RISK MANAGEMENT

AND
SHAREHOLDER VALUE
RISK
MANAGEMENT
Involves the management of unpredictable events
that have adverse consequences for a firm
DIFFERENT RISKS A FIRM IS
EXPOSED TO:
• Pure risks – risks that offer ONLY the prospect of a
loss. There is no possibility that a gain may occur.
• Speculative risks – there is a chance of a gain but
there’s also a chance of a loss.
• Demand risks – risk that demand for a firm’s
products or services will go down.
• Input risks – risks that input costs will increase, and
that these costs cannot be transferred to the
customer.
• Financial risks – risks resulting from financial
transactions
DIFFERENT RISKS A FIRM IS
EXPOSED TO:
• Property risks – risks that productive assets will be
destroyed.
• Personnel risks – risks resulting from the actions of
employees.
• Environmental risks – risks of public outcry in case of
pollution.
• Liability risks – risks associated with product, service,
or employee actions.
• Insurable risks – risks that can be covered/mitigated
by insurance.
Does risk management add value
to Shareholders?
• If most investors hold well-diversified portfolio
then the answer is theoretically, NO.
• Recall the CORPORATE VALUE MODEL:

MARKET VALUE OF THE COMPANY =PV OF

EXPECTED FCF

MV = FCF1/(1+WACC)^1 + FCFn/(1+WACC)^n
 Therefore, MV of shares depends
on 2 variables, FCF and WACC. If and
only if risk management can increase
expected FCF or decrease WACC can the
market value of the stock increase.
That is why some stockholders are
indifferent to whether or not a firm
reduces the volatility of its cash flows
because…..
• Diversified shareholders may already hedged
against various types of risk.
• Reducing volatility increases the firm’s value
only if its leads to a higher expected cash
flows (FCF) and/or a reduced WACC
To demonstrate….

Suppose that you are in the business of

buying and selling bananas. The price
now is P20 per bananas. You expect that
the price is going to increase 10% for the
next 5 years. So to manage risk, you
entered into an agreement with the
supplier to buy bananas at P20.50 per
apple for the next 5 years.
What happens to the risk? Does it
add shareholders’ value?

• You have reduced the risk but it didn’t add

shareholders’ value since the price of P20.50
is already known and therefore expected the
absolute amount of FCF won’t change
• Also in order to affect the WACC the
components must be affected (cost of debt,
cost of preferred stock, cost of RE or
common stock) or the capital structure
changes.
 Derivatives
• manage risks
• Securities
• Equities
– Stock option
• Indexes
– Common stock within the market index
• Bonds
• Physical assets
• Interest rates
 Derivatives
• manage risks
• Securities
• Hedge Risk
• Profit
• Potentially risky