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Stuvia 470807 rsk4803 topic 6 learning unit 11 summary
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Risk Financing (University of South Africa)
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RSK4803 Topic 6 Learning Unit 11
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Topic 1
Learning unit 3
Define risk capital.
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Discuss the economic cost of capital.
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What is the purpose of capital of an enterprise?
To conduct its activities and respond to its risks,
a company needs capital—to fund its operations, to
cushion it against adverse fnancial results, and to
assure observers of its fnancial soundness.
Distinguish between operational, risk and signalling capital.
Risk capital is the additional capital a frm
requires to cover the fnancial consequences of its
business risks. The amount of risk capital depends
on the risk tolerance of the frm. In practice, risk
capital is calculated as the capital needed to keep the
frm’s probability of ruin belob some defned level.
The sum of operational capital and risk capital
represents the economic capital of a firm
Capital in excess of economic capital (the sum of operational and risk capital) to serve as a
buffer for external stakeholders (e.g., indication of financial strength).
Discuss the interrelationship of firm capital and firm risk.
The capital required by a firm, then, consists of
operational capital, risk capital, and signaling capital.
Figure 1 illustrates this relationship for a hypothetical
firm.1 The figure shows the capital required
on the horizontal axis and the number of scenarios
on the vertical axis. It shows that the minimal capital
the firm will need to operate is $500; that amount is
considered its operational capital. In only 1% of the
scenarios is the capital needed greater than $1500.
This means that the economic capital of the firm is
$1500, of which $1000 is risk capital.
Although the firm’s business itself does not have
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any other risks, there is a very real risk of not being
able to demonstrate capital adequacy to interested
third parties. The capital effect of this risk needs to
be added on. If this signaling capital amounts to $50,
then the capital required is $1550.
Explain the sources of capital.
It is easy to think
that capital is limited to equity and various classes of
corporate debt—that is, the paid-up capital that
appears on the frm’s balance sheet. But a frm also
has the ability to access off-balance-sheet capital.
There are tbo primary sources of offbalancefsheet
fnancing. The frst is to pay a fee for the right to
access capital in case it is needed. An example is a
bank line of credit, bhich does not form part of the
frm’s onfbalancefsheet capital until it is borrobed
and outstanding. This is a costfefective bay for a frm
to postpone putting capital on its balance sheet until
it needs to. Of course, such a bank facility comes bith
terms and conditions that limit its availability and cost.
The second way to access off-balance-sheet
capital is to transfer risks to other firms, thereby
altering the retained risk profile and the consequent
capital structure of the firm. For example, by paying
a premium to an insurance company, a firm can
eliminate its exposure to property damage at its
manufacturing facilities. The firm does not have to
keep any paid-up capital to cover this risk (though
it will need some operational capital to pay the
ongoing insurance premium). All losses arising from
that risk are borne by the insurer.
Explain the standard model to the capital structure.
The Standard Model is the conventional corporate
fnance approach to capital structure. The frm’s
risk is not explicitly specifed. Instead, the starting
point is a statement of the frm’s paidfup capital
requirement, and the objective is to construct the
appropriate combination of equity, mezzanine (or
subordinated) debt, and senior debt. Normally, the
distinction betbeen these forms of capital is understood
in terms of the priority of claims on corporate
cash fobs bhile the frm is operating, and on
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corporate assets if the frm is liquidated.
There is another bay to describe this model—
namely, in terms of riskfbearing. The model distinguishes
betbeen the forms of capital according to
their exposure to the frm’s retained risks. The
Standard Model stratifes all the frm’s risks and
specifes that capital providers share those risks
sequentially. The senior debt providers are the least
exposed, and the equity investors are the most
exposed
Explain the insurative(not insurance model).
Combining the efects of the Standard Model and
the Insurance Model gives us a simple generalized
framebork to consider the efects of onf and ofbalancef
sheet capital, accessing both the insurance
and capital markets. We call this the Insurative Model.
In efect, the Insurative Model equates all frm
capital to the amount necessary to cover all frm
risks, bhether retained or transferred
Define WACC.
Weighted average cost of capital (WACC) is a calculation of a firm's cost of
capital in which each category of capital is proportionately weighted.
All sources of capital, including common stock, preferred stock, bonds and
any other long-term debt, are included in a WACC calculation. A firm’s WACC
increases as the beta and rate of return on equity increase, because an
increase in WACC denotes a decrease in valuation and an increase in risk.
To calculate WACC, multiply the cost of each capital component by its
proportional weight and take the sum of the results. The method for
calculating WACC can be expressed in the following formula:
Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
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D/V = percentage of financing that is debt
Tc = corporate tax rate
Define TACC.
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