FIN 413
Corporate Financial
Policy
Clifford W. Smith, Jr.
Spring 2007
Presentation 7
* 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
Managing Risk
 Bear it
 Change it
 Hedge it
Risk Management Spectrum
From Smith (2006)
Risk Profiles
ΔV
Risk Profile
ΔP(oil)
For an oil producer, rising oil prices [ΔP(oil) >0]
increase revenues and increase firm value.
Risk Profiles
ΔV
ΔP(oil)
Core Business
For an oil user, rising oil prices [ΔP(oil) > 0]
increase costs and decrease firm value.
Impact of Hedging
on Core Business Risk
ΔV
Hedge
ΔP(oil)
Net Exposure
Core Business
The Effects of Risk Management
Probability
Distribution after
risk management
Inherent
distribution
Firm Value
The World has Become
A More Risky Place
0.07
Percent
0
-0.1
57
61
65
69
73
77
81
Swaps
Futures
Options
Options on Futures
85
Break,
Range,
Participating
Forwards
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
Tax
Liability
E(T(Y))
T(E(Y))
Y1
E(Y)
Y2
Income
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.
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 minimum 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
Tax
Liability
Y0
Y1
Y2
Income
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.
Hedging and Taxes

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%).
Corporate Insurance
 Efficiency in project evaluation
 Efficiency in claims settlement
–
Claims only policies
–
Retroactive Insurance
War Fears, Insurance Costs Curb
Air Service to Mideast
Special 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 warrisk 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 Kuwait 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 in
Risk Bearing
Lessors
Lessees
Shareholders
Suppliers
Firm
Customers
Bondholders
Board of
Directors
Managers
Employees
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.
Hedging and the Firm's Employees
 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.
Du Pont's Incentive Pay Plan
 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.
Hedging and the
Bondholder–Stockholder Conflict
 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
ΔV
Hedge
ΔP(oil)
Net
Core business
Hedging and the
Bondholder–Stockholder Conflict
BP's Insurance Decision
 Benefits
– Taxes
– Contracting Costs
– Investment Incentives
 Costs
– Insurance premium
Cost of Insurance
Expected
Indemnity + Loading Fees
Payment
Premium = PV
Loading
Fees
=
Expected
Service
Costs
+ Profit
BP's Insurance Decision
Loss
Range
$0 to $10
$10 to $500
$500 plus
Total
Number
per Year
1845.0
Average
Loss
$
1846.73
Loss
Std. Dev.
0.03 m
$ 52 m
$ 12 m
40.0 m
70 m
98 m
1000.0 m
35 m
233 m
1.7
.03
Expected
Ann. Loss
$
0.66 m
$157 m
BP's Insurance Decision
 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
"Why Hedge?" and "What to Hedge?"
"Why?" and "What?" are not independent questions in
hedging decisions.
Why Hedge?
What is Hedged?
Taxes
Taxable income
Contracting costs
Reported income
Investment incentives
Market value
"What to Hedge?" and "How to Hedge?"
 What is hedged?
– Taxable income
– Reported income
– Market value
 How is it hedged?
– Off-balance sheet hedging
– On-balance sheet hedging
Firm Characteristics
Growth Options (Merck)
Leverage
Credence Goods (Eastern)
Product Warranties (Yugo)
Future Product Support (Yugo/Wang)
Supplier Financing (Campeau)
Closely Held Firm
Size
Regulation
Firm Specific Assets
Investment Tax Credits
Marginal Corporate Tax Rate
Marginal Personal Tax Rate
Tax Progressivity
Hedging Policy
?
?
Higher
Higher
Higher
Higher
Higher
?
Higher
Higher
Higher
----Higher