OBJECTIVE AND RISK MANAGEMENT.ppt

1、OBJECTIVE AND RISK MANAGEMENT,Chapter 2,Need for a RM Objective,Risk imposes costs on businesses and individuals Risk Management (e.g., loss control and insurance) also is costly Tradeoffs must be made Need a criteria for making choices about how much risk management should be undertaken Appropriate

2、 Criteria: Minimize Cost of Risk,Components of the Cost of Risk,Tradeoffs in the Cost of Risk,Decreasing one component of the cost of risk usually is associated with an increase in another component Examples: Decreasing expected direct losses (worker injury costs) by increasing loss control costs (i

3、ncreased workplace safety) Decreasing expected indirect losses (bankruptcy costs) by increasing loss financing costs (insurance costs) Decreasing cost of residual uncertainty by increasing loss financing costs (insurance costs),Cost of Risk Example,Firm value in ideal world of no risk = $100,000. Is

4、sues to be examined: What is firm value with risk of worker injuries? What is relation between firm value and cost of risk?,Cost of Risk Example,Business is faced with one source of risk: Probability of worker injury = 1/10 Losses from a worker injury: medical expenses $10,000 lost pay $50,000 total

5、 $60,000 Expected loss = $_,Cost of Risk Example,Option 1: Do Nothing Cost of risk: Expected loss = $_ Cost of residual uncertainty = $4,000 (assumed) Cost of loss control = $0 Cost of loss financing = $0 Cost of internal risk reduction = $0 Total cost of risk = $_ Firm value = $100,000 - $_ = $_,Co

6、st of Risk Example,Option 2: Loss control Spend $2,000 to reduce probability of loss to 1/20 Cost of risk: Expected loss = $_ Cost of residual uncertainty = $3,000 (assumed) Cost of loss control = $2,000 Cost of loss financing = $0 Cost of internal risk reduction = $0 Total cost of risk = $_ Firm va

7、lue = $100,000 - $_ = $_,Cost of Risk Example,Option 3: Additional Loss control Spend an additional $2,000 to reduce probability of loss to 1/40 Cost of risk: Expected loss = $_ Cost of residual uncertainty = $2,700 (assumed) Cost of loss control = $4,000 Cost of loss financing = $0 Cost of internal

8、 risk reduction = $0 Total cost of risk = $_ Firm value = $100,000 - $_= $_,Cost of Risk Example,Option 4: No loss control, but full insurance Premium = $7,500 Loading = premium - expected loss = $7,500 - $6,000 = $1,500 Cost of risk: Expected loss = $6,000 Cost of residual uncertainty = $0 Cost of

9、loss control = $0 Cost of loss financing = $1,500 Cost of internal risk reduction = $0 Total cost of risk = $7,500 Firm value = $100,000 -$7,500 = $92,500,Cost of Risk Example,Key points from example: Do NOT minimize risk, Minimize cost of risk There are cost tradeoffs: Increase insurance coverage =

10、 Increase loading paid Decrease residual uncertainty Additional loss control = Decrease expected losses Increase loss control costs,Determinants of Value,Firm Value depends on Magnitude of expected net cash flows Timing of expected net cash flows Risk of expected net cash flows Net cash flows = cash

11、 inflows cash outflows,Firm Value Maximization & the Cost of Risk,Maximizing Value by Minimizing Cost of Risk Define: Cost of risk = Value without risk Value with risk Rearrange: Value with risk = Value without risk Cost of risk Implication: Maximize Value Minimize Cost of Risk,Hypothetical construc

12、t,Do Managers Maximize Shareholder Value?,In practice, there are several factors that motivate managers to maximize shareholder value Management compensation contracts (e.g., bonuses) Market for corporate control (e.g., hostile takeovers) Product market competition Monitoring by shareholders with la

13、rge stakes Legal duty of managers,Individual RM and the Cost of Risk,Cost of risk concept applies to individual RM An individuals cost of residual uncertainty depends on the persons degree of risk aversion Risk aversion Pay extra to reduce risk (buy insurance even though premium exceeds expected cla

14、im costs) Require higher expected returns to take on more risk (demand higher expected returns on riskier stocks),Risk Management & Societal Welfare,Minimizing the cost of risk is also an appropriate objective for society, because doing so generally results in an efficient level of risk for society

15、Efficiency = risky activities are pursued until the marginal costs exceed the marginal benefits Implication: public policies should consider the cost tradeoffs Example: greater safety regulation lower expected losses, but higher loss control costs,Conflict between Private & Societal Objectives,Issue

16、: Will individuals and businesses acting to minimize their own cost of risk result in the minimization of societys cost of risk? Observe: For a business to maximize value (minimize its own cost of risk), the business must consider the effect of its decisions on other parties (even in the absence of

17、regulation and legal liability) Why b/c decisions affect the terms at which other parties contract with the firm Example: riskier workplace higher wages,What if business cost of risk societal cost of risk? Example: workers are uninformed about injury risk Then, a business might engage in excessively risky behavior (they may not consider t