Good day to all the loyal followers of my blog. Although you currently number less than one, it's comforting to know that you all come to me for your risk management knowledge. Today we're going to look more at the variables in the net present value equation and the increased risk to a firm when adding new projects. In an example in class we had a pharmaceutical company that is considering the introduction of a new drug. There is, of course, litigation risk. The cost of the drug is $100M and expected revenue for year one is $140M. The standard deviation of current drug earnings is $25M and $20M for the new drug. The cost of capital is 6%, the marginal cost of holding risk capital is 11%, and the correlation between the new and existing drugs is 25%. Here we look at the 95% level and find that CaR is $41M currently and $59M when the new drug is added. Thus, the NPV is (140/1.06)-100-.11(59-41)=$30.13M.
Now let's assume that three things have changed from above but the rest has remained the same. Expected revenue in year one is now $106, the cost of capital has dropped to 5%, and we're going to look at the 99% level. The 99% level means in this case that we are looking at the worst loss in cash flow we could expect one percent of the time. The net present value in this case would be (106/1.05)-100-.11*((59*2.326)-(25*2.326))=-1.8M. If we ignored the increased risk to the company, then the NPV would be a positive $1M and the new drug would be added. But since we need to consider the added risk, this new drug would not be added. Also, I looked at the same numbers but at the 95% level and that alone reduced the NPV by $800K. So, it depends on what level we want to be protected at.
Sunday, February 22, 2009
Monday, February 16, 2009
The Demise of Fannie Mae
I came across an interesting article from the New York Times Online regarding the failure of Fannie Mae and the subsequent takeover by the government. The link for this website is http://www.nytimes.com/2008/10/05/business/05fannie.html?pagewanted=1&_r=1. For those of you who don't know, Fannie Mae is a government sponsored enterprise created to increase the availability and reduce the cost of credit in the mortgage market. Fannie Mae makes their money by purchasing mortgages from lenders, holding some and reselling most to Wall Street investors. Loans are classified according to their level of risk. Fannie Mae will guarantee to pay a loan it sells in case of default for a fee according to its risk. If the risks are accurately classified the fees should cancel out the cost of the loan.
Where Fannie Mae went wrong was in taking on too many risks. There was pressure from shareholders, Congress, and even the mortgage companies they were buying the loans from. Countrywide Financial, a longstanding and important trading partner, demanded that Fannie take on riskier loans or else they would sell to competitors. Fannie Mae felt that too much business would be lost and bought loans they weren't necessarily comfortable with. I think the main problem was that the risks weren't being properly identified. A former employee speaking on the condition of anonymity said that they were buying loans that would have previously been rejected and that they weren't charging nearly enough for payment in case of default. They felt they had to keep up with competitors and this was justification for taking on so much risk. For a two year period, they didn't have a Chief Risk Officer. When they did hire one he urged the CEO to charge more for the risky loans, but that urging went unheeded.
Where Fannie Mae went wrong was in taking on too many risks. There was pressure from shareholders, Congress, and even the mortgage companies they were buying the loans from. Countrywide Financial, a longstanding and important trading partner, demanded that Fannie take on riskier loans or else they would sell to competitors. Fannie Mae felt that too much business would be lost and bought loans they weren't necessarily comfortable with. I think the main problem was that the risks weren't being properly identified. A former employee speaking on the condition of anonymity said that they were buying loans that would have previously been rejected and that they weren't charging nearly enough for payment in case of default. They felt they had to keep up with competitors and this was justification for taking on so much risk. For a two year period, they didn't have a Chief Risk Officer. When they did hire one he urged the CEO to charge more for the risky loans, but that urging went unheeded.
Sunday, February 15, 2009
Taking on a New Project
Hello, y'all. The topic today is what happens to a firm's risk when a new project is undertaken. In class we had an example looking at the profitability of adding a new project with an expected cash flow in year one of $58M and a volatility of $50M. It was determined that the new project looked profitable until we looked at the added risk to the firm. Now, I am going to look at changing our expected cash flow from $58M to $75M and the volatility from $50M to $55M. I will assume all other variables remain unchanged, i.e. initial cost is $50M and the cost of capital is 6%.
The net present value of the project is $20,754,717. It looks very profitable. Let's look now at the added risk. The volatility of the existing projects and the new one is $90,967,027. The CaR of the existing projects is 1.65 times the volatility of $50M and that is $82,500,000. The CaR of the new and the existing projects is 1.65 times $90,967,027, which is $150,095,595. It costs the firm some money to hold the extra risk. Let’s suppose that cost is 10%.If we assume that the cost of the firm holding the extra risk is 10%, then our new NPV is 20.8M - .1*(150.1M-82.5M) which is $13,995,198. This project would be accepted since we have a positive net present value.
The risk of the firm always goes up when a new project is added that has a positive correlation with the existing projects. A new project carries a certain volatility which puts a certain amount of money at risk. When adding new projects that are positively correlated to the old ones, the risk of the firm will go up. Projects that are negatively correlated will lower the risk of the firm since it does the opposite of the other projects, thus canceling out some of the fluctuations between new and old projects.
The net present value of the project is $20,754,717. It looks very profitable. Let's look now at the added risk. The volatility of the existing projects and the new one is $90,967,027. The CaR of the existing projects is 1.65 times the volatility of $50M and that is $82,500,000. The CaR of the new and the existing projects is 1.65 times $90,967,027, which is $150,095,595. It costs the firm some money to hold the extra risk. Let’s suppose that cost is 10%.If we assume that the cost of the firm holding the extra risk is 10%, then our new NPV is 20.8M - .1*(150.1M-82.5M) which is $13,995,198. This project would be accepted since we have a positive net present value.
The risk of the firm always goes up when a new project is added that has a positive correlation with the existing projects. A new project carries a certain volatility which puts a certain amount of money at risk. When adding new projects that are positively correlated to the old ones, the risk of the firm will go up. Projects that are negatively correlated will lower the risk of the firm since it does the opposite of the other projects, thus canceling out some of the fluctuations between new and old projects.
Monday, February 9, 2009
Why is RMI valuable?
How's everyone doing? This is the third installment of the ever more popular "Mike Talkin" and probably the best one yet. The topic today is a good one: why is risk management and insurance valuable? I know what you're thinking...didn't risk management cause the AIG meltdown? No, that was bad risk management or risk mismanagement as I like to say.
Risk management is the process of settling on a level of risk aversion/tolerance, then identifying and measuring the risks, and then by protecting oneself with insurance or other means. The simple answer is that risk management is valuable because it protects a company from large losses. A couple of ways that effective risk management can benefit a firm are by reducing the number of on-the-job accidents and most importantly, minimizing legal liability. By understanding your risks, a company can implement procedures such as safer working conditions as one example. Lawsuits can be devastating to small companies and having a good protocol in place can minimize the number of accidents. Furthermore, your employees will be more efficient if they feel they are in a safe workplace.
Risk management is the process of settling on a level of risk aversion/tolerance, then identifying and measuring the risks, and then by protecting oneself with insurance or other means. The simple answer is that risk management is valuable because it protects a company from large losses. A couple of ways that effective risk management can benefit a firm are by reducing the number of on-the-job accidents and most importantly, minimizing legal liability. By understanding your risks, a company can implement procedures such as safer working conditions as one example. Lawsuits can be devastating to small companies and having a good protocol in place can minimize the number of accidents. Furthermore, your employees will be more efficient if they feel they are in a safe workplace.
Hello, again. Back for another exciting edition of Mike Talkin, I will try not to disappoint. No promises though. The topic du jour is the basic valuation model and what happens when the variables are manipulated. The formula is as follows:
∞
∑ (E[NetCashFlow@t]/(1+r)^t) – Bankruptcy Costs
t=1
Bankruptcy costs include paying collection costs for lenders, numerous court costs, and having to pay everyone you can among other things. These costs are affected by the probability of going bankrupt. With proper risk management and insurance, these costs will decrease. This alone will increase the value of the firm, but lower bankruptcy costs also allow the firm to receive a better interest rate. The lower the interest, the more valuable a firm will be. This inverse relationship also implies that with a higher interest rate, the value of the firm will decrease.
∞
∑ (E[NetCashFlow@t]/(1+r)^t) – Bankruptcy Costs
t=1
Bankruptcy costs include paying collection costs for lenders, numerous court costs, and having to pay everyone you can among other things. These costs are affected by the probability of going bankrupt. With proper risk management and insurance, these costs will decrease. This alone will increase the value of the firm, but lower bankruptcy costs also allow the firm to receive a better interest rate. The lower the interest, the more valuable a firm will be. This inverse relationship also implies that with a higher interest rate, the value of the firm will decrease.
Hello, people on the Internet. Welcome to my musings: "Mike Talkin'". Yes, you read right: I spell "talkin'" with no G. That is because I have attitude. My topic today is the CAPM and the assumptions that are necessary for it to operate. The Capital Asset Pricing Model is designed to find the required rate of return on a particular asset. Components of the CAPM are β, the risk-free rate and the expected market return. β measures the firm's sensitivity to the market.
The assumptions under the CAPM are: it's a publicly traded firm, many shareholders with well diversified portfolios, management is risk neutral, no agency problems, uninsured risk is uncorrelated with the risk of other securities in the portfolio, and there are no taxes. These assumptions limit the reliability of the model because we don't live in a perfect world. Most shareholders aren't going to be terribly diversified so that right there puts the model into question. Management isn't going to be risk neutral, there will be some level of risk aversion. Lastly, the no taxes assumption doesn't make sense since those are one of the two certain things in life.
The assumptions under the CAPM are: it's a publicly traded firm, many shareholders with well diversified portfolios, management is risk neutral, no agency problems, uninsured risk is uncorrelated with the risk of other securities in the portfolio, and there are no taxes. These assumptions limit the reliability of the model because we don't live in a perfect world. Most shareholders aren't going to be terribly diversified so that right there puts the model into question. Management isn't going to be risk neutral, there will be some level of risk aversion. Lastly, the no taxes assumption doesn't make sense since those are one of the two certain things in life.
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