Why Shareholders Might Be Indifferent About Reducing the Volatility of Cash Flows?

Introduction

Risk management helps firms to reduce the volatility of cash flows. However, stockholders can be indifferent since it is not certain that lowering the volatility of cash flows increases the value of a firm. According to Brigham and Ehrhardt (2017), the value of a firm can only improve if risk management leads to either an increase in expected cash flows and or a decline in the company's weighted average cost of capital (WACC). The company's cost of capital can only fall when there is a decline in the cost of equity or cost of debt. If the volatility is due to unsystematic risks, investors can eliminate this risk through diversification hence the company's value does not change significantly. However, if the volatility is due to systematic risk, the company cannot hedge it since systematic risk affects the entire market.

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Secondly, reducing the volatility of cash flows involves costs. A company that hedges the risk would pass the cost of hedging to investors thereby decreasing their return. However, most large investors, especially institutional investors, can hedge such risks at the same or lower cost than the company's cost. Besides, the volatility of cash flows can only affect the cost of debt if it is significant enough to increase the threat of bankruptcy. Due to the above reasons, the stockholders of Tennessee Sunshine Inc. might be indifferent about mitigating the volatility of the company's cash flows.

Reasons why Risk Management can Increase the Value of a Corporation

Effective risk management might increase the value of a corporation. Surveys have indicated that risk management accounts for about 3.8% of the market value of firms. It might enhance the value of a company due to the following reasons.

Enhanced Debt Capacity

Risk management decreases the volatility of cash flows thereby lowering the threat of bankruptcy (Brigham & Ehrhardt, 2017). A firm with stable cash flows is less likely to go bankrupt. This enables the firm to use more debt in its capital structure. Besides, a significant reduction in the risk of bankruptcy can reduce the firm's cost of debt thereby increasing its value.

Decline in Financial Distress

Financial distress occurs when the corporation is unable to or finds it difficult to pay its creditors. A firm will experience financial distress if its cash flows are insufficient to meet its obligations. Costs of financial distress include higher interest rate on debt, concerns of shareholders, defections of customers, as well as bankruptcy (Brigham & Daves, 2013). Risk management limits the possibility of the firm's cash flows falling to unacceptable levels thereby reducing the risk of financial distress and its associated costs.

Optimal Capital Budget Over Time

Capital investments are critical for growth and future profitability of firms. When a firm invests in a project whose net present value is positive, the value of the firm increases (Berk & DeMarzo, 2017). Therefore, it is essential for firms to maintain a capital budget to exploit growth opportunities. Capital budgets are mostly financed through a combination of internally generated funds and debt since external equity involves high flotation costs (Brigham & Daves, 2013). Risk management improves the stability of internally generated cash flows thereby enabling a corporation to maintain a favourable capital budget over time (Brigham & Ehrhardt, 2017). It mitigates the risk of significant decreases in cash flows that might force a firm to cut its capital budget. This is more important for large-growth firms since their value depends on the ability to exploit growth opportunities. Thus, risk management is essential to smoothen cash flows and enable the firm to avoid the high-cost external equity. Hedging is effective in reducing the underinvestment problem. This illustrates why large growth firms use more derivatives than low-growth firms.

Borrowing Costs

Risk management can help firms reduce the cost of borrowing thereby lowering the average cost of capital. For instance, derivative instruments such as interest rate swaps reduce the cost of borrowing thereby increasing the value of the firm (Brigham & Ehrhardt, 2017). Besides, effective risk management reduces the financial risk in a firm. Lenders can advance credit at lower interest rates to borrowers with low risk of default (Berk & DeMarzo, 2017).

Tax Effects

The timing of earnings has tax implications that can affect the value of the firm. This is due to the treatment of tax credits, loss carryforwards as well as carrybacks (Brigham & Ehrhardt, 2017). Thus, the present value of taxes a corporation paid is lower when the earnings are stable than when the earnings are volatile (Madura, 2018). Risk management reduces the volatility of earnings thereby leading to tax benefits.

Comparative Advantages in Hedging

Hedging by a company can be more beneficial to the investors than when the investors hedge the risks themselves. Firms can hedge risks more efficiently than individual investors. This leads to lower transactional costs due to the larger volume of hedging activities (Brigham & Ehrhardt, 2017). Besides, firms can employ experts thereby improving the effectiveness of risk management strategies. Since markets are perfect, managers of firms have more information about risks than individual investors.

COSO and its Definition of Risk Management

COSO denotes the Committee of Sponsoring Organizations of the Treadway Commission. It is a joint initiative established in 1992 to combat corporate fraud. In 1992, it issued a framework for the internal control system to prevent fraudulent accounting. COSO also issued a framework for enterprise risk management in 2004 (Brigham & Ehrhardt, 2017). Enterprise risk management is a process that is designed to identify potential events that can affect the firm, and manage the risk within acceptable levels. It further states that risk management is implemented by everyone in an entity right from the board of directors to the management as well as other personnel (Arnold, 2012). Risk management is applied in strategy setting, and other processes as well as across the enterprise.

Components of the COSO ERM Framework

Internal Environment

The internal environment consists of the firm's culture, mission, workplace environment, attitude towards risk, among other internal aspects (Brigham & Ehrhardt, 2017). The internal environment affects the effectiveness of the enterprise risk management system. For instance, an organization with active boards overseeing operations tend to be more efficient in managing risk than organizations with weak corporate governance structures.

Objective Setting

Strategic objectives provide the background for operational, compliance, and reporting objectives (Brigham & Ehrhardt, 2017). It forms the risk appetitive and risks tolerance of the organization. Risk appetite is the amount of risk the entity is willing to accept with risk tolerance is the acceptable variation around the firm's objectives. Strategic objective setting ensures that the entity's goals are consistent with its risk appetite.

Event Identification

This involves identifying potential events that may positively or adversely affect the achievement of the entity's objectives (Brigham & Ehrhardt, 2017). Events that can positively impact the organization are opportunities while that can affect it negatively represent risks. Event identification provides a basis for risk assessment and the determination of risk responses.

Risk Assessment

It involves using qualitative and quantitative methodologies to evaluate the likelihood of risks as well as their potential impact on the organization (Brigham & Ehrhardt, 2017). Risk assessment is conducted on an inherent and residual basis. It provides the foundation for the entity's risk responses.

Risk Response

This component involves the identification of strategies to mitigate risks. Risk responses include risk reduction, avoidance, acceptance, and transfer (Arnold, 2012). Responses are identified and executed based on the risk evaluation. The management also considers the cost of these responses as well as their impact. The goal of risk responses is to reduce risk to desired tolerance levels.

Control Activities

These are policies and procedures implemented at all levels and in all functions of the organization to ensure that risk responses are appropriately executed. Control activities include approvals and authorizations, security of assets, segregation of duties, information systems controls, and performance reviews, among other activities. Effective control activities help the entity to reduce risks.

Information and Communication

The component involves identifying and communicating relevant information in a suitable form and timeframe to enable employees and management to cay out the duties effectively. For communication to be effective, it should occur in a broader sense implying that it should flow down, up as well as across the organization. It facilitates reporting which is essential in a risk management system.

Monitoring

It involves evaluating the enterprise risk management components to determine their quality and performance over time. It ensures that risk management initiatives are effective in mitigating risk and improving the performance of the entity. Monitoring helps in improving the efficiency and effectiveness of risk management.

Categories of Risk Events

Strategy and Reputation

An entity's strategic choices including competitive actions and corporate social responsibility can influence its reputation among its customers, suppliers and peers (Brigham & Ehrhardt, 2017). For instance, an action or omission that adversely affects the environment can damage the reputation of the company thereby affecting its performance, among other negative consequences. Examples include BP's oil spill and Volkswagen's defeat devices to cheat on emission tests. Both companies suffered reputational damages.

Control and Compliance

ERM helps an entity to enhance its internal control system and enhance compliance with regulatory requirements including financial reporting, intellectual property rights, among other laws. Weak internal controls can lead to the violation of financial reporting rules which attracts penalties, among other adverse effects. For instance, in 2016 the SEC fined Monsanto Company $80 million for accounting violations (SEC, 2018). The company had insufficient internal accounting controls for the accounting for rebates given to retailers (SEC, 2018).

Hazards

Hazards include fires, floods, riots, terrorism, among other natural and human-made disasters. They lead to losses with no potential positive effects. ERM helps entities to mitigate the impact of hazards through measures such as insurance. For instance, insurance losses resulting from Hurricane Florence are estimated to be between $15 and $20 billion (Dey & Freund, 2018).

Human Resources

Enterprise risk management can reduce risks related to human resources. Such risks include violation of anti-discrimination laws in recruitment, the safety of employees, violations such as sexual harassment by employees or managers, among other risks (Brigham & Ehrhardt, 2017). Such violations, including injuries to employees in the cause of their duties, can lead to litigation against the company, among other adverse consequences. ERM helps entities to establish strategies to mitigate such risks.

Operations

Entities face operational risks such as disruptions in the supply chain, changes in consumer demand, product recalls, and equipment failures, among other risks (...