Course Review
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Complete ERM lecture
What you should have learned from this class
Final exam details
Sample exam questions
Current State of Financial Risk
Management
• Modeling is used extensively in measuring
market risk
• Interest rate sensitivity measures depend on cash
flow models and term structure models
• Value-at-Risk measures also depend on models
• Don’t be fooled by indicated precision of
measures
• Understand the models underlying the
calculations
Operational and Strategic Risk
Analytics
• Analytic methods are primitive
• Top-Down Approaches
– Analogs
• Remove identifiable risks first
• Remaining risk is classified as operational risk
– Historical loss data
• Bottom-Up Approaches
– Self assessment
– Cash flow model
Solvency Related Risk Measures
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Probability of Ruin
Shortfall Risk
Value-at-Risk (VaR)
Expected Policyholder Deficit (EPD) or
Economic Cost of Ruin (ECOR)
• Tail Value at Risk (Tail VaR) or Tail
Conditional Expectation (TCE)
• Tail Events
Performance Related Risk Measures
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Variance
Standard Deviation
Semi-variance and Downside Standard Deviation
Below-target-risk (BTW)
Conclusion
• There is a standard approach for dealing
with each type of risk
• Each area has its own terminology and
techniques
• The ERM challenge is to combine these
different approaches into a common method
that can deal with risk in an integrated
manner
• The first step is to understand the different
approaches
Acknowledgements
• Frank Strenk, Lockton Companies
• James Lam
• Mark Vonnahme, Department of Finance, U of I
In This Course You Should Have
Learned How to:
• Analyze the financial condition of a corporation
• Calculate the cost of capital for a project
• Recognize the various ways the risk of the
project can be altered
• Determine whether a corporation should invest
in a project
• Compare debt, equity and alternative financing
approaches
• Explain how a particular project should be
structured and funded
Combined Final Exam
Both 8:30 am and 10 am sections
Friday, May 4, 2007
8-11 am
120 Architecture Building
Conflict exam 8-11 am Monday, May 7
115 DKH
You have to let me know by today if you want to take
the conflict exam and explain why
(See signup sheet)
Final Exam Details
• Exam is open book, open note.
• You may use calculators, including financial
calculators, but not laptops, cell phones or any
other communication devices.
• Test covers material from the entire semester,
including guest speakers and student presentations,
assignments 1-4 and all three cases.
– Keys for assignment 4 will be posted today (5/1)
• Exam tests your ability to make informed corporate
finance decisions, perform financial calculations
and to explain corporate finance concepts.
Test Taking Advice
• First answer all the questions you can without
relying extensively on your notes.
• Then work on the remaining questions if time
permits.
Exam Topics Include - 1
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Corporations
Roles and Titles of Financial Managers
Principal-Agent Problems
Financial Statements
– Balance Sheet (Figure 29.1)
– Income Statement (Figure 29.2)
– Sources and Uses of Funds (Figure 29.3)
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Measuring a Firm’s Financial Condition
Key Financial Ratios
Financial Planning
Introduction to Present Value
Objectives of the Firm
Corporate Governance
Exam Topics Include - 2
• Calculations
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Valuing Assets
Perpetuities and Annuities
Compound Interest
Nominal and Real Interest Rates
Bond Valuation
Stock Valuation
How Common Stocks are Traded
Estimating the Cost of Equity Capital
Linking Stock Price and Earnings per Share
Net Present Value
Internal Rate of Return
Alternative Investment Decision Rules
Exam Topics Include - 3
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Capital Asset Pricing Model
What Discount Rate to Use
Risk and Return
The Market Risk Premium
Capital Asset Pricing Model Considerations
Determining Beta
Arbitrage Pricing Model
Certainty Equivalents
Why Manage Diversifiable Risk?
Types of Risk
Traditional Approach to Risk Management
Enterprise Risk Management
Exam Topics Include - 4
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Sensitivity Analysis
Scenario Analysis
Monte Carlo Simulation
Real Options
Decision Trees
Market Values
Economic Rents and Competitive Advantage
Warren Buffet on Growth and Profitability
Sources of Funds for Corporate Financing
– Internal financing
– Stock
– Debt
Exam Topics Include - 5
• How Corporations Issue Securities
– Role of venture capital
– IPOs
– Private placements
• Payout Policy
– Dividends
– Stock repurchases
• Debt Policy
– Modigliani and Miller propositions
– WACC (before and after tax)
• Why M&M Does Not Hold
– Taxes
– Financial distress
Exam Topics Include - 6
• Theories of Capital Structure
– Trade-off theory
– Pecking order of financing choices
• Financing and Valuation
– After-tax WACC
– Adjusted present value
• Capital Investment Process
– Agency problems
– Monitoring
– Incentives
• Stock Options
– Valuation
– Appropriate and inappropriate uses
Exam Topics Include - 7
• Integrating Capital and Risk
– Insurative model
– Total Average Cost of Capital
• Enterprise Risk Management
– Concept
– Applications
– VaR
Sample Question
The WACC for a firm is 10%.
The after-tax WACC is 8.5%.
The cost of debt is 8%.
The cost of equity is 13%.
The opportunity cost of capital for a project is 20%.
The firm’s marginal tax rate is 35%.
What is the appropriate interest rate to use to determine
the NPV of this project if it will be financed entirely by
debt?
A)
5.0%
D)
20%
B)
8.5%
E)
None of the above
C)
13.0%
Increasing the corporate tax rate while leaving
personal tax rates unchanged would have what
effect on the value of leverage per $ of debt for a
leveraged firm compared to an unlevered firm?
A) Increase
B) Decrease
C) No effect
D) It depends on the relationship among the
tax rates
E) None of the above
What is the present value of the corporate tax
shield if a firm plans to borrow $1 million for 1
year at an interest rate of 10% to invest in a project
with an opportunity cost of capital of 15%? The
firm’s marginal tax rate is 35% and average tax rate
is 25%.
A) 21,739
D) 31,818
B) 22,727
E) None of the above
C) 30,435
A firm is financed with 50% debt and 50%
equity. The interest rate is 10%, the firm's cost
of equity capital is 20%, and the firm's marginal
tax rate is 35%. What is the firm's weighted
average cost of capital?
A) 10.00%
B) 13.25%
C) 16.04%
D) 20.00%
E) None of the above
A firm is financed with 30%, 60% common equity and
10% preferred equity. The interest rate is 5%, the firm's
cost of common equity is 15%, and that of preferred
equity is 10%. The marginal tax rate is 30%. What is
the firm's weighted average cost of capital?
A) 10.05%
B) 11.05%
C) 12.5%
D) 15%
E) None of the above
Given the following data for Year 1:
Profit after taxes = $5 million;
Depreciation = $2 million;
Investment in fixed assets = $4 million;
Investment net working capital = $1 million.
Calculate the free cash flow for Year-1:
A) $7 million
B) $3 million
C) $11 million
D) $2 million
A firm has zero debt in its capital structure. Its overall
cost of capital is 8%. The firm is considering a new
capital structure with 50% debt. The interest rate on the
debt would be 5%. Assuming that the corporate tax rate
is 40%, its cost of equity capital with the new capital
structure would be?
A) 9.8%
B) 9.2%
C) 11%
D) None of the above
A firm has an average investment of $10,000
during the year. During the same time the firm
has an after tax income of $2,000. If the cost of
capital is 15%, what is the net return on the
investment?
A) 5%
B) 15%
C) 20%
D) 35%
E) None of the above
A firm has an average investment of $10,000
during the year. During the same time the firm
has an after tax income of $2,000. If the cost of
capital is 15%, calculate the economic value
added (EVA) for the firm.
A) $500
B) $1,500
C) $2,000
D) $10,000
E) None of the above
What is TACC if:
D = 500; Cost of debt = 10%
E = 400; Cost of equity = 20%
I = 100; Cost of insurance = 5%
A) 8.5%
B) 13.0%
C) 13.5%
D) 14.5%
E) None of the above
Which was the first force that began to drive
ERM?
A) Corporate disasters
B) Regulatory actions
C) Industry initiatives
D) Best practices
E) None of the above
For assignment 4, question 10, what method did
you use to determine VaR?
A) Historical simulation
B) Variance-covariance method
C) Monte Carlo simulation
D) Equity allocation method
E) None of the above
What factors need to be considered when a firm
is trying to determine its appetite for risk?
I
the amount of risk it can accept
II
the expected return for taking a risk
III the best alternative for treating a risk
A) I only
D) I, II and III
B) II only
E) None of the above
C) III only
Pre-Exam Office Hours
311 Wohlers Hall
Wednesday, May 2
1-2:30 pm