Chapter 9: Risk Management and Shareholders Wealth

The cost of risk The principles of business valuation Risk mgmt and the opportunity cost of capital Risk mgmt and expected cash flows An overview of tools used in corporate risk mgmt
Introducing Excel Determining probability distribution parameter

Using Monte Carlo simulation to estimate aggregate loss distribution

1

More specifically, its

The time, effort and hassle you spend on Identifying, assessing and reducing risk Securing quotes, analyzing quotes and purchasing insurance Attending to all of the insurance detail The dollars you spend on Insurance premiums Deductible losses Uninsured losses

Cost of risk
Expected loss Cost of loss control Cost of loss financing Cost of residual uncertainty

magnitude

=
=
timing

( + )
Risk
5

Cost of capital, r
Risk Free Rate

Risk Premium
Rate of Return on assuming additional risk

Rate of Return that Diversifiable Noncompensates for Diversifiable time value of money because Firm-specific Market Risk of delaying Risk Systematic risk consumption Unsystematic
6

Cost Benefit Analysis

Accept Reject
Methodology:
Benefits are greater than cost
Benefits are less than cost

Marginal Cost Net present value

Implement Risk Management Minimizing the cost of risk Marginal Cost = Marginal Benefit (Min) Accept :: MB > MC Implement Risk Management Compute NPV Maximizing Business Value Accept:: NPV >0

For explanation on Monte Carlo simulation: http://www.palisade.com/risk/monte_carlo_simulation.asp

Demo on Monte Carlo using simple Excel: https://www.youtube.com/watch?v=XOA0_X5yJHQ&feature=youtu be_gdata_player