % gain? It represents a gain of 10.2,

without any change in expected value of before tax earnings.Dr. Tahir Khan Durrani

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Tax Function

Corporate EarningsCBA

T(A)

T(B)

E(tax)

Tax Payable

T(C)

= (0.5)T(A) + (0.5)T(C)

Negative income this year can be used as deduction against future earnings.

The expected present value of each $1 carried forward would be a tax relief

Tax function is not convex but a straight line, no gain from hedging

Loss carry forward has tax advantage to reducing the riskiness of earnings.


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A bankrupted firm according the absolute priority rule will have its shares expire worthless and the firm transferred to creditors.

If reorganised transaction costs fall the principle stakeholders.

Ex ante, these costs will be anticipated in the value of bonds and stocks.

Reducing default risk enhances the value of the firm’s bonds


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The value of the firm, V(F), is the capitalised value of its expected future cash flows, CF, discounted at a rate r:

If the firm is bankrupted, but not liquidated, the cost of bankruptcy will be captured by

1 )1(

)()( trtCFEFV

t trBCtPtCFEFV

)1())(()()(


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Bankruptcy resulting in liquidation also includes loss of future earnings.

Assumption: The probability of survival in year ‘s’ is (1-Ps), with the probability of Ps, being the probability of bankruptcy conditional on having survived to that year.

The PV of the firm is srBCs

ttrtCFE

FV

11 )1(

)()(


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With the probability that the firm will survive to year t, then be liquidated, as (1-P1)(1-P2)….(1-Pt-1), then the value of the firm becomes:

Its apparent from the equations that the value of the firm can be increased by reducing the probability of default, which in turn reduces the expected value of bankruptcy costs.

11)1(

)(1

1

1

1)(

tsr

BCtPtrtCFE

tPt

itPFV


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Underinvestment Asset Substitution

Agency problems arise between shareholders and creditors

Bondholders receive a fixed payment of principal and interest if the value of the firm is sufficient to cover this obligation.

Shareholders receive the residual claim. This relationship is shown in a one period

setting, as shown below.


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The agency costs of debt increase as leverage increases and as financial distress approaches.

Hedging can reduce the likelihood of financial distress, and consequently reduce the adverse incentives associated with debt financing.


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Debt

Value of Firm

ZXY

Y

X-D

Z-D

Value of Claims

D

D

Equity

45º

0

The range of risk

The firm raises debt, promising to undertake low risk project, but having secured the funds, it then substitutes high-risk investments causing a wealth transfer from debtholders to shareholders.

Debtholders anticipates this behaviour and accordingly issue discounted debt to reflect the cost.

Shareholders would be better off if they could send debtholders some credible signal , that they would not engage in such expropriatory behaviour


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Arises also from the asymmetry in the payoffs to bondholders and shareholders.

From the figure above if the probabilities of Z and Y are 0.5, then:

Value of the Firm = V(F) = ½(Y) + ½(Z) Value of Equity = V(E) = ½(0) + ½(Z - D) Value of Debt = V(F) = ½(Y) + ½(D) If the firm is faced with a new riskless

investment with a positive NPV (N-C) of future cash flows. The cost is C, paid up front by shareholders and PV of the new investment is N. Assume this scenario: NPV not sufficient to pull the firm out of bankruptcy;

(N - C < D - Y), Dr. Tahir Khan Durrani

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After this investment, the values are: New value of the firm = ½(Y+N) + ½(Z+N) - C = V(F) + N- C

New value of equity = ½(0) + ½(Z - D + N) - C = V(E) +½N - C

New value of debt = ½(Y + N) + ½(Z) = V(D) +½N

Shareholders pay full cost of project but only benefit if firm does not become bankrupt, shareholders likely to pass up- this project even with positive NPV.

The greater the risk, the more likely that underinvestment will occur and the less attractive are the bonds to investors.


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Hedging/insurance permits the firm to undertake value adding reinvestment opportunities, which might be lost if post-loss financing is not forthcoming or is too costly.

Capital sources have different costs. External capital is more costly than internal capital,

due to issue costs and underwriting costs and information asymmetry costs.

The perking order hypothesis In the face of costly external capital, hedging

preserves internal funds sources, and avoids the loss of positive NPV projects.


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How can a firm achieve more effective job performance from managers by design of their compensation.

Do managers have to bear risk and how much do they need to be compensated for doing so.


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Assume that managers may serve their self interest and are risk-averse, which is captured by the following utility function:

U = W0.5 Where: U = utility W = manager

wealth Risk in employment income

is important. The firm value can either be

£500m or £1,000m, each with 0.5 probability. Value may be stabilised on £780m with hedge.

Consider a manager with a flat salary of £300,000 and job security is not affected by purchase of hedge. The manager’s utility is

U = (300,000)0.5 = 547.72

irrespective of the hedge.


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Assume manager is now paid some proportion x of the value of earnings.

X represent a proportion sufficient to leave managers no worse off than with flat salary

547.72 0.5([500m]x)0.5 + 0.5([1,000m]x)0.5 1095.45(500m0.5 + 1,000m0.5 )(x)0.5

x = 0.000412Manager’s utility with hedge:U = {0.000412(£780m)}0.5 = £566.89Manager’s utility without hedge:U = 0.5(500m x 0.000412)0.5 + 0.5(1,000m x

0.000412)0.5

= 547.72Dr. Tahir Khan Durrani

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To retain the same quality of management team, increasing compensation risk requires increasing expected compensation levels.

Thus, higher compensation risk imposes costs on the firm

These costs will be borne only if there are offsetting benefits

tax benefits incentive benefits


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Incentive benefits If the compensation risk is related to the

managers’ actions, then compensation risk improves incentives.

Thus, it is important to distinguish between controllable risk.


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Firms offering incentive compensation are likely to hedge risk because managers will reduce their own risk and secure any efficiency gains from the hedge.

Those with flat salaries have weaker incentives to hedge.

By hedging risk, incentive compensation becomes riskless and may be lowered. Firms no longer pay risk premium to managers.

Compensation scheme focus on productivity and pay only bonuses.

Managers rewarded with stock options are less likely to hedge, since it can lower the value of their options (Peter Tufano (1996)).


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Tax Nonlinearity

Financial Distress – DirectFinancial Distress – Indirect

Crowding out

Managerial UtilityMaximisation

Stakeholder Risk Aversion

Ratio – Tax Shield:E(earnings) 1High leverageHigh leverageHigh growthHigh R&D

High LeverageHigh GrowthHigh R&D

Managers hold fewoptions/many shares

Creditors/waranties


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Because of its relatively high probability of going bankrupt, Omega plc’s consumers are concerned about its ability to fulfil warranties, employees are demanding greater compensation for the risk of losing their jobs, and suppliers are demanding higher prices for the risk of losing the value of their specific investments.

Assume that Omega’s high probability of bankruptcy can be reduced by hedging its exposures. What factors should Omega’s Managers examine when deciding whether to hedge its exposures? Explain.


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L 02.03 Strategic Hedging.ppt

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