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MIT OpenCourseWarehttp://ocw.mit.edu 15.997 Practice of Finance: Advanced Corporate Risk Management Spring 2009 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms.Financial Policy MIT Sloan School of Management 15. 997 Advanced Corporate Risk Management John E. Parsons Outline  Objective: why hedge?  Liability Management – structuring debt  Strategic Hedging – equity & investments 2 1Objective Objective  Organize the company’s contact with external capital markets… … to facilitate the company’s investment program and overall strategy.  The company’s strategy and competitive advantages are CENTRAL. ¾ The financial policy should be custom tailored to fit its assets, strategy and competitive advantages. ¾ The left-hand-side of the balance sheet should shape the right-hand-side of the balance sheet. 4 2Not Objectives    To find “low cost” sources of capital ¾ there is no such thing as a free lunch ¾ MM theorem of hedging To execute profitable financial transactions To buy secure profits today in exchange for future risks  The right-hand-side of the balance sheet is not the source of profitability. The right-hand-side of the balance sheet should not be autonomous, and certainly should not shape the left-hand-side of the balance sheet. 5 Modigliani-Miller Theorem of Hedging  First order, direct effect of hedging is zero gain to shareholder value  Risks are bought and sold at fair market value ¾ Firms that are long commodity price risk, capture the risk premium associated with it ¾ Firms that hedge the commodity price risk by selling forward, give away the risk premium ¾ Hedging doesn’t change shareholder value 6 3Spot vs. Forward Sales  Selling into the spot market is risky, but the expected future spot price offers a return for the risk  Selling forward offloads that risk, but the forward or futures price is on average lower, representing the risk discount  From a present value perspective, the two are equivalent. 7 An Operations Research Problem That Isn’t  An electric utility is trying to decide how best to source its coal.  How much should it buy under long-term contracts – say 10 years – and how much to buy under medium-term contracts – say 5 years – and how much to leave for purchase under short-term contracts or in the spot market?  The company has forecasts for long-term contract prices, medium-term contract prices and spot prices.  Run an optimization model to find the right mix of contracts: trading off lower prices against risk. 8 4The Real Financing Problem  Friction between the company and outside capital sources is the issue;  there are incentive problems and information problems;  these problems distort the company’s operations and its investment program, hurting shareholder value. 9 Key Strategic Tasks  Your Task: Organize the company’s contact with external capital markets to minimize these frictions and problems. ¾ minimize the need to access external capital markets, ¾ optimize the timing for access to external capital markets, ¾ efficiently redesign the financing to minimize the frictions.  Minimizing the frictions and problems with the external capital market enables the company to exploit all of its opportunities and to capture the fullest value from its competitive advantages. 10 5What’s $1 Worth? What is the Market Value of a Dollar of Corporate Cash?  Course packet: JACF, Pinkowitz & Williamson.  Model: to estimate the marginal contribution of a company’s cash holdings to its value, we expressed the value of the firm as a function of several key variables, including holdings of liquid assets: ¾ V is the market value of the firm ¾ E is earnings before extraordinary items plus interest, deterred tax credits and investment tax credits ¾ L is liquid asset holdings (cash + marketable securities) ¾ NA is net assets (total assets – liquid assets) ¾ RD is research and development expense ¾ I is interest expense ¾ D is common dividends paid. 12 6What is the Market Value of a Dollar of Corporate Cash? (cont.)  40 years of data, 1965-2004  Annual data on 12,888 different companies  Result: $1 is worth $1.04 … close!  Standard error of $0.06, so the 90% confidence interval includes $1. 13 14 7 Image removed due to copyright restrictions.8 15 Liability Management Image removed due to copyright restrictions.What are these Frictions?  Direct costs of bankruptcy  Moral hazard: the indirect cost of debt ¾ risk shifting ¾ failure to contribute equity capital ¾ cash in and run ¾ playing for time ¾ bait and switch  Asymmetric information: the cost of equity ¾ lemons problem  See Brealey, Myers & Allen, Ch. 18.3 and 18.4  These frictions mean the MM theorem no longer holds; it matters how the company finances its business, whether with debt or equity, whether with short or long-maturity debt, and whether it hedges 17 How to Do It  Tailoring the risk structure of the liabilities to the risk structure of the assets produces shareholder value  The risk structure of the assets is key 18 9Indirect Benefits of Hedging  The benefits of hedging are INDIRECT  Not through the value captured in the hedge itself, not through buying and selling risk at premia or discounts, but  Through the private benefits captured by improving the firm’s own operations ¾ avoiding bankruptcy costs ¾ minimizing agency costs ¾ maximizing tax benefits ¾ positioning the firm to maximize investment opportunities 19 Copper Mine Example  see course packet article in “e-lab” on “Natural resource projects: debt contracts that increase profits, decrease defaults”  builds on the Brennan-Schwartz mine valuation case ¾ original article ignores the financing problems, assuming away any frictions  assumptions: ¾ annual production rate of 10 million pounds ¾ in-ground inventory of 150 million pounds of copper, i.e., 15 years ¾ production costs of $0.50/pound ¾ opening and closing costs of $2 million ¾ zero cost to maintain a closed mine ¾ real interest rate of 2% ¾ current copper price $0.65/pound ¾ copper price volatility of 28% ¾ convenience yield of 1.5% 20 10Benchmark Valuation  What is an asset optimization plan? ¾ the copper price fluctuates; we need to decide when to produce,


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MIT 15 997 - Financial Policy

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