Adrian Crockett, CFA

In this paper we propose a new risk management framework that can evaluate the cost-risk tradeoff of alternative risk management strategies. Although there is ample theoretical support for risk management as an activity, common risk management approaches suffer serious problems:
 Minimize Risk: Completely eliminating risk is expensive and impractical
 Efficient Frontier: Can eliminate many poor risk management strategies but rarely gives a definitive optimal
strategy
 Sharpe… Mehr zeigen

In this paper we propose a new risk management framework that can evaluate the cost-risk tradeoff of alternative risk management strategies. Although there is ample theoretical support for risk management as an activity, common risk management approaches suffer serious problems:
 Minimize Risk: Completely eliminating risk is expensive and impractical
 Efficient Frontier: Can eliminate many poor risk management strategies but rarely gives a definitive optimal
strategy
 Sharpe Ratio: Provides a cost-risk trade-off but the price of one unit of risk is arbitrary
Based on a recent empirical study, we propose a new cost-risk measure which directly values the impact of earnings per share and cash flow per share volatility.
This new approach will enable corporate CFOs and treasurers to make more robust risk management decisions and, critically, better defend those decisions internally and to the broader market. Weniger anzeigen

The use of risk management products has grown tremendously in recent years and companies now employ large numbers of risk managers. A fundamental notion underlying these risk management practices is that cash flow and earnings volatility are harmful to shareholders—that is, these measures of volatility have a direct impact on the company’s stock price. If so, risk management tools that lower this volatility will benefit shareholders by raising the company’s stock price. In designing risk… Mehr zeigen

The use of risk management products has grown tremendously in recent years and companies now employ large numbers of risk managers. A fundamental notion underlying these risk management practices is that cash flow and earnings volatility are harmful to shareholders—that is, these measures of volatility have a direct impact on the company’s stock price. If so, risk management tools that lower this volatility will benefit shareholders by raising the company’s stock price. In designing risk management programs, therefore, it is essential that managers have an understanding of the degree to which the market rewards the company’s stock price when cash flow and earnings volatility are lower. That is, CFOs need a market-
based measure of the benefits of reducing volatility through risk management practices.
In this paper, we provide evidence on whether companies with lower volatility are more highly valued than those with greater volatility. Our main findings are as follows:
 Valuation multiple is substantially higher for companies with lower earnings per share (EPS) volatility. For example, a movement from the 75th percentile of EPS volatility to the 25th percentile increases the observed market-to-book (M-B) ratio from 1.15 to 1.32 (i.e., an increase of 15%).
 Similarly, valuation multiple is significantly higher for companies with lower cash flow volatility. For example, a movement from the 75th percentile of cash flow volatility to the 25th percentile increases the observed market-to-book (M-B) ratio from 1.21 to 1.23.
 Once we control for other determinants of the M-B ratio in a multivariate regression framework, we continue to find that cash flow volatility and earnings volatility have an economically meaningful impact on company value. All else equal, 10% reductions in EPS volatility and cash flow volatility are associated with increases in M-B ratios of 1.6% and 0.6%, respectively... Weniger anzeigen

Most CFOs believe intuitively that reducing risk increases shareholder value. As part of a new series of papers on corporate risk management, we describe the theoretical mechanisms through which risk management may create shareholder value.

Under the assumption of perfect capital markets, risk management adds no value since shareholders can simply hedge any relevant risks themselves. However, perfect capital markets are highly unrealistic, and in practice risk management can add value if… Mehr zeigen

Most CFOs believe intuitively that reducing risk increases shareholder value. As part of a new series of papers on corporate risk management, we describe the theoretical mechanisms through which risk management may create shareholder value.

Under the assumption of perfect capital markets, risk management adds no value since shareholders can simply hedge any relevant risks themselves. However, perfect capital markets are highly unrealistic, and in practice risk management can add value if risk could cause any of the following:
Financial Distress: Reducing risk reduces the probability, and therefore expected costs, of financial distress.
Cuts in Capital Expenditures: Reducing risk reduces the probability of having to cut capex. Insofar as capex is value additive (otherwise it should not be undertaken), cutting it destroys shareholder value.
Increased Expected Taxes: Many firms face asymmetric tax regimes where stable earnings result in lower expected taxes than volatile earnings. Under asymmetric tax regimes, reducing the volatility of earnings reduces expected taxes.
Problems Communicating with Shareholders: Many shareholders and companies attach great importance to meeting expected financial performance targets. Reducing risk increases the probability of meeting expected results.

Risk management quantifies these costs and suggests mitigating strategies. In this paper we show two central results. First, prudent use of financial hedging derivatives can reduce earnings volatility and increase shareholder value. Equally significant, market and economic realities highlight the importance of the firm, rather than its investors, undertaking these hedging transactions. Weniger anzeigen

Recent corporate finance trends lay the groundwork for a powerful new type of capital structure rebalancing: the hybrid-financed share repurchase. Three notable trends, each individually significant, conjoin to create a uniquely appealing environment for such a restructuring:
Significant growth in the hybrid capital market
Increasing importance of share repurchases
Downward rating migrations toward the Baa/BBB category

We believe that using hybrid capital to finance share… Mehr zeigen

Recent corporate finance trends lay the groundwork for a powerful new type of capital structure rebalancing: the hybrid-financed share repurchase. Three notable trends, each individually significant, conjoin to create a uniquely appealing environment for such a restructuring:
Significant growth in the hybrid capital market
Increasing importance of share repurchases
Downward rating migrations toward the Baa/BBB category

We believe that using hybrid capital to finance share repurchases will become a popular mechanism for management to increase shareholder value, and that companies that check most of the boxes below are likely to benefit from using hybrid capital to finance share repurchases.
Thirst for Additional Distributions from Shareholders
Companies that have experienced calls from shareholders to receive larger
distributions
Especially companies that have a lower total shareholder return than the market or their peer group
Equity Relatively Undervalued
Companies with undervalued equity compared to either their peers’ or to
“true” value
The benefits of a share repurchase will be magnified as the unrealized value is transferred to remaining shareholders
Undervaluation will also increase the EPS pickup Investor Perception of Inefficient Balance Sheet
Companies that are perceived to have additional balance sheet capacity and which the market believes could safely operate with higher leverage
Especially companies that have activist shareholders or that may be LBO targets
Limited Capacity Within Target Ratings Constraints
Companies that have limited debt capacity within their targeted rating
(which may be lower than their current rating)
The hybrid instrument’s equity credit will increase the size of share repurchase capacity within the ratings constraints

The key takeaway from this paper is that if your shareholders are tapping you on the shoulder and asking for additional shareholder distributions, but you want to maintain a... Weniger anzeigen

Weighted Average Cost of Capital (WACC) is often used for company valuation and for setting hurdle rates for project planning. With the recent increase in issuance of hybrid securities it is important to have a robust methodology for including hybrid capital in WACC.
Many analysts use a method based on rating agency equity credit. Unfortunately this can lead to misleading results.

In this paper we describe the correct methodology for computing WACC with hybrids, as well as a shortcut… Mehr zeigen

Weighted Average Cost of Capital (WACC) is often used for company valuation and for setting hurdle rates for project planning. With the recent increase in issuance of hybrid securities it is important to have a robust methodology for including hybrid capital in WACC.
Many analysts use a method based on rating agency equity credit. Unfortunately this can lead to misleading results.

In this paper we describe the correct methodology for computing WACC with hybrids, as well as a shortcut method that can be used if the hybrid is used only to repurchase debt or equity or both (rather than being used to fund company projects or acquisitions).

For situations in which the hybrid is being used to repurchase debt or equity or both, we recommend the shortcut method. Otherwise, we recommend the full WACC and Capital Asset Pricing Model (CAPM) approach.

We also note that hybrids reduce the cost of capital in many situations. However, since they typically form only a moderate proportion of a firm's capital structure, expectations of reduction in WACC from hybrid issuance must be kept realistic. Weniger anzeigen

For financial institutions and real estate investment trusts (REITs), hybrid securities are a familiar tool and regular component of the capital structure. Corporates have only begun using hybrids since the ratings agencies changed their guidelines, which enabled instruments to be structured that receive significant equity credit and a tax deduction. The corporate market is already established and liquid, but corporates so far have focused on using hybrids to relieve ratings pressure and… Mehr zeigen

For financial institutions and real estate investment trusts (REITs), hybrid securities are a familiar tool and regular component of the capital structure. Corporates have only begun using hybrids since the ratings agencies changed their guidelines, which enabled instruments to be structured that receive significant equity credit and a tax deduction. The corporate market is already established and liquid, but corporates so far have focused on using hybrids to relieve ratings pressure and strengthen their balance sheets. They are not yet proactively optimizing their capital structure with hybrids but we expect this to be a trend in 2007 and beyond, as corporates assess the value of hybrids in reducing equity funding required for acquisitions and in upsizing share repurchases.

We examined the use of funds provided in the documentation of 211 issues in 2005 and 2006. Weniger anzeigen

This study examines intra-industry information transfer after Helix Resources announced a successful drill result in the Gawler Craton region of South Australia that sparked significant investor interest in mining companies with tenement holdings in the area. This study shows that the price response of competing explorers was determined by press coverage immediately following the discovery of gold, but stocks that received the most press attention in the immediate post-announcement period… Mehr zeigen

This study examines intra-industry information transfer after Helix Resources announced a successful drill result in the Gawler Craton region of South Australia that sparked significant investor interest in mining companies with tenement holdings in the area. This study shows that the price response of competing explorers was determined by press coverage immediately following the discovery of gold, but stocks that received the most press attention in the immediate post-announcement period suffered the greatest long-term underperformance. The research is the first in capital market literature to make use of geographical information systems software technology. Weniger anzeigen