Corporate Valuation and Risk Management - Literature review Example

Introduction Weiying & Baofeng’s (2008) selected paper investigates and explores the linkage between Risk Management & Firm Value. Perfect market doesn’t pose any financial risks to the firm but neither do perfect markets exist nor do we live in one. The management of risk is not merely a glossy analysis but a well directed pre-emptive measure to identify and mitigate the effects of future events, thereby positively effecting firm’s value. This positive effect on firm’s value is derived not only from reduction in taxes and financial distress but also from avoidance of underinvestment issues. However, Risk Management exercise may decrease the firm’s value as it is often perceived by the managers a mean to increase their personnel value. Cowherd & Manson’s (2003) research paper outlines the severity of enterprise risks and their impact on firm value. The credit, liquidity, market & operational risks dent the firm financially reducing the shareholders value and effect the reputation as well. The paper emphasizes the incorporation of RM mechanism in the structure of the organization enabling the risk to identify the risks in advance and turn them into opportunities. The heated competition aided by technology, deregulation & free market trends, mergers & re-engineering has presented new forms of risks which calls for an established and well-directed risk aversion mechanism. The importance of corporate governance is discussed in the light of increasing regulations on business for increasing firm’s value by implementing best RM techniques. Bartram (2001)highlights the importance of firm value in today ever-changing and vulnerable market. The implementation of corporate risk management to curb volatile financial risks with specific focus on Foreign Exchange Risk, Interest Rate Risk & Commodity Price Risk is viewed as a measure to enhance firm’s value. The firm value is of utmost importance for shareholders and hence relationship between RM and shareholders interest is analyzed. Positive theories of RM as a mean to create SH value are examined with a key emphasis on agency costs, transaction costs, taxation, financial and investment policies. Besides increasing firm’s value, RM provides a competitive advantage to the organization. Shin & Stulz’s (2000) research paper establishes a relation between expected risk and Tobin’s q which is the ratio of firm’s market value & its book value in the light of risk management. The risks considered under the envelope of expected risks are equity risk relating to the capital for business & cash flow risk relating to the liquidity of organization. The bonding between expected cash flows & growth opportunities is explored keeping in view the cost of debt and debt restructuring. The risk management practices serves as a double edged sword which can either increase or decrease the firm’s value depending upon the adopted policies to cater financial distress. Richardson & Gerzon’s (2011) research paper explores the impact of risks which have very low chance of occurrence and can considerably reflect on firm’s value and in some cases its existence. The different nature of emergent risks makes them less visible to the medium term and at times long term planning. The lesser probability of occurrence make them appear non-important but can have devastating effect on firm’s value such as US Housing Crisis. The emergent risk matrix is developed to identify and list down the emergent risks, their chances of occurrence, and their effects both in terms of financial and economical values. Different methods are utilized to address the risks and effective measures are taken in contrast to the consequences. Important Review Notes Paper Title The Relationship between Risk Management & Firm Value. Authors JIA Weiying & CHEN Baofeng Journal Modern Finance and Global Trading Cooperation: Proceedings of the 5th International Annual Conference on WTO and Financial Engineering. 2008 June Focus of Paper Effect of Risk Management on firm Value in an imperfect market. Incremental Effect is inferred from the reduction of taxes, financial distress & underinvestment which is inline with the interests of shareholders. Detrimental Effect stems from the very fact that managers possess self interests of empire building. Key Findings 1. Enterprise Risk Management is not only required due to internal factors (Shareholder’s Interests) aimed at increasing profitability but also due to external factors (Technological Forces, Globalization & CG Regulations) aimed at sustainability. 2. Tax shielding resulting from depreciation & increased debt to equity ratio can elevate firm’s financial standing. 3. Financial Distress poses both a direct cost (bankruptcy) and an indirect one (opportunity cost) which can be addressed by ERM. 4. RM can reduce the WACC and ensure the presence of internal funding. 5. Shareholder activism is of key importance to align managerial interests with those of the firm. Paper Title Enterprise / Operational Risk Management Authors Jeffrey Lee Cowherd and Daniel P. Manson Journal IT Audit Manager City National Bank California State Polytechnic University, Pomona Focus of Paper Enterprise Risk Management is devoted in highlighting, evaluating, supervising and controlling enterprise risk which may come in any form. (financial, market, operational & strategic) The cost associated with many risks effects the organization in the longer run and keeps haunting all the future endeavors. The versatility of business environment presents newer challenges which require a vigilant risk aversion mechanism. Key Findings 1. The evolving business structures & core competencies have revolutionized the businesses which require effective risk management mechanism. 2. The risk management system needs to be integrated in the core structure of the organization making it an integral function. 3. The importance of audit committees (internal & external) is helpful in oversight of the organization. 4. The impact of inadequate risk management can affect the non-financial firms more severely because of lack of expertise in handling risks. 5. The magnitude of risks can be identified under CG and effective measures can be put in place. Paper Title Corporate Risk Management as a Lever for Shareholder Value Creation Authors Söhnke M. Bartram (Lancaster University) Journal Financial Markets, Institutions and Instruments, Vol 9 (5). pp. 279-324. August 10, 2001 Focus of Paper Importance of RM in relation to shareholder’s interest and firm’s value. The financial risks focused are foreign exchange, interest rate & commodity price. Imperfections of market are empirically viewed as an opportunity to increase firm value by realizing the significance of agency & transaction costs, taxes & financing costs. Key Findings 1. The utilization of derivatives is the most widely acceptable measure of risk analysis. 2. Non financial firms usually rely on derivatives on short term basis. The widely utilized derivatives have a maturity period of 180 days. 3. Commodity price risks are often catered by hedging instruments. 4. The firms with low credit rating are reluctant to utilize interest rate derivatives. 5. RM is not considered seriously in a majority of organization (>63%) which explains the large number of bankruptcies. 6. The role of corporate governance is of vital importance in aligning managerial and shareholders interests. 7. The corporate income usually follows a convex tax code which can be utilized as an incentive to curtail taxes by efficient implementation of RM. Paper Title Firm Value, Risk & Growth Opportunities Authors Hyun-Han Shin & Rene M. Stulz Journal National Bureau of Economic Research Working paper 7808 www.nber.org/papers/w7808 July 2000 Focus of Paper The empirical relation between expected risks Tobin’s q is utilized to aid risk management practices for effective decision making in order to enhance firm’s financial value. The nature of business and industry is ignored in this analysis and empirical relations between symmetrical risks and growth opportunities are focused. The framework for RM is established on the basis of expected risks. Key Findings 1. The symmetric risk increases with an increase in the cash flows which are expected to occur at a future point of time. 2. The growth opportunities increase with the increase in the presence of real assets rather than intangible securities or expected cash flows. 3. The financial distress is inversely proportional to debt which calls for a lower value of debt for firms which have higher financial distress 4. The financial instruments for hedging also possess an inherent risk which can affect the expected cash flows of the firm. 5. The magnitude of risks changes with the characteristics of equity and affects the firm’s value directly. Paper Title Emergent Risks Authors Bryan Richardson and Peter Gerzon Journal The Institute of Risk Management This paper was produced as a result of research by the IRM Emergent Risks Special Interest Group. Website: www.theirm.org Focus of Paper Emergent Risks are unique in the sense that the firm has no experience or history to deal with them. These risks are not low occurrence potential but very high consequential potential. The methods for identification, recognition, evaluation and management are very important and should be in place well before any sign of risk so as to effectively deal with it. Key Findings 1. Emergent Risk Way is a structural way of identifying the risks which saves time and effort in the longer run. 2. The risk identification techniques include risk workshops, historical data, panel discussions, forms and pro formas & brainstorming. 3. Emergent Risk covers a 360 degree environmental parameter including the societal, security, technology, environmental, cultural, economical and financial risks. 4. The consequences can range from a delay in some important deliverable to a lifetime failure. 5. The mitigation of emergent risks is directly proportional to the impact, the earlier the risk is identified and catered for, and the lesser would be the loss. Discussion & Integration Risk Management is not a damage control strategy formulated to reduce firm’s vulnerability but a mean to increase the overall credibility and long term sustainability. Effective utilization of RM tools such as tax shielding to reduces taxes, debt restructuring to evade financial distress & derivatives to avoid underinvestment can help to establish the risk appetite of the organization. The utilization of stock options and revision in managerial compensation package can avoid the conflict between personal & organizational interests. ERM helps the firm to avoid uncertainty by reducing external & internal threats and exploit possible opportunities to reward from them. The increasing importance of RM has made it need of the hour amid changing business processes. RM can increase the firm’s value by preparing it to take effective measures as a routine procedure to avoid potential risks. The increase in the regulatory concerns has contributed positively towards the incorporation of RM in organizational policy framework. The rapid development of business models clearly marks the beginning of an era in which only those organizations would thrive who not only possess the ability to avoid potential risks but also the capabilities to take calculated risks and benefit from them. “If you don’t risk anything, you risk even more.” The importance of corporate governance is increasing to by the day with the objective of aligning managerial interests with those of shareholders. The role of board committees for identifying and evaluating risks in consultation with firm’s managers is significant for strategic decision making. The financial risks arising from global forces can be dealt with hedging at the firm level which not only increase shareholders value but also pinpoints agency costs. The incorporation of risk management for non-financial organizations can result in financial as well as strategic advantages in the longer run. The relationship between symmetric risks holds a direct relationship with firm’s market value because share prices are directly linked with the market expectations. The increase in value serves the interests of shareholders, increases the worth of firm, improves the credibility of organization but at the very same time increases the cost of financial distress. This increase in financial distress needs to be addresses by a proper risk management mechanism so as to safeguard the firm’s value when the expected share prices are not realized. The risk management mechanism outlines the risk appetite of the firm answering the question, how much is too much. The emergent risks are not usually incorporated in organizational planning due to their lesser chances of coming to surface but their effects are catastrophic to firm’s value both economically & strategically. The formal integration of emergent risk management in firms planning is highly advisable owing to the fact that the cost included in its implementation is nothing as compared to the damage it can inflict to the firm even if the possibility of occurrence is once in a lifetime. The cost associated with emergent risk management has an additive effect but can reap exponential benefits for the firm. References: Bartram, S. (2001) Corporate Risk Management as a Lever for Shareholder Value Creation. Financial Markets, Institutions and Instruments, Vol 9 (5). pp. 279-324. Cowherd, J. L. and Manson, D. (2003)”Enterprise / Operational Risk Management”. IT Audit Manager City National Bank. California State Polytechnic University, Pomona. Richardson, B. & Gerzon, P. (2011)Emergent Risks. The Institute of Risk Management. Shin, H. & Stulz, R. M. (2000) Firm Value, Risk & Growth Opportunities. National Bureau of Economic Research. Weiying. J. & Baofeng, C. (2008) “The Relationship between Risk Management & Firm Value”. Modern Finance and Global Trading Cooperation. Proceedings of the 5th International Annual Conference on WTO and Financial Engineering. Read More