brn 482 corporate financial policy clifford w. smith, jr. summer 2007 presentation 6 * covers...
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BRN 482Corporate Financial PolicyClifford W. Smith, Jr.Summer 2007 Presentation 6 * Covers readings on course outline through Doherty/Smith (1993)
Risk Management Spectrum
Firm Specific Risks
– Fire
– Lawsuit
– Payoffs to R&D projects
Market-wide risks
– Interest rates
– Foreign exchange rates
– Commodity prices
Risk Profiles
ΔP(oil)
ΔVRisk Profile
For an oil producer, rising oil prices [ΔP(oil) >0]
increase revenues and increase firm value.
For an oil user, rising oil prices [ΔP(oil) > 0]
increase costs and decrease firm value.
ΔP(oil)
ΔV
Core Business
Risk Profiles
The Effects of Risk Management
Distribution after risk management
Inherent distribution
Firm Value
Probability
The World has Become A More Risky Place
0.07
0
-0.1
57 61 65 69 73 77 81 85
Futures
Swaps
Options
Options on Futures
Break,Range,ParticipatingForwards
Percent
Corporate Hedging and Insurance
Firm value
The cost of capital (r) depends on the systematic risk of the firm's cash flows.
Insurable risks are generally nonsystematic.
Since insurance purchases do not affect the firm's systematic risk, they do not lower the firm's cost of capital.
Even if the beta of a hedging instrument is not zero, as long as it is fairly price, it will not change the discount rate in a way that would increase value.
Corporate Hedging and Insurance
Does this mean that hedging does not increase firm value?
If risk management increases firm value, it must increase expected net cash flows.
Hedging and the Modigliani/Miller Theorem
If hedging affects the current firm value, then it must
– change expected tax liabilities
– change contracting costs
– change future investment decisions.
Hedging and Taxes
A progressive tax scheme provides the government with a call option on the taxable income of the corporation. Reducing the volatility of income reduces the value of this option.
TaxLiability
Income
Y1
Y2E(Y)
E(T(Y))T(E(Y))
LOSS CARRYFORWARDS
are restricted by some revenue-hungry
states.
Federal and most state laws let
corporations carry forward their net
operating losses and deduct them
from taxable income in future years.
But a countertrend may be beginning
at the state level, says James P.
Sweeney of Arthur Andersen & Co.,
CPAs. Pennsylvania not only raised
corporate tax rates this year but also
eliminated the use of loss
carryforwards. California suspended
for tax years started in 1991 and 1992
its partial deduction for
carryforwards.
Texas enacted a corporate levy
that critics call a disguised income
tax. A deduction for carryforwards
isn’t allowed in the first year, 1992,
but is supposed to be after then. In
New York, Sweeney notes, many
companies are required to pay the
state’s alternative minimum tax,
which doesn’t allow deductions for
carryforwards. For that matter the
calculation of the 20% federal mini-
mum tax permits the deduction of
only 90% of a carryforward.
Multistate companies coming out
of the recession will have to plan
carefully for state taxes, Sweeney
declares.
THE WALL STREET JOURNAL WEDNESDAY, NOVEMBER 27, 1991
Hedging and Taxes
TaxLiability
Income
Y1
Y2
Y0
Tax loss carry backs and carry forwards can make your tax
liability concave over some income levels. In this case,
increasing volatility can reduce the expected tax liability.
Using data from COMPUSTAT, Graham/Smith (1998) find
– Major source of convexity arises from statutory rates.
– Carry backs and carry forwards reduce convexity at the kink - spread it over a wider array of taxable incomes.
– ITCs and alternative minimum tax (AMT) provisions have little effect on convexity.
– Firm tax schedules are convex (50%), linear (25%), concave (25%).
Hedging and Taxes
Corporate Insurance
Efficiency in project evaluation
Efficiency in claims settlement
– Claims only policies
– Retroactive Insurance
War Fears, Insurance Costs Curb Air Service to MideastSpecial to The Wall Street Journal
Flights to Israel and other Mideast points are being cut back, the result of war fears and soaring insurance costs.
Pan Am Corp.’s Pan American World Airways said it was suspending all flights to Tel Aviv for a least a week following a rate increase by Lloyd’s of London. The carrier also said it was suspending flights to Saudi Arabia. Insurance rates for Tel Aviv flights increased 10-fold to $102,000 per flight and rates to Riyadh increased 20 times to $65,000 per flight, Pan Am said.
Meanwhile, British Airways and KLM Royal Dutch Airlines said they were reducing flights to Israel. Those two airlines, as well as Swissair, also changed flight plans so crews could avoid flight plans so crews could avoid overnight stays in Israel.
Pan Am previously operating two weekly flights to Riyadh and daily service to Tel Aviv. Pan Am has applied to the
Federal Aviation Administration for war-risk insurance. Under the FAA program, the government provides such insurance to carriers if they can’t get it from commercial insurance companies on reasonable terms.
British Airways is reducing its Tel Aviv service to four weekly flights from six weekly flights, beginning Jan. 15, the deadline given to Iraq to relinquish Ku-wait or face possible force. But an airline spokeswoman said the pull down isn’t related to the Gulf crisis and called it a “seasonal cutback.” She said full service will resume April 1.
Citing security risks and slower traffic to the region, KLM said it is reducing service to Tel Aviv to three weekly flights from four. KLM canceled service to Amman, Jordan, on Wednesday.
Israel’s national airline, El Al, was ordered to accommodated passengers or tourists affected by the cuts.
THE WALL STREET JOURNALPRIDAY, JANUARY 4, 1991
Comparative Advantage inRisk Bearing
Firm
Share-holders
Bond-holders
Board ofDirectors
Managers
Employees
LessorsLessees
Suppliers
Customers
Hedging and the Firm's Employees
To retain the same quality 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
Hedging and the Firm's Employees
Tax Benefits (Miller/Scholes 1982)
– If the marginal personal tax rate exceeds the
marginal corporate tax rate, then there is a
tax deferral benefit to bonus plans, stock
option plans, and restricted stock plans.
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 and uncontrollable risk.
Hedging and the Firm's Employees
In 1989 Du Pont's fiber division instituted an incentive compensation plan for most of its 20,000 employees
– Pay linked to overall profitability of division
– Managers and lineworkers were part of the plan
Du Pont's Incentive Pay Plan
Two years later, the 'incentive' compensation plan was canceled
– Recession reduced sales
– Gulf War raised oil prices
– 'Incentive' pay was very low.
Risks unrelated to incentives dominated the variability of the compensation
– Employees have no control over the state of the economy or world oil prices.
Du Pont's Incentive Pay Plan
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
Hedging and the Bondholder–Stockholder Conflict
BP's Insurance Decision
Benefits
– Taxes
– Contracting Costs
– Investment Incentives
Costs
– Insurance premium
Cost of Insurance
Expected Premium = PV Indemnity + Loading Fees Payment
Loading ExpectedFees = Service + Profit Costs
BP's Insurance Decision
LossRange
Numberper Year
Average Loss
Expected Ann. Loss
LossStd. Dev.
$0 to $10 1845.0 $ 0.03 m $ 52 m $ 12 m
$10 to $500
1.7 40.0 m 70 m 98 m
$500 plus .03 1000.0 m 35 m 233 m
Total 1846.73 $ 0.66 m
$157 m
Loss < $10 Million– Benefits
Claims Administration Taxes Riskshifting
– Costs Competitive Markets → Low Spreads "Common" Claims → Big Reputation
Effects
BP's Insurance Decision
$10 Million < Loss < $500 Million– Benefits
Claims Administration Taxes Riskshifting
– Costs Lloyd's → High Spreads "Uncommon" Claims → Small
Reputation effects
BP's Insurance Decision
$500 Million < Loss
– Benefits
Investment Incentives
Riskshifting
– Costs
Market Virtually Non-Existent
BP's Insurance Decision
"Why?" and "What?" are not independent questions in hedging decisions.
"Why Hedge?" and "What to Hedge?"
Why Hedge?What is Hedged?
Taxes Taxable income
Contracting costs Reported income
Investment incentives Market value
What is hedged?
– Taxable income– Reported income– Market value
How is it hedged?
– Off-balance sheet hedging– On-balance sheet hedging
"What to Hedge?" and "How to Hedge?"
Firm Characteristics Hedging Policy
Growth Options (Merck) ?
Leverage ?
Credence Goods (Eastern) Higher
Product Warranties (Yugo) Higher
Future Product Support (Yugo/Wang) Higher
Supplier Financing (Campeau) Higher
Closely Held Firm Higher
Size ?
Regulation Higher
Firm Specific Assets Higher
Investment Tax Credits Higher
Marginal Corporate Tax Rate ---
Marginal Personal Tax Rate ---
Tax Progressivity Higher