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Overview and Introduction
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
2
First part: Performance Measurement
Second part: Enterprise Risk Management
3
Information posted on the website:
Course Syllabus; Exam Dates; Slides; Other Materials
Exam: Interview
Midterm tests: Two Midterm Tests (not mandatory)
Contacts:
Department of Statistics (Viale Regina Elena – First Floor -
Room 10)
Office hours: Wednesday at 4,00pm.
To make an appointment, it is recommended to send an email
the day before (Tuesday).
Class schedule:
Tuesday 8am (Class 3); Wednesday 2pm (Class 2)
General overview
1. Course goals
2. Performance measurement (PM) motivations and
definition
3. Enterprise risk management (ERM) motivations and
definition
4. Course motivations (linkages between PM and ERM)
5. Course topics
6. Details about the exam
Issues of enterprise risk management
Issues of performance measurement
Overview – Title and goals
Performance measurement and enterprise risk management
Goals: 1. Acquisition of basic skills in order to measure firm performances
2. Acquisition of basic skills in order to develop an enterprise risk management
process and measure firm risks in an integrated way.
Performance measurement (PM): motivations and definition
In recent decades, the PM discipline has assumed increasing
importance due to the growing complexity in understanding the
meaning of business results as a consequence of the instability
that occurs both inside and outside organizations.
Performance measurement (PM): motivations and definition
The main PM task is to connect “dots” of a firm activity by
combining decisions, their operating applications and related
performances according to both a feedback approach and
forecasting approach
A PM process has to be fit expectations of a different
stakeholder kinds
Performance measurement (PM): motivations and definition
Internal
Instability:
- Propensity to make innovations;
- Dynamic organization processes;
- Accounting noise;
- ….
Environmental
Instability -Price per unit volatility;
- Consumers behavior;
- Changes in the competitors
strategies;
- ….
Unclear current and
expected results of the
company
Need of a PM system able for analyzing: -The real and potential company capacity to achieve performances;
- The interactions between several performance kinds;
- The internal and/or external motivations which are behind company's
performances;
- How to maintain or improve a certain level of company's performances
Performance measurement (PM): motivations and definition
PM
SYSTEM Firm’s
Managers
Firm’s
Employees
Board
components
Internal stakeholders External stakeholders
Bank(s)
Financial
investors
Public
institutions
Commercial stakeholders:
Customers and suppliers
Unions
The double relationship
between the PM system and firm’s stakeholders, in terms of
information flows, rules about the manner to spread information,
performance goals’ definition, and so on.
Performance measurement (PM): motivations and definition
Firm’s goals
In the long run
Strategic
decisions
Operating
decisions
Operating
activities
Effective
Results
Measurement Indicators
selection
Feedback analysis Results
motivations
Firm’s stakeholders
pressures
Performance measurement (PM): motivations and definition
A Broader PM definition :
PM as a coordinated set of quantitative and qualitative
indicators aimed, on the one hand, to asses the capacity of a
firm (or other organization kinds) to achieve desired
objectives, on the other hand to figure out potential new goals.
According to this definition the PM activity is based on two
general indicators kinds:
1) Indicators which focused on the past. They allow to figure
out how earlier plans and their execution affected the
current results;
2) Indicators which focused on the futures. They allow to
figure out, under uncertainty conditions, how current (or
potentially activated) plans could affect expect results.
Performance measurement (PM): motivations and definition
Past
decisions
and activities
Current
performances
measurement
PM indicators as a set of management control tools
Current
decisions
and activities
Expected
performances
measurement
PM indicators as a set of management planning tools
The PM's activity looks at events already happened; therefore produces
outputs under certainty conditions
The PM's activity inquires potential future scenarios; therefore
gives indications under uncertainty conditions
Enterprise risk management (ERM): motivations and definition
The need of an ERM system is a consequence uncertainty seen as a
threat and an opportunity.
Performance
uncertainty
Economic value creation
Economic value conservation
ER
M S
YS
TE
M
Performance measurement (PM): motivations and definition
General definition of ERM:
“Enterprise risk management is a process, effected by an
entity’s board of directors, management and other personnel,
applied in strategy setting and across the enterprise, designed
to identify potential events that may affect the entity, and
manage risk to be within its risk appetite, to provide reasonable
assurance regarding the achievement of entity objectives. ”
(Enterprise Risk Management — Integrated Framework, 2004)
Performance measurement (PM): motivations and definition
The ERM as a multidimensional tool :
1) ERM as a strategic tool to assumes decisions;
2) ERM as a corporate governance and accountability tool;
3) ERM as a tool for managing the double side of risk and
uncertainty;
4) ERM as an organization tool.
Performance measurement (PM): motivations and definition
Benefits of ERM
A good ERM system:
1) Allows to achieve strategic and operating goals;
2) Brings near managerial decisions and operating processes to
corporate governance rules;
3) Reduces informational inefficiency between companies and their
stakeholders;
4) Fosters “risk culture” and creates a “risk‐aware” across the
organization;
5) Allows to develop new risk models taking into account the
features of a given company and its environmental context.
Performance measurement (PM): motivations and definition
The strategic side of ERM
Return
expectations and
risk propensity
Strategies Alignment
Strategies’ risk Firm ‘s features Alignment
Change in the
firm ‘s features Strategies’ risk
Dynamic alignment
Performance measurement (PM): motivations and definition
General representation of the ERM approach
All risk kinds are considered as a part of unique risk
The traditional risk management approach arises a
component of the ERM approach
Source: NYU Enterprise Risk Management
Risk measurement and
capital adequacy
Enterprise risk management (ERM): motivations and definition
The importance of internal risk drivers in ERM
A central aspect in the ERM is the focus on the business risk drivers
that can be managed through managerial decisions.
The main internal risk drivers regard operating and financial
leverages
Course motivations (linkages between PM and ERM)
The motivation for combining PM and ERM appear clear
- The measurement of performance must take into account the
volatility (risk) of company results;
- An ERM system starts from a deep knowledge of linkages between
performances, decisional process and decisions implementation;
- Both PM and ERM produce effects on the relationship between
corporate governance aims and managerial goals;
- The spread of PM and ERM outputs help external actors for
analyzing the firm value in the long run.
Course motivations (linkages between PM and ERM)
PM , ERM and economic value creation/ destruction
Good
PM system
Good
ERM system
Bad
PM system
Bad
ERM system
VALUE CREATION
Mistakes
discovery and
reworking
of decisions
and/or processes
Improvement of
the capacity
to analyze internal and
external phenomena
Improvement of
external relations
VALUE DESTRUCTION
Shadow
mistakes and
lower possibility
to rework decisions
and/or processes
Lower
capacity
to analyze
internal and
external phenomena
Worsening of
external relations
Course topics
First part - Performance measurement
1. Overview on the firm activity and its environmental context.
2. Overview on managerial decisions and firm performances
3. The performance measurement according to the
accounting view: financial statement analysis
4. The performance measurement according to the economic
value view: market value vs. intrinsic value; the present
value analysis according to several methods
5. The Balance Scorecard Model
Course topics
Second part – Enterprise risk management
1. Business risk, uncertainty and ambiguity .
2. Overview on the main firm risks.
3. Unlevered and levered idiosyncratic risk: operating
leverage, financial leverage and economic performances
volatility; the dynamic analysis of unlevered idiosyncratic
risk.
4. The systematic risk according to a managerial perspective:
the bottom up approach
5. Corporate governance pressures, compliance, economic
performances smoothing and inter-temporal risk transfer.
6. Internal risk control according to an integrated approach
Two midterm tests during the course
Midterm tests are not mandatory and can only be taken by
who attending classes
Oral test (Interview) – Formal sessions
Final valuation:
For students who attend lectures and take the first and
second midterm test, the final grade will depend on the
average midterm tests.
You can choose to register (during the a formal session of
exam) the average grade which comes from midterm tests. In
this case the maximum grade is 26/30.
Exam details
In what cases do you have to take the oral test?
1) If you want to improve your average grade on midterm tests.
2) If you don’t get a minimum average grade (18/30) on midterm
tests.
3) If you choose not to take midterm tests.
If you just take one of two midterm tests, the final interview will
not regard all of the syllabus but just a part of it.
Exam details
Exam dates (formal sessions)
•June 10, 2020
•July 20, 2020
•June 10, 2020
•September 16, 2020
Validity period about of both
the first and second midterm test
Midterm tests do not have a formal value. Therefore, all
students must register the final score during one of the
above exam sessions.
Exam details
A brief introduction on fundamentals of
business management
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
1. The business management discipline
2. The theory of firm: neo-classical theory
3. The theory of firm: neo-institutional theory
4. The theory of firm: Schumpeter theory
5. Entrepreneurship, risk and arbitrage profits
6. Entrepreneurial firms, public companies and decisional
power
7. The business model as logical business design tool
8. The environmental context and firm performance
9. Firm’s performance classifications
The business management subject
Business management arises as sort of evolution of
microeconomics and industrial economics, where the main
focus is on:
-Conceptualization of the firm as an economic entity;
- The relationship between firm and its sector (industrial perspective);
- The relationship between firm and its market (marketing perspective);
- Top management (strategic perspective);
- Firm goals and related decisions (decision making perspective);
- Managerial tools to support firm decisions;
- Managerial tools to measure firm performance;
- Financial tools and methods.
The business management subject
-Strategic management;
- Corporate management;
- Innovation management;
- Knowledge management;
- Strategic and operating marketing;
- Corporate governance;
- Corporate finance;
- Performance measurement;
- Enterprise risk management;
.
- Entrepreneurship;
- Family business
-Total quality management;
- Organization;
- Human resource management
- Supply change management;
- Operations;
- Accounting management;
- Others
From a functional point of view the business
management subject includes a number of specific disciplines:
The theory of firm: Neo-classical theory
Main assumptions:
1) Firms are seen as profits maximizers.
2) In the short run, firms, during the early (or growth) stages of
their lives, have decreasing profits caused by fixed investment.
3) Markets work under equilibrium conditions, therefore, prices will
be determined by competitive pressures.
4) The labor factor arises like a “normal” production input.
5) Neo-classical theory also assumes salaries are flexible: The
salary dynamic depends on demand dynamic.
6) All internal and external actors are rational.
The entrepreneur role
1) According to Neo-Classical Theory the entrepreneur is, on the
on hand a capitalist, on the other hand an organizer of
production inputs;
2) The idea of the entrepreneurs as organizer implies that most
successful entrepreneurs are able to find competitive
advantage in terms of higher efficiency.
3) The entrepreneur is not an innovator.
The theory of firm: Neo-classical theory
Weaknesses of Neo-classical theory
1) Normally markets don’t work under equilibrium conditions.
2) Normally goods prices don’t discount all information;
3) The market chaos could be seen as a source of arbitrage
profits.
4) What appears now like a good inputs organization could
implies sunk cost in the future.
5) Often successful entrepreneurs are innovators.
6) Often economic actors think irrationally.
The theory of firm: Neo-classical theory
Main assumptions:
1) The firm is seen as an institution with hierarchical structure
2) Property rights and long-term contractual relationships
determine the allocation of resources
3) The ownership of the company must be attributed to a number
of stakeholders.
The theory of firm: Neo-institutional theory
The markets have discontinuous curves, in the sense that the
stability phases (equilibrium) are followed by strong shocks
(disequilibrium).
During the stable periods, the firms that have dominant positions
tend to maximize profits thanks to the inertia of given drivers of
competitive advantage.
On the contrary, during shocks, the success of firm depends on
entrepreneur ability to exploit the chaos through the destruction of
pre-existing factors of success and the creation of new drivers of
competitiveness.
This phenomenon is known as “the process of
creative destruction"
The theory of firm: Schumpeter Theory
The entrepreneur as innovator
36
According to Schumpeter the entrepreneur is able to make the following innovation
activities:
• Product innovation;
• Process innovation;
• Acquisition of a new production factor
• Organizational innovation
Creativity is the main characteristic of entrepreneurs
The theory of firm: Schumpeter Theory
Some examples of creative destruction
37
1. Innovations about new apps in Internet have destroyed (or decreased in a strong
way) the value of several businesses such as travel agencies, a part of music
industry etc.
2. The born of personal computer sector (1980s) has destroyed the industry of
typewriters
3. The first product of Microsoft (DOS) has destroyed (or decreased in a strong way)
the value of IBM’s software.
The theory of firm: Schumpeter Theory
The timing of innovation: the strange case of Olivetti
Olivetti was the first firm to develop a personal computer (1960s).
The new product did not succeed because it was not aligned with the
marked needs.
Then, Olivetti decided to abandon the new product for increasing the
investments in the sector of typewriters.
Twenty years later (1980s), the sector of typewriters was destroyed
by the new personal computer.
38
The theory of firm: Schumpeter Theory
39
The entrepreneurship subject is focused on new small
businesses that promise a potential growth
An new entrepreneurial firm (start up) in not just a young firm,
but a new economic activity based on one or more innovations
Entrepreneurship, risk and arbitrage profits
40
Entrepreneurship
issues
Startups
and new
businesses
Entrepreneurs
Economic
Growth
INNOVATION ISSUES
Entrepreneurial Risk Venture concept
Entrepreneurship, arbitrage profits and risk
An entrepreneurial activity is a venture when it is based on an
innovative project that entails high expected profits and high risk.
Ventures
High probability
to fail
High expected
profits
Ventures imply an extreme risk-return relationship
Entrepreneurship, risk and arbitrage profits
The entrepreneur as decision maker : arbitrage profit
Mistakes done by other entrepreneurs became the main driver of
arbitrage profits.
The entrepreneur is able to exploit mistakes in terms of arbitrage
profit: he buys (or sells) when the price of a product is lower (of
higher) than its real value.
42
Market efficiency
Arbitrage profit = 0
Intrinsic value Market value (price)
Market inefficiency
Intrinsic value = Market value (price)
Arbitrage profit > 0
Entrepreneurship, risk and arbitrage profits
The entrepreneur as decision maker: arbitrage activity
43
The higher capacity of successful entrepreneurs to make new strategies in
advance than new phenomena gives them the opportunity to take a large
economic value through arbitrage operations based on the exploitation
of the resources’ intrinsic value.
Inefficiency and instability of the market
Intrinsic value Market values (prices)
Investments in one or more
undervalued resources
Appreciation
of resources
Intrinsic values
=
Market values
(prices)
Arbitrage value = Final Value – Initial Value
Entrepreneurship, risk and arbitrage profits
44
The decisional power
In an entrepreneurial firm
the decision-making
power belongs to the
entrepreneur.
The managers have a
residual decision power
tied to their skills. The
residual manager power
arises during the phases
of strategies
implementation
Entrepreneurial firms Public companies
The decision-making
power of managers is
higher in the case of
public companies, where
the ownership of the
company is diluted
among many investors.
The power of
shareholders regards the
control activity on
decisions of managers
and their behavior
The transformation of an entrepreneurial firms in a public company causes a change
in relation to the decisional power. This kind of transformation is often due to
dimensional goals. In fact the margin growth of a firm can be amplified by new
financial resources that come from the capital market.
Dimensional
goals
Decisional power
changing
Entrepreneurial firms, public companies and the decisional
power
There are several and heterogeneous definitions of what is a “business
model”
However, there are some general recurring concepts, which are the
following:
• The business model is a logical scheme that connects the dots among
ideas; technologies, and economic results;
• The business model expresses the value proposition;
• The business model is a sort of structural template.
The business model as a logical business design tool
Source: Osterwalder, Pigneur (2010)
Business model “canvas” and revenues/costs formation
The business model as a logical business design tool
Breakdown of canvas
The canvas facilitates both the unification and the breakdown process.
Breakdown process: it allows to extract the four dimensions and the nine
elements of the business.
The business model as a logical business design tool
Right side of Canvas
Value/Customer oriented
(external perspective)
The business model as a logical business design tool
Left side of canvas
Activity/Role oriented (internal perspective)
The business model as a logical business design tool
Up side of canvas
Structural and strategic dimension
The business model as a logical business design tool
Down side of canvas
Economic dimension
The business model as a logical business design tool
The environmental context and firm performance
Internal context
Environmental
context
Decisions
Firm performance
The environmental context and firm performance
Two main approaches to link environmental
context and firm performance
1) The firm must be consistence with its environmental
context
2) The firm seeks performance drivers inside itself and in
some cases produces external changes
The environmental context and firm performance
The structure-conduct-performance paradigm
Industry structure:
- Barriers to entry;
- Concentration degree;
- Competitors;
- Clients;
- Suppliers
- Others
Conduct:
- Differentiation strategies
- Cost strategies
- Niche strategies
Competitive
advantage Performance
The environmental context and firm performance
Resource based view
Strategic resources
Capabilities
Competitive advantage
Strategies
Performance
Possible changes
in
the environmental
context
The environmental context and firm performance
The business cycle life
Financial need: High; Current Profit: Low;
Potential profit growth: High
Financial need: ?; Current Profit: Low;
Potential profit growth: ?
Financial need: Low ; Current Profit: High;
Potential profit growth: Low
Financial need: Low ; Current Profit: Low;
Potential profit growth: Low
The BCG Matrix
The environmental context and firm performance
Relationships between environmental context, decisions and performance
The environmental context and firm performance
Industry structure
and business cycle life
Firm resources
and managerial capabilities
Strategic, tactical
and operating
decisions
Economic and financial
performance
Ne
w r
eso
urc
es
External
stakeholders
pressure
Internal
stakeholders
pressure
Social
performance
- Quantitative and qualitative performances.
-General and specific performances (divisional performances, .e.g.
marketing performance, production efficiency, organizational performances,
R&D performances, innovation performances etc).
- Strategic and financial/economic performances.
- Accounting and expected performances.
- Corporate Social Responsibility (CSR) performances.
- Growth performances (structural growth, sales growth, market share
growth etc)
At list, the combination of all performance kinds produces the “general firm
performance”
In the short run the above performance kinds are often in contrast to other.
In a long term perspective the above performance kinds tends to be
consistence to other, especially in the case of both a good PM system and a
proper organizational structure .
Firm’s performance classification
Long run vs. short run: the administrative paradox
The current performance maximization may reduce the firm capacity to
provide results in the long run
The performance maximization in the long may reduce the firm capacity to
maximize current results
Firm’s performance classification
Performance measurement according to the
accounting view: financial statement analysis
(First part)
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
1. Firm, financial system and financial reporting
2. From business activities to financial statements
3. Typical issues about accounting information
4. Financial performance measures and financial
statement structure
5. The net income statement
6. Revenue analysis
7. EBIT analysis
Firm, financial system and financial reporting
- From a financial point of view a firm arises a units in deficit, because
the formation of costs occurs before the achievement of revenues.
- Consequently, each company has as its first market the capital
market which can be acquired in the form of equity or financial debt.
- Therefore, financial reporting system must fit rules and constraints
coming from financial system
Firm, financial system and financial reporting
Financial actors who have interest on firm’s financial reporting
are the following:
- Financial Authorities (e.g., SEC in USA, CONSOB in Italy)
- Financial intermediaries (commercial banks, investment banks,
private equity founds, venture capital founds, insurance companies
etc);
- Informal investors (small investors who do not intermediate capital
flows, business angels, startups accelerators etc.)
- Independent financial analysts (single practitioners, rating agencies)
From Business Activities to Financial Statements
Source: Palepu K.G, Healy P. M. (2012), Business Analysis & Valuation, fourth ed., chapter 1
Typical issues about accounting information
- Accounting information shows just a part of firm dynamic in
economic and financial terms.
-Accounting managers own a certain flexibility in order to make
accounting report.
- The external analysts have to figure out when and how this
managerial discretion was used and its reasons.
- Accruals, or more in general accounting techniques, could create
formal firm's performance which are partially or totally just artificial
results.
- Normally, accounting information coming from public companies are
clearer than the case of private companies.
- Accounting information arise a the initial tool for estimating the past
and present dynamic of the firm. They are not sufficient to asses the
firm’s economic value.
What could lead a manager make accounting information
worse?
- To exploit tax benefits hiding the real firm’s profitability
- To hid the firm risk to failure.
- To exploit personal benefits coming from artificial results.
- A lack of skills and/or mistakes to figure out the real amount of
assets, liabilities, revenues and costs.
Typical issues about accounting information
What could induce a manager to make accounting information
as correct as possible?
- In the medium to long term, incorrect information worsen the
relationship between the firm and its stakeholders.
- The constant spread of proper accounting information increases the
bankability of the firm.
- Growth-oriented strategies require growing confidence in the
business from many economic players; confidence that could
decrease in the case of shadow accounting information.
- The compliance than accounting rules avoids the risk of penalties
for the company and / or manager.
Typical issues about accounting information
Financial performance measures and financial statement structure
Financial performance measures aims to analyze values and
drivers about:
- Economic inflows (revenues), economic outflows (costs) and related
net income;
- Balance sheet structure (assets an liabilities);
- Capital structure
- Unlevered profitability and levered profitability
- Cash inflows, cash outflows and related net cash flow
These measure kinds can concern the firm considered as whole, or specific organizational
areas
Financial performance measures and financial statement structure
The economic performance measurement
1) Analyzing the firm capability to cover operating costs through
revenues tied to the core business (operating equilibrium).
2) Identifying of the causes of possible operational losses (negative
operating disequilibrium)
3) Analyzing the firm capability to produce a sufficient operating
profit than non typical managerial areas (general equilibrium)
4) Analyzing the firm capability to produce a positive net income
5) Identifying of the causes of possible negative net income (general
disequilibrium)
Financial performance measures and financial statement structure
The balance sheet performance measurement
1) Analyzing the firm capability to cover the financial need caused by
investment decisions
2) Analyzing the firm capability to balance the assets’ time to
maturity with that of liability ones.
3) To figure out solutions about a potential lack of liquidity
4) To figure out solutions about a potential slack of liquidity
Financial performance measures and financial statement structure
The capital structure measurement
1) Analyzing the firm propensity towards financial debt.
2) Measuring the financial leverage.
3) Analyzing the relationship between leverage and the risk of
financial distress.
4) Analyzing consistency / inconsistency between the firm life
cycle and the equity level
Financial performance measures and financial statement structure
The profitability measurement
1) Measuring the unlevered profitability by combining net operating
profit wit net investments
2) Measuring the levered profitability by combining net income with
net equity
3) Linking profitability and risk in terms of volatility of both unlevered
and levered conditions
4) To figure out a right trade off between profitability and volatility
Financial performance measures and financial statement structure
The cash slow measurement
1) Analyzing the firm capability to cover cash out flows through cash
in flows
2) Analyzing the net cash flows composition taking into account
structural cash flows and economic cash flows
Income statement
Revenues and costs
analysis
Balance sheet
Static and dynamic
analysis of assets and
liabilities
Capital structure and
profitability ratios
Cash flow analysis
Financial performance measures and financial statement structure
Firm
bankability
Survival firm's
degree
Potential
firm’s growth
Failure firm's
risk
First inputs to outline new strategies, investment/financing decisions,
organizational changes etc
The net income
The net income definition
The net income is an accounting document which shows firm’s
economic results concerning a given year.
Revenues linked to the core business, as well as non-typical
revenues (e.g. interest income), achieved in the last administrative
period are the positive side of firm’s profit.
Operating costs, as well as non-typical costs (e.g. financial costs) ,
related to the last administrative period are the negative side of
firm’s profit.
Net income (or net profit) = Total revenues – total costs
The net income
Net income expresses a general result that can be broken
down in several areas:
A) Operating net income (EBIT or operating profits) ;
B) Financial net income;
C) Extraordinary net income;
D) Gross profit
E) Fiscal costs (taxes)
Gross profit = A + B + C
Net income (Net profit) = Gross profit - E
The net income
Revenues
(-) Variable costs (costs of goods sold)
a1) Contribution margin
Salries
(+) Rents
(+) Amortization and depreciation
(+) Other administrative costs
a2) Total fixed costs
a1 - a2 = A) EBIT (earning before interest and taxes)
EBIT (+) Amortization and depreciation = EBITA
(+) Interets income
(-) Financial costs
B) Fianncial income
(+)Extraordinary revenues
(-)Extraordinary costs
C) Extraordinary income
A + C + C = D) Profit before taxes
E) Taxes
D - E = Net income (Net profit or net loss)
Revenues analysis
Revenue Model
Primary Demand Secondary Demand
Competitive
strategies
Customers composition
Marketing
Unit Price
EBIT (or operating profits)
Revenues
-Operating variable costs
= Contribution margin
- Operating fixed costs (including amortization and depreciation)
= EBIT (Earning before interests and taxes)
R = revenues; VC = operating variable costs; p = price per unit;
vc = variable cost per unit; (p – vc) = contribution margin per unit;
Q = quantity of sales; Q(p – vc) = contribution margin;
FC = operating fixed costs.
FC -vc)-(pQFC -VC-REBIT
0EBITFCvc)-(pQ If
0EBITFC vc)-(pQ If 0EBITFC vc)-(pQ If
CM
CMCM
0EBITvc-p
FCQ'Q
Q’ = equilibrium quantity
Q ‘ shows the minimum level of quantity produced and sold below
which the company is unable to cover fixed costs through the
contribution margin
EBIT (or operating profits)
FC
VC
Total operating costs
R
Q’ Q
. Break even point
The break even analysis
EBIT (or operating profits)
Profitable area
Profitable area
Ebit
- FC
FC = 1000
VC = 4000
T. op. costs = 5000
R = 8000
Q’
=
100
Q = 400
. Break even point
The break even analysis (Example with EBIT > 0)
Fixed cost = 1000
Price per unit = 20
Cost per unit = 10
Quantity sold = 400
75%
EBIT = 400(20-10) -1000 = 3000
If DQ = - 75% DEBIT = - 100% EBIT = 0
EBIT (or operating profits)
EBIT (or operating profits)
t0 t1 D
Q 400 100 -75% p 20 20 0% R 8000 2000 -75% vc 10 10 0% VC 4000 1000 -75% CM 4000 1000 -75% FC 1000 1000 0% EBIT 3000 0 -100%
The break even analysis (Example with EBIT > 0)
-75% represents the safety margin compared to the risk of reducing sales
EBIT (or operating profits)
The break even analysis (Example with EBIT < 0)
t0 t1 D
Q 50 100 100% p 20 20 0% R 1000 2000 100% vc 10 10 0% VC 500 1000 100% CM 500 1000 100% FC 1000 1000 0% EBIT -500 0 -100%
+ 100% is the change in sales (Q) which would allow to move from a negative EBIT
to a null EBIT
EBIT (or operating profits)
Profitable revenue (PR), contribution margin rate (cmr) and EBIT
R' - R )p(Q'- p(Q) PR
FCvc-p
pR' )p(Q'
p
vc-p cmr
FC-vc)-(pQFCvc-p
p
p
vc-p-Qp
p
vc-p)R'-cmr(R EBIT
EBIT (or operating profits)
Profitable revenue (PR), contribution margin rate (cmr) and EBIT
(Example with EBIT > 0)
Q 400 p 20 R 8000 vc 10 VC 4000 CM 4000 FC 1000 EBIT 3000
3000PRcmr EBIT
6000PR ;20000,5
1000 R' ;5,0
p
vc-p cmr
EBIT (or operating profits)
Fixed cost, internal resources and production
The fixed costs level and related value of both Q’ and R’ depends
on internal durable resources such as plants, machinery, human
resources, intangible resources (e.g. patents).
Each level of durable resources determines the level of fixed costs
the related values of Q 'and R‘
The fixed costs are stable for a given max production level,
beyond which fixed costs increase. Therefore, fixed costs do not
have a linear trend compared to production, but a "stepped" trend
related to the max production capacity.
Variable costs = (Variable cost per unit) x (Expected sales )
Sales
Technical coefficients Negotiation skills
Distance of potential
suppliers
Number of potential
suppliers
Variable cost per unit
+
+ -
-
EBIT (or operating profits)
EBIT (or operating profits)
Durable resources increasing, current EBIT decreasing
FC
Q Q1 Q2 Q3
Q’1 Q’2 Q’3
Increasing of both expected EBIT and volumes’ risk
Max
production
Increasing 1
Max
production
Increasing 2
Max
production
Increasing 3
Start-up, development and dynamics of total costs
FC = Total costs
Q
Q*
First growth
FC
Q**
VC
TC
VC
Stable
resources
Q
Before production start First stage
Incre
asin
g
reso
urc
es
Increasing
resources
TC
TC
FC
FC
EBIT (or operating profits)
VC
First
stage
First
growth
Stability
Internal
efficiency
Stability
Stability
Stability,
expansion or
downsizing
EBIT (or operating profits)
Q’ =
equili
brium
quantity
DEBIT < 0 DEBIT = 0
DEBIT = 0
Break even point and EBIT dynamic
Ebit
Q
Q’
p - c
FC
First
stage
First
growth
Break
even
Efficiency
Competitiveness
Break even analysis (Q’ ) and entrepreneurial stages
EBIT (or operating profits)
Performance measurement according to the accounting
view: financial statement analysis (Second part – Ratios
analysis)
Prof. Antonio Renzi
Performance Measurement and Enterprise Risk Management
Agenda
1. The ratios analysis: general logic
2. Profitability ratios
3. Profitability ratios improvement
4. Capital structure ratios
5. Capital structure ratios and equity profitability
6. The internal (or sustainable) growth rate
7. The net working capital
8. Accounting solvency ratios
9. Liquidity ratios
10.Expected revenues, capital intensive ratio and financial need
estimation
The ratios analysis: general logic
The ratios analysis definition
The ratios analysis is a typical financial statement tool aimed to
connect dots of firm’s performance in a unique framework. The main
kinds of ratios point out the following items:
- Profitability and growth;
- Capital structure and dividend policy;
- Solvency and liquidity;
- Asset management.
The ratios analysis: general logic
Investment
/financing
decisions
t0
Ratios
analysis
t1
The double relationship between Investment/financing
decisions and ratios analysis
t2 t1
Direct relationship
Direct relationship
The ratios analysis: general logic
The ratios inputs
The ratios analysis is based on accounting information coming from:
- Net income statement;
- Balance sheet statement
Net income
statement
Total revenues – Total cots
Balance sheet
statement
Assets Liabilities
Profitability and
growth ratios
Capital structure ratios
Solvency and
liquidity ratios
Assets
management ratios
The profitability ratios aims to point out the economic capacity in
relative terms, therefore allow comparisons in space and/or time.
For example, a big corporation that produces a high profits level
could be less profitable than the case of a small business which
provides lower profits.
The most part of profitability ratios are based on the comparison
between a profit flow and a stock of capital.
Just a little part of them compare two kinds of income flow
The profitability ratios analysis my be used to inquire both specific
profitability areas and the general firm’s profitability (composition and
decomposition of profitability).
Profitability ratios
Composition and
decomposition of profitability
Operating
profitability
Non-operating
profitability
General firm’s
profitability
Operating
profitability
Non-operating
profitability
Composition
process
Decomposition
process
A composition process implies to combine
profitability ratios with capital structure
ratios
Profitability ratios
Revenues profitability
ROS
(Rerun on sales)
Measures the portion of each
revenue (R) euro that becomes
operating or net income
Turnover
Measures the portion of each
investment euro that becomes
revenue (R)
R
loss)(or profit Net ROS ;
R
EBIT ROS NetOperating
assets Total
R )Turnover(2 ;
sInvestmentNet
R )Turnover(1
Where: Net investments = Equity + Financial debts
Profitability ratios
ROA
(Return on assets)
Measures the portion of each
asset euro that becomes net
income
ROI
(Return on
investments)
Measures the portion of each
net investment euro that
becomes EBIT
assets Total
loss)net (or profit Net ROA ;
assets Total
EBIT ROA NetOperating
Turnover ROS debts Financial Equity
EBIT
NI
EBIT ROI
Profitability ratios
Investments profitability
ROI, ROS , Turnover analysis
(Example 1: the effect of price per
unit)
NI = 1.000.000 Equity = 400.000
Debt = 600.000
A
A
B
NI = 1.000.000 Equity = 400.000
Debt = 600.000
B
Profitability ratios
Combination between investments
profitability and revenues profitability
ROI, ROS , Turnover analysis
(Example 2: the effect of sales)
NI = 1.000.000 Equity = 400.000
Debt = 600.000
A
A
B
NI = 1.000.000 Equity = 400.000
Debt = 600.000
B
Combination between investments
profitability and revenues profitability
Profitability ratios
Other two kinds of net investment (NI) profitability
NI
onsDepreciati EBIT
NI
EBITA ROI
NI
rate)tax -EBIT(1
NI
NOPAT ROI
Profitability ratios
The ratios analysis
Equity profitability
ROE
(Rerun on equity)
Measures the portion of each
equity euro that becomes net
income
debts finacial - inv.Net
loss)net (or profit Net
Equity
loss)net (or profit Net ROE
Profitability ratios
Some ways to improve profitability
- Price premium coming from a differentiation strategy.
- New knowledge creation.
- Economy of scale and/or scope coming from cost strategy.
- Improvement of goods’ portfolio through a correlated
diversification strategy (synergies’ and network benefits).
- Increasing / decreasing of the vertical integration degree.
- disinvestment of unprofitable assets (sunk costs issue).
- Inventory management.
- Capital structure changing
Profitability ratios improvement
The asset profitability improvement in the long run and
new knowledge creation
Both radical and incremental innovations need the exploitation
of new knowledge or a new use of existing knowledge.
Four ways for creating new knowledge as driver of innovation:
-Learning by doing;
-Learning by using;
-R&D investments;
-Acquisition of external knowledge.
Field experiences produce
flows of new knowledge
New investments produce
flows of new knowledge
Profitability ratios improvement
The asset profitability improvement in the long run
through learning by doing
Learning by doing means to improve products, services and
processes thanks to the constant acquisition of incremental
experience.
Each firm’s worker learns from their own mistakes: the current
mistakes produce new experiences that reduce the probability of
future mistakes.
Constant production improvements allow firms to achieve marginal
innovation in stable conditions.
Profitability ratios improvement
The asset profitability improvement in the long run
through learning by doing
The focus is on internal experiences.
The firm improves what it is able to produce.
The learning by doing approach is consistent with incremental
innovations.
Profitability ratios improvement
The asset profitability improvement in the long run
through learning by doing
The application of the learning by doing logic needs choices in relation to
the organizational structure and the information flows.
Profitability ratios improvement
Strengths and weaknesses of learning by doing
Lower innovation costs
Stability of organizational structure
A higher efficiency
Strong technical interrelations between
top management, managers and workers.
Strengths
Rigidity of organizational structure in
relation to radical innovations.
Rigidity of organizational structure in
relation to strong external changes.
Constant improvement is just based on
an internal perspective.
Weaknesses
Profitability ratios improvement
The asset profitability improvement in the long run
through learning by using
"Learning by using" means to improve products, services and processes thanks to the capability to figure out the consumers
needs.
Marketing oriented approach: new market needs drive improvements and innovations over time.
Profitability ratios improvement
The asset profitability improvement in the long run
through learning by using
The focus is on user experience.
The firm improves its production in a way that fits with needs and
requests of consumers.
The learning by using approach is mostly consistent with
incremental innovations and only in some cases is it consistent with
radical innovations.
Profitability ratios improvement
Strengths and weaknesses of learning by using
Dynamism of organizational structure.
A higher propensity to face external
changes.
Higher strategic interrelations between
top management, managers and workers.
Client satisfaction and increase of the
price for sale (price premium).
Strengths
Higher innovation costs.
A higher complexity of organizational
structure.
Risk of internal inefficiency.
Risk to realize wrong innovations linked
to the difficulty to figure out real market
needs.
Weaknesses
Profitability ratios improvement
Capital structure ratios
Equity
Debts Financial (1) ratioequity Debt
Equity
Liquidity -debts Finacial
Equity
debts finacialNet (2) ratioequity Debt
Debt equity ratio (1) doesn’t take into account liquidity which may
be used to respect (partially or totally) the debt service.
The debt ratio (2) must be analyzed considering the possible
change in liquidity. From this point of view, a prudential approach
is to use as a correction factor for financial debt the average
liquidity stock over a given period, rather than the current level of
liquidity.
NI
Debts Financial (1) ratio inv.net Debt
NI
Liquidity -Debts Financial (2) ratio inv.net Debt
Equity
NI Leverage
Capital structure ratios
Debts Financial
Equity
ratioequity Debt
1 (1) ratio edebt Equity
In the shareholder perspective the equity debt ratio implies an
opportunity cost due to the higher cost of equity in comparison than
debt cost.
At the same time a high level of the equity debt ratio gives the following
advantages : 1) a high protection buffer against the risk of financial
distress; 2) a high bargaining power compared to banks, other lenders
and inputs suppliers; 3) greater opportunities to explore new
opportunity by investing in very risky activities such as R&D activity.
Liquidity -Debts Financial
Equity
(2) ratioequity Debt
1 (2) ratio edebt Equity
Capital structure ratios
Equity debt ratio and business risk
Business risk
Eq
uit
y d
eb
t ra
tio
High
High
Low
Low
Alignment between the
capital structure
and business risk
Relative high
opportunity cost
Misalignment between the
capital structure
and business risk
Relative high
opportunity cost
Misalignment between the
capital structure
and business risk
Relative low
opportunity cost
Alignment between the
capital structure
and business risk
Relative low
opportunity cost
1 2
3 4
Capital structure ratios
Dividend policy, investment growth and capital structure
Residual
dividend policy High propensity to
self financing
InvestmetsNet
InvestmetsNet
Debts Financial
Debts Financial
D
D
0 ratioequity Debt D
First hypothesis
Capital structure ratios
Dividend policy, investment growth and capital structure
Residual
self financing
High dividend
distribution
InvestmetsNet
InvestmetsNet
Debts Financial
Debts Financial
D
D
0 ratioequity Debt D
Second hypothesis
Capital structure ratios
Capital structure and ROE decomposition
)t1(Equity
Debts Fin.i)-(ROI ROIROE
i = interest rate
t = tax rate
)t1(Equity
Costs Fin. -EBIT
Equity
profitnet NormalizedROE
Capital structure ratios and equity profitability
)t1(Equity
Debts Fin.i)-(ROI ROIROE
Equity
profitnet Normalized)t1(
Equity
Cost Fin.-EBIT
)t1(Equity
Cost Fin.-
NI
EBIT
Equity
EBIT
NI
EBIT
)t1(Equity
Cost Fin.-1
Equity
NI
NI
EBIT
NI
EBIT
)t1(Equity
Debts Fin.
Debts Fin.
Cost Fin.-
Equity
Equity-NI
NI
EBIT
NI
EBIT ROE
Algebraic explanation:
Capital structure and ROE decomposition
Capital structure ratios and equity profitability
Levered ROE, unlevered ROE and financial leverage effect
ROE Unlevered
ROE Levered
)t1(ROI)t1(Equity
Debts Fin.i)-(ROI ROI
effect leverage Financial
ROI > i positive financial leverage effect
ROI = i neutral financial leverage effect
ROI < i negative financial leverage effect
Capital structure ratios and equity profitability
Capital structure and Gross ROE decomposition
Equity
Debts Fin.i)-(ROIROI-ROE Gross
Equity
Costs Financial-EBIT
Equity
Debts Fin.i)-(ROI ROI
t-1
ROE ROE Gross
The Gross ROE is bigger than ROI when there are the two
following conditions:
1) Financial debts > 0 (levered condition);
2) ROI > i
When the above conditions arise, the firm can improve the shareholder’s
profitability operating just a financial strategy aimed to maximize the ROE level.
This strategy is known like financial leverage exploitation.
Capital structure ratios and equity profitability
The negative side of financial leverage
A strong use of financial leverage could implies negative
consequences in terms of economic value, due to an increasing of
expected ROE volatility, cost of capital and failure risk:
Debt to
equity ratio
Accounting
ROE
Debt to
equity ratio
Economic
value
Capital structure ratios and equity profitability
The negative side of financial leverage and equity constraints
The negative side of financial leverage explains why there are
constraints about a minimum equity level.
These constraints could come from external authorities such the case
both bank industry and insurance one.
In other cases the firm’s management defines equity constraints to
insure the firm survival.
In addition, in several countries the tax low tends to increase firms’
capitalization through a reduction of fiscal benefits linked to financial
costs.
Capital structure ratios and equity profitability
Internal (or sustainable) growth rate
The internal (or sustainable) growth rate (G), measures the firm
capacity to develop itself without external capital coming from
investors and/or lenders:
G = ROE x Retention Rate
Retention Rate = (Net Income - Dividend) / Net Income
Equity
DivROE
PtofitNet
Div1
Equity
PtofitNet G
ROE and internal (or sustainable) growth rate
Example
Sustainable growth
of new investments
D Financial Debts = 0
D Number of shares = 0
Internal (or sustainable) growth rate
The “G” rate provide the following information:
1) Indentifies the combination between firm’s strategy and its life
cycle;
2) Indentifies the dividend policy (residual or not-residual policy);
3) Provides useful information to analyze the financial side of firm’s
risk and related firm's bankability.
Internal (or sustainable) growth rate
Main accounting solvency ratios
sLiabilitie T.
onDepreciati incomeNet ratiosolvency General
Equity
Debts Financial ratioequity Debt
PaymentsInterest
EBIT (1) coverageInterest
PaymentsInterest
flowcash Operating (2) coverageInterest
Accounting solvency ratios
Repayments CapitalPaymentsInterest
EBIT (1) coverage serviceDebt
Repayments CapitalPaymentsInterest
flowcash Operating (2) coverage serviceDebt
ratiosLiquidity and capital gNet workin
The Net Working Capital (NWC)
Balance sheet equation: CL DFCA FI
NWC = CA – CL = DF - FI
FI DF
CA CL
NWC > 0
FI DF
CA CL
NWC = 0
FI DF
CA CL
NWC < 0
Disequilibrium:
Excess of liquidity
Equilibrium Disequilibrium:
Lack of liquidity
The Net Working Capital (NWC)
Liquidity ratios
The two main liquidity ratios
CL
CAratioCurrent
CL
Iventories-CAratioQuick
Direct and indirect relationship between profitability ratios and
Liquidity ratios
Profitability
ratios
Liquidity
ratios
Direct effect
Indirect effect
A good (or bad) profitability increases (or
decreases) directly potential
and effective liquidity
Liquidity ratios affect in
indirectly profitability
Liquidity ratios
Direct and indirect relationship between economic crisis and
Financial crisis
Economic
crisis Financial
crisis
Constant
losses
Equity
reduction
Liquidity ratios
reduction
Liquidity ratios
Reduction caused
by non-economic factors
Loss of
suppliers and
lenders trust
Higher operating
and financial cost
Liquidity ratios
Expected revenues, capital intensive ratio and financial
need estimation
)(need(FN) Financial 10 REVf 000 SFEFEFN
REV1 = expected revenues
EFN = external financial need
SF = self-financing.
Capital
intensive
Commercial
credits
Management
of inventry
EFN0 +SF0
REV1
The estimation of durable financial need: Synthetic approach
(T0)jj(T1)sj(T0)
n
1i i
is
FI)(REVACI FN
nREV
FIACI
ACIs = Average capital intensive of cluster s
FNj = Financial need of business j
REVj(T1) = Expected j revenues
Fij(T0) = Fixed investments
Expected revenues, capital intensive ratio and financial
need estimation
Example of synthetic approach
)FI(FI)REV(REVACI FN j(T0)j(T1)j(T0)j(T1)sT1)j(T0,
Hypothesis: Each expected Euro of revenue requires a durable investment equal to three
Euros
ACIs
Expected revenues, capital intensive ratio and financial
need estimation
The estimation of durable financial need: Synthetic approach
The synthetic approach is useful especially in the first stage of analysis,
when the specific business goods are not identified. From this point of
view, the synthetic approach helps the estimation of the general capital
amount necessary to finance the industrial structure of the project.
Moreover the synthetic approach could be useful to analyze the causes
about differences between the capital intensive of a certain industry and
capital intensive of a certain business:
ACIj> ACIs ACIj= ACIs ACIj< ACIs
Lower efficiency than
the average efficiency
of competitors
Efficiency equal to
the average efficiency
of competitors
Higher efficiency than
the average efficiency
of competitors
Expected revenues, capital intensive ratio and financial
need estimation
The case ACIj < ACIs must be analyzed in relation to the business
cycle phase.
Goals of cash flow analysis
1) The Cash flow shows the inflow and outflow of cash between
two balance sheet dates
2) The cash flow analysis aims to list any item that affects
corporate liquidity by increasing or decreasing it .
3) The cash flow analysis is a tool to optimize the liquidity
management
4) The expected cash flows are the final piece of business
design (business plan)
5) The expected cash flows are the positive side of present
value
Performance measurement according to the accounting
view: financial statement analysis (third part – Cash flow
analysis)
Prof. Antonio Renzi
Performance Measurement and Enterprise Risk Management
Agenda
1. Goals of cash flow analysis
2. Cash flow kinds
3. General framework of cash flow analysis
4. Economic and structural cash flow
5. Free cash flow concept
6. Free cash flow to firm and free cash flow to equity
Goals of cash flow analysis
1) The Cash flow shows the inflow and outflow of cash between
two balance sheet dates
2) The cash flow analysis aims to list any item that affects
corporate liquidity by increasing or decreasing it .
3) The cash flow analysis is a tool to optimize the liquidity
management
4) The expected cash flows are the final piece of a business
design (business plan)
5) The expected cash flows are the positive side of present
value
Cash flow kinds
1) Operating cash flow
2) Economic cash flow
3) Structural cash flow
4) Free cash flow:
Free cash flow to firm;
Free cash flow to equity.
General framework of cash flow analysis
DLiquidity
=
Casht1 – Casht0
Operational
activities
Non-operational
activities
External
financings
Investments
management
Dividends policy Firm’s growth
Inputs of accounting cash flow analysis
General framework of cash flow analysis
t0 t1
Balance sheet
statement (t0)
Balance sheet
statement (t1)
Income statement(t1)
Variation in assets and
liabilities (including
equity) caused by
revenues and costs
Financing / investments
done in the period t0→t1
At the time t1 all inputs of the cash flow are known
Inputs of forecasting cash flow analysis
General framework of cash flow analysis
t0 t1
Balance sheet
statement (t0)
Forecasting balance
sheet statement (t1)
Forecasting income
statement(t1)
Variation in assets and
liabilities (including
equity) caused by
revenues and costs
Financing / investments
will be done in the
period t0→t1
At the time t0 just the balance sheet (t0) is known
Economic and structural cash flow
Net Income (- ) D Net operative Working Capital (+) Depreciations A) Economic cash flow (+) D Equity – (Net Income +Dividends) (+) Financial debts (-) New Fixed Investments (+) Disinvestments B) Structural cash flow Total Cash flow = A +B
D Net operative Working Capital =
D Accounts receivable + D Inventory D Accounts payable
D Accounts receivable (or D Commercial credits) = revenues without cash inflow DAccounts payable (or D Commercial debts) = operating costs without cash out flow
Economic and structural cash flow
Cash flow analysis
A) Economic cash flow B) Structural cash flow
Goal: maximization
Goal: ?
A positive value of the structural cash flow indicates a surplus of financing
A negative value of structural cash flow could depend on self-financing processes
A null value of the structural cash flow arises when there is a perfect balance between
the acquisition of new equity (and/or new financial debts) and the dynamic of fixed
investments
The free cash flow concept
The free cash flow (FCF) shows the cash flow measured after cash
outflows to support operations and maintain (or development) its
assets.
First, the FCF size depends on the following constraints:
1) The reconstitution constraint of the inputs consumed in the last
administrative period;
2) Remuneration constraints of financial backers.
Secondly, the FCF size depends how the firm uses cash flow that
remains after complying with the above constraints.
The free cash flow concept
The free cash flow (FCF) shows the cash flow measured after cash
outflows to support operations and maintain (or development) its
assets.
First, the FCF size depends on the following constraints:
1) The reconstitution constraint of the inputs consumed in the last
administrative period;
2) Remuneration constraints of financial backers;
Secondly, the FCF size depends how the firm uses cash flow that
remains after complying with the above constraints.
Free Cash Flow
To Firm
It comes just from
investment decisions.
Free Cash Flow
To Equity
It comes from both
investment decisions and
financing choices
Equity
Debt
Assets
The Free Cash Flow
is correlated in negative way with the business dynamic:
Investment growth
Δ Net Fixed Investments + Depreciation > 0
The free cash flow concept
Asset side perspective Equity side Perspective
Revenues Revenues
- Cost of sold goods - Cost of sold goods
- Other operating costs - Other operating costs
- Depreciations -Depreciations
= EBIT = EBIT
- Taxes on Operating Income - Interests
= NOPAT - Taxes
+ Depreciations = Net Profit
- Variation in accounts receivable + Depreciations
- Variation in Inventories - Variation in accounts receivable
+ Variation in commercial liabilities - Variation in Inventories
- New fixed Investments + Variation in commercial liabilities
+ Disinvestments - New fixed Investments
= Free Cash flow to Firm (FCFF) + Disinvestments
= Free Cash Flow to Equity (FCFE)
Free cash flow to firm and to equity
1) Firm’s decisions, strategies, environmental context and accounting measures
2) Revenues and costs drivers
3) Ebit and break even analysis
4) Limits of accounting measures
5) Profitability ratios
6) Capital structure ratios
7) How capital structure affects the equity profitability (the role of financial leverage)
8) Return of equity and internal growth rate
9) The net working capital
10) Solvency and liquidity ratios
11) The double relationship between profitability and liquidity
12) How the weakness of the economic firm determines its financial weakness and vice versa
13) The capital intensity and financial need
14) Economic and structural cash flow analysis
15) Free cash flow analysis
Key points of accounting performance measurement
The economic value measurement : First part – Introduction
to economic value measurement and capital structure
theories
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
158
The DCF approach: general logic
Intrinsic value vs. market value
Capital structure, Wacc and value: Modigliani and Miller (M.M) theory (I, II)
Capital structure and value: trade off theory
From accounting performance measurement to economic value
measurement
Weighted average cost of capital (Wacc)
Main issues about economic value measurement
Equity cost and capital structure
From accounting performance measurement to economic value
measurement
Accounting performance
measurement
Current and past
firm’s
performances
Economic value
measurement
Present value of
expected firm’s
performances
Set of analysis tools to
check effects on
performances coming from
internal decisions
and external events
General goal:
to figure out strengths and weaknesses
of the decisions already taken
Set of analysis tools to
select current strategies and
related investment/financing
decisions.
General goal:
to maximize the economic value in terms
of market price and/or intrinsic value
Main issues about economic value measurement
• The meaning of economic value according to several perspectives
• The choice about the expected performance kind as the positive side of economic
value
• Technical issues about forecasting analysis
• How to measure risk and uncertainty
• How to use strategic analysis into a quantitative analysis
• Cost of capital (or discount rate) measurement
• The capital structure role than economic value creation
• How to consider the irrational behavior of investors (behavioral finance)
• How to combine micro and macro issues
• The role of managerial flexibility than economic value creation
• How to check over time the quality of a given economic assessment
The need to contextualize the economic value measurement
• Objective contextualization: to link choice about the assessment
model with the valuation object
• Subjective contextualization: to take into account the subject
perspective of who has a specific interest than a valuation.
Main issues about economic value measurement
Intrinsic value:
This kind of estimate is based on the evaluation of flows and risks
linked to future expected performances and their probability.
Market value (stock price): Exogenous variable, defined by the
market.
In other words, the price is an objective factor, emerging from market
transactions. On the converse, the intrinsic value emerges from a
subjective estimation that reflects an opinion about expected
performances, under given hypotheses and risk conditions.
Intrinsic value vs. market value
Intrinsic value vs. market value
Equilibrium hypothesis
Informational efficiency
Economic rationality Homogeneity
of expectations
Equilibrium: Demand of stocks = Supply of stocks
Market prices = Intrinsic values
No stock is overestimated or underestimated
Intrinsic value vs. market value
Disequilibrium hypothesis
Informational inefficiency
Economic irrationality Not homogeneity
of expectations
Equilibrium: Demand of stocks ≠ Supply of stocks
Market prices ≠ Intrinsic values
Stocks may be overestimated or underestimated
Main factors which cause disequilibrium
• Liquidity excess in the financial system that reduces the risk
perception of financial actors.
• Liquidity lack in the financial system that increases the risk
perception of financial actors.
• Changes about the trust in market investments.
• “Noise factor” and irrational behaviors.
• Financial analysts’ inattention to fundamental analysis.
• Value and risk estimation based on pro-cyclical methods.
Intrinsic value vs. market value
Intrinsic value vs. market value
The DCF approach: general logic
The asset side and equity side perspectives
Asset side
perspective
Equity side
perspective
Enterprise
Value (EV)
Equity
Value (S)
Debt
Value (D)
EV = Total value = S + D
S= EV - D
The asset side and equity side perspectives
Enterprise value:
present value of
assets
Expected free
cash flow to
firm (FCFF)
Discount rate:
Weighted average
cost of capital
(Wacc)
(+) (-)
Equity value:
present value of
equity
Expected free
cash flow to
equity (FCFE)
Discount rate:
Equity cost
(ke)
(+) (-)
The DCF approach: general logic
Asset side perspective Equity side Perspective
Revenues Revenues
- Cost of sold goods - Cost of sold goods
- Other operating costs - Other operating costs
-Amortizations -Amortizations
= EBIT = EBIT
- Taxes on Operating Income - Interests
= NOPAT - Taxes
+ Amortizations = Net Profit
- Appreciation in accounts receivable + Amortizations
- Appreciation in Inventories - Appreciation in accounts receivable
+ Appreciation in commercial liabilities - Appreciation in Inventories
- Net Investment flow + Appreciation in commercial liabilities
= Free Cash flow to Firm (FCFF) - Net Investment flow
= Free Cash Flow to Equity (FCFE)
The positive driver of present value: FCF
The DCF approach: general logic
Discount rate of FCFF (asset side perspective)
τ)(1SD
Dk
SD
SkeWacc
jj
j
ij
jj
j
j
kej= equity cost of j;
kij = debt cost of j;
Sj = equity of j;
Dj = financial debt
The weighted average cost of capital (Wacc)
kej: expected return of equity → the shareholder expectation
kij: expected return of debt → the lender expectation
kej > Wacc > kij
Three important rules
1) Equity financing implies a higher risk premium than the case of debt financing:
2) In the absence of failure risk the debt cost equals the risk free rate (Rf):
3) The equity cost is positively correlated with debt financing, also in the case in
which there is not the failure risk:
Rfkij
kej > Wacc > kij
Increasing
in financial leverage
Higher risk premium
due to a higher
volatility of equity
return
Higher risk premium
due to a higher
failure risk
The weighted average cost of capital (Wacc)
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
One of the main issues in corporate finance regards the role of capital structure
than the economic value creation.
The first theory of M.M. aims to demonstrate the irrelevance of the capital
structure than Wacc and therefore enterprise value.
According to M.M. theorem the economic value comes just from risk-return
profile of real assets.
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
• No frictions about capital market mechanisms
• Competitive capital markets: Individuals and firms are pricetakers.
• Informational efficiency
• No taxes
• No risk of financial distress (or bankruptcy)
Assumptions
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
1) A firm’s total market value is independent of its capital structure.
2) The equity cost of a firm increases with its debt equity ratio.
3) The economic value of a new firm’s investment doesn’t depend on its capital
structure.
Propositions
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
First Proposition
Unlevered condition Levered condition DWacc = 0
DEV = 0
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
First Proposition
s
jj
j
jj
j
jko
SD
DRf
SD
SkeWacc
kej= equity cost of j;
Rf = risk free rate
kos = unlevered cost of capital of the
firms cluster s
The capital structure can’t affect kos
Firms belong to the cluster “s” have the same risk-return profile under unlevered
conditions
Unlevered condition
Unlevered Enterprise
Value (EVu)
Unlevered Equity
Value (Su)
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
EFCEFEEFE
ValueAsset ko
EFEEV
Lu
s
u
u
EFu= expected unlevered cash flow to
equity
EFL= expected levered cash flow to
equity
ECF= expected financial cost
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
First Proposition
s
u
su
L
jj
j
jj
jj
ko
EFEEV
koEV
EFE
EV
FCEFE
SD
DRf
SD
SkeWacc
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
Second Proposition
premiunrisk FinancialS
DRf)-(kokoke
premiumrisk Leverd Rf-ke
premiumrisk UnleverdRf-ko
S
DRf)-(kokoke
sj
j
s
ssj
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
Second Proposition and value conservation
Unlevered condition Levered condition Dke > 0
DEquity value < 0
DDebt value > 0
DDebt value = - DEquity value
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
Second Proposition and value conservation
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
Value conservation
D/S
EV
Unlevered Enterprise Value = Evu
Levered Enterprise Value = EvL
Despite the M.M. it is based on strong simplifications, it expresses two basic truths:
1)The quality of real investments is the main driver of value creation;
2)The debt acts positively on the shareholder expected return and therefore negatively
on the share value.
Evu = EvL
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
With a second theory M.M focused on how taxes affect the relationship between
capital structure and the enterprise value.
They ague how fiscal benefits linked to financial debts generate a positive
correlation between debt level and e enterprise value:
Levered enterprise value > Unlevered enterprise value
Second theory
j
i
jiτD
k
DτkPVFA
Present value of the fiscal advantage (PVFA):
Capital structure, Wacc and value: Modigliani and Miller (M.M)
Theory (I, II)
D/S
EV
EVu
sjj
j
jj
jj ko)1(
SD
DRf
SD
SkeWacc
Second theory
Evu + D
Capital structure, Wacc and value: Trade off Theory
Trade off theory aims to indentify an optimal leverage which maximizes the
firm’s value.
The leverage optimization comes from a proper combination between fiscal
benefits and risks linked both linked to the financial leverage (D/S).
In particular, the increase in leverage corresponds to an initial phase in which
the levered value (EVL) increases, for the same unlevered value (EVu), due to
the tax shield generated by interest expense (fiscal benifits); this until an optimal
leverage point (D / S)* which maximizes EVL.
The increase in debt beyond the optimal leverage causes a proportional
increase in the probability of bankruptcy and the costs associated with it and
consequently a reduction in the EVL.
Capital structure, Wacc and value: Trade off Theory
Therefore according to the trade off theory, given an assts profitability, the value
maximization implies to seek the optimal financial leverage taking into account
two factors:
- Fiscal benefits of financial debts ;
- Costs caused by the financial distress risk.
About the fiscal benefits issue, the trade-off theory uses the same framework of
M.M theory II: the financial leverage acts positively on financial charges and
therefore on the tax shield (1 –).
Capital structure, Wacc and value: Trade off Theory
Financial distress costs
The financial distress (or bankruptcy) risk causes two kinds of costs:
1) Direct financial distress costs: costs to avoid a potential failure or related to
a failure procedure.
2) Indirect financial distress costs: costs related to relationships with internal
and external stakeholder.
Both direct and direct costs determine the non-independence of Ebit with
respect to the financial structure.
Capital structure, Wacc and value: Trade off Theory
Direct financial distress costs
- Asset liquidations
- Legal costs
- Accounting costs
- Loss of fiscal benefits
Capital structure, Wacc and value: Trade off Theory
Indirect financial distress costs
- Increasing of financial debt costs
- Loss of lending from lenders
- Deterioration of the relationship with the inputs suppliers (loss of
inputs quantity, higher cost per unit, lower duration of commercial
debts)
- Deterioration of the relationship with the customers (loss of sales,
lower price per unit, higher duration of commercial debts)
- Less chance of working with the public administration.
190
EV
(D / S)
Unlevered
value
Levered
Value
Fiscal
benefits
E
H
•
Capital structure, Wacc and value: Trade off theory Capital structure, Wacc and value: Trade off theory
EVu
Bankruptcy
costs
Debt financing and cost of Failure
Levered EV < Unlevered EV
(D / S)*
(D / S)*= Optimal debt equity ratio with failure costs
EVu + D (M.M II)
EVL without
bankruptcy costs
Capital structure, Wacc and value: Trade off Theory
Trade off theory and agency theory
According to agency theory the capital structure optimization depends on
agency costs minimization.
Principal:
Shareholder
Agent:
Manager
The shareholder delegates
the company management
The manager could engage in unruly behavior aimed at obtaining personal benefits. This
implies agency costs coming , on the one hand from corporate governance tools for
controlling manager activity, on the other hand from incentives that lead the manager to work
in the interest of the shareholder.
The debt level reduce agency costs, because implies higher remuneration constraints: the
mandatory to respect the debt service reduces the manager decisional margin.
Capital structure, Wacc and value: Trade off Theory
Trade off theory and agency theory
According to agency theory, the debt benefits in terms of lower agency costs
have a limit caused by a possible unruly behavior of the shareholder against
lenders.
Principal:
Lender
Agent:
Shareholder
The lender delegates
the capital structure management
The shareholder could engage in unruly behavior aimed transfer firm’s risk towards
lenders through an increase in the debt equity ratios.
The equity cost according to the CAPM:
The three fundamentals theoretical steps
Equity cost and capital structure
Equity cost and capital structure
Rp
sp
Rp= Rf+(Rm –Rf)(sp/ sp)
.
sm
Rf
Rm
Portfolio theory Capital market line
2,11121
2
2
2
2
2
1
2
1p
2211p
ρσσXX2σXσX
RXRXR
:assets Two
s
CAPM
M
The equity cost according to the CAPM
Equity cost and capital structure
La security market line
mR~
Rf
1
M
βRf)-R~
( Rf m
Premio
β-Rf)(R'm
Security
market line
The equity cost according to the CAPM: equilibrium hypothesis
and the security market line (SML)
Equity cost and capital structure
Rf
SML Rf + (Rm-Rf)
1
Rm . M
. . . . . . .
The equity cost according to the CAPM: disequilibrium hypothesis
and the security market line (SML)
Equity cost and capital structure
Rf
SML Rf + (Rm-Rf)
1
Rm . M
.
. .
.
.
.
.
Black points show underestimated stocks
Green points show overestimated stocks
The equity cost according to the CAPM:
Assumptions
• Market equilibrium;
• Diversification as tool for optimizing financial portfolios
• The investor operates just as a take-over and take-risk: He can’t
affect the market prices.
Variables of CAPM:
• Risk free rate (Rf);
• Market return(Rm );
•Beta (j).
kej = f(Rf, Rm, j)
Equity cost and capital structure
The equity cost according to the CAPM : the beta factor
jmj βRf)-R~
( Rf ke RfR
~Rfke
β m
j
j
2
m
mj,
jσ
σβ
sj,m = covariance j,m; s2j = variance m
Covariance is a measure of how much two random variables change together.
The covariance j,m measures how j return changes for each change of the
average return of market portfolio and vice versa.
Variance m measures the capital market volatility.
sj,m = systematic risk of j
s2j = 100% of systematic risk
j = systematic risk coefficient
Equity cost and capital structure
Equity cost and capital structure
The equity cost according to the CAPM : the effect of capital
structure on beta
1) Unlevered beta: coefficient of unlevered systematic risk
Measures how much of the business risk depends on the market portfolio volatility
2) Levered beta: coefficient of levered systematic risk Measures how much of the firm’s total risk (business risk + financial risk) depends on the
market portfolio volatility
Levered beta > Unlevered beta
The equity cost according to CAPM: From unlevered to levered
beta
Sj
τ)1(D1ββ
j
j(u)j(L)
j(u) = unlevered beta (business j)
j(L) = levered beta (business j)
Dj = debt value
Sj = equity value
Dj / Sj = financial leverage
Sj
τ)1(Dβββ
effect Leverage
j
j(u)j(u)j(L)
Sj
D
τ1
11
β
β
Leverage
j
j(u)
j(L)
Equity cost and capital structure
The equity cost according to CAPM: From levered beta to
unlevered beta
Sj
τ)1(D1
ββ
j
j(L)
j(u)
Equity cost and capital structure
The equity cost according to CAPM: The levered beta
effect structure Capital
j
j(u)jSj
τ)1(D1Rf)β-(Rm Rfke
Equity cost and capital structure
The above formula is congruent with M.M. theory (both I, II), where
the financial leverage is a positive driver of equity cost and therefore
negative driver of equity value.
The equity cost according to CAPM: The levered beta
effect structure Capital
j
j(u)jSj
τ)1(D1Rf)β-(Rm Rfke
Equity cost and capital structure
Given a level of unlevered beta, a firm may reduces its equity cost by changing the capital
structure through the following policies:
-A residual dividend policy;
- Capital increases.
In terms of trade off analysis the analyst has to inquire the change of financial leverage
effect on Wacc and EV.
Du = 0; DFin. leverage <0; Dkej<0; DSj>0
Capital restructuring, Wacc and EV
j
ij
j
j
j(u)jDSj
τ)1(Djk
DSj
Sj
Sj
τ)1(D1Rf)β-(Rm RfWacc
Equity cost and capital structure
DDj < 0; DSj =- DDj >0
DDj > 0; DSj =- DDj <0
L → - Wacc → +EV
Lower f. distress risk → - Wacc → +EV
Higher weight of equity → + Wacc → -EV
Lower tax shield → + Wacc → -EV
L → + Wacc → -EV
Higher f. distress risk → + Wacc → -EV
Lower weight of equity →-Wacc → + EV
Higher tax shield →-Wacc → +EV
The economic value measurement : Second part –
Basic valuation tools
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
207
The DCF approach
The APV (Adjusted Present Value) method
The economic value in the venture capital pesrpoective
Market multiples
The equity value according to Gordon’s model
The DCF approach
EqV = Present value of equity
Div = dividend
ke = equity cost
The Gordon’s model consists in a particular application of the DCF framework
where the focus in on expected dividends. The model’s goal is to solve the problem
of teporal indeterminacy of a company's life.
1tt
t
ke)(1
DivEqV
t
1tt
1tt
t
ke1
g1Div
ke)(1
DivEqV
0
g = dividend growth
(1+g)/(1+ke) = geometric progression factor
ke > g
The equity value according to Gordon’s model
The DCF approach
g - ke
)g1(DivEqv
ke1
g1Div....
ke1
g1Div
ke1
g1DivEqv
0ke1
g1xn
....ke1
g1
ke1
g1
ke1
g1
t0
1x
t0
2
t0t0
x
32
The equity value according to Gordon’s model
The DCF approach
The DCF approach
g0
1
p
Div ke
Starting from Grdon’s model, some analysts measure both the
equity cost a g rate by using the current price (p0) as the equity
present value.
0
1
p
Div-keg
The DCF approach
Asset side
Equity side
Equity value FCFE = = FCF to equity
Enterprise value EV= Enterprise Value
FCFF= FCF to firm
TV= terminal value
n
nnt
1tt
t
Wacc)(1
TV
Wacc)(1
FCFFEV
n
j
nnt
1tt
j
t
)ke(1
TV
)ke(1
FCFEEqV
The DCF approach
The terminal value without growth
Asset side
Equity side
nnWacc)(1
Wacc
FCFF
TV
n
j
j
n)ke(1
ke
FCFE
TV
The DCF approach
• Stable growth model
• Two-stage growth model
• Three-stage growth model
DCF and different growth (g) hypotheses
The DCF approach
DCF and growth (g) hypotheses
High-Growth
Stable Growth
g
t
Three-Stage Growth
g
Two-Stage Growth
g
Stable High-
Growth Stable Transition
The DCF approach
The terminal value with stable growth
Asset side
Equity side
The DCF approach
njnj
nn
)Wacc)(1g(Wacc
)g(1FCFFTV
njnj
nn
)ke)(1g(ke
)g(1FCFEEqV
DCF and stable growth
b
njnj
nn
a
tj
n
1t)ke)(1g(ke
)g(1FCFE)ke(1FCFEEqV
b
njnj
nn
a
tj
n
1t )Wacc)(1g(Wacc
)g(1FCFF)Wacc(1FCFFEV
Asset side perspective
Equity side perspective
The DCF approach
The APV method (Adjusted Present Value)
The APV method is a specific case of the DCF, and it is adopted when it’s
needed to measure the unlevered value of a venture. The unlevered value
refers to the value of an initiative when it is entirely financed with equity;
while the levered value refers to the value of a venture that is financed
both with equity and debt.
According to APV, financing with debt has both advantages and
disadvantages. As an advantage, there’s the tax shelter. However, more
debt causes more costs; and, therefore, an increased default risk.
Unlevered value
+
Tax advantage of financial debts
–
Default risk due to financial debts
=
Leverage value
The APV method (Adjusted Present Value)
The APV method (Adjusted Present Value)
g)(ke
g)(1FCFFW
u
o
u
FCFFo= net operating cash flow (operating cash - taxes);
keu= unlevered equity cost (cost of equity in absence of debt);
g= expected growth rate.
Unlevered equity value (Wu)
j
i
jiτD
k
DτkPVFA
Present value of the fiscal advantage (PVFA)
= fiscal rate;
ki = cost of debt;
Dj= debt.
The APV method (Adjusted Present Value)
Discounted value of the cost of default (VCF)
p = default probability
BC = discounted default cost
πBCVCF
Levered value (WL)
BCπτDg)(ke
g)(1FCFFW aj
u
0L
The APV method (Adjusted Present Value)
The APV method for new ventures
• Normally, in the early years there are no tax benefits
•The financial leverage is lower than the average of existing firms
• The overall risk depends primarily on the operational risk
• For each level of debt, the costs of failure is higher than the
average of existing firms
• The Tobin’s q is used to measure the degree of intangibles of a firm.
This measure is given by the ratio between the market value and the
cost for assets replacement.
• The ratio it is also used as a proxy to measure intangibles
performance. When the value of the ratio goes down, then, this could
be a signal that also the intangibles value is decreasing.
• However, it must be taken into account that, after a market bubble
bursts, investors tend to be more risk adverse and the value of
overall market shares results diminished.
The Tobin’s q
Value and intangibles
Market multiples approach
The estimate of a private firm’s value can be done using the value of public
companies, operating in the same sector and with similar characteristics.
First, there’s the selection of one or more benchmark public companies.
Hence, the ratio among the price of the public company and a reference
parameter is our multiple.
Multiple= Market Value of the comparable/ reference parameter
Target firm value= multiple x reference parameter of the firm
Market multiples and comparable transactions
The so-called market methods are based on the following hypotheses:
Economic value Market value = = Price X number of shares
In case of a private company, it is needed to select some public
firms that can be considered as comparables.
Market multiples and comparable transactions
Market multiples approach: Price earning (PE)
Market multiples and comparable transactions
)E(PE PV
E
P PE
jSj
PEs = Price earning of cluster s
PVj = Present value of j
Ej = Current earning of j
Comparable transaction approach
This methodology is similar to market multiples ones.
However, in this case there’s the use of a different firms’ panel as
benchmark. In particular, the benchmark value is the one of similar
firms that went under a takeover (as instance, the price of the deal).
Market multiples and comparable transactions
The VCM is the forecast of a future value (as instance, by five
years from now). This future value is discounted at a high rate (e.g.
50%).
The VCM allows to determine the pre-money value (before the firm
is financed from a third party) in case of both poor historical data for
making a forecast and high risk-return expectations.
This method can be considered as a variation of the DCF: the
forecast concerns the start up firm value (expected cash flow) at
the external financer’s exit moment (when the backer will sell his
share).
The economic value according to the venture capital perspective
The Venture Capital Method (VCM)
Phases of the VCM
• Determination of the cash flow at the time of the venture capitalist’s exit.
•Future value estimation using comparables: in general, it is adopted the
market multiples method to measure the firm value in the later period. This
last value is considered as the terminal value: it is measured considering
expected revenues after a certain date and using a multiple (as instance
Price/Earnings from exit onward).
•The terminal value is discounted at a high rate, which reflects the high risk
of the initiative. The discount rate is estimated according to the capital gain
expected by the venture capitalist. Usually, this rate is extremely high.
Venture Capital method (VCM)
1-Inv.
FVTR
Inv.
FVTR)(1
TR)(1
FVInv. TR)Inv.(1 FV
1/n
n
n
n
Inv. = Initial investment
FV = Final value
TR = Target return
n = Years between the venture capitalist’s investment and his exit.
VCM: Present value, final value and target return
Venture Capital method (VCM)
Multiple of initial investment
Venture Capital method (VCM)
Target return and business life
Start up 50-70%
First stage 40-60%
Second stage 35-50%
Bridge / IPO 25-35%
Phase Target Return
Source: Damodaran, 2009.
VCM and price earning
1Inv.
PEFE1-
Inv.
FVTR
PEsFEFV
1/n
sj
1/n
j
Period 0 1 2 3 4 5 Earning -20 0 0 0 0 20 Initial investment 100 P/E (cluster s) 20 20 20 20 20 20 Final Value 400 Target Return 31,95%
The economic value according to the venture capital perspective
Feasibility analysis according to VCM
Assumptions
PE of cluster 15 Maximum Waiting Time 6 years
Minum Return 40%
Portfolio return
The economic value according to the venture capital perspective
The economic value measurement : Third part –
Deepening on beta and equity cost measurement
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
236
Beta measurement according to the market model
Comparables approach
Specific risk according to bottom up approach
Reworking the CAPM according to bottom up approach
Diversification issue and total beta
Reworking of CAPM according to four correction factors
Beta’s kind
- Top down beta (traditional beta)
- Comparable beta
- Bottom up beta
- Total beta (subjective logic)
Beta’s kinds
Beta’s kinds
Beta kind Model/Approach Field of application
Top down beta
beta Market model Listed firms
Comparable
beta
Comparables
approach Unlisted firms
Bottom up
beta
Fundamentals
approach Unlisted firms
Total beta Subjective
approach
Non-diversified
investor
The CAPM assumes the possibility to measure systematic risk with a
direct correlation between returns of individual stock and returns of
market portfolio. The market equilibrium hypothesis causes
homogeneous expectations.
From the application point of view, analysts use CAPM with strong
compromises, so that the model used in the real world is substantially
different from its the original version
Beta measurement according to the market model
Analysts prefer to build linear regression based on historical data
According to the top-down approach, the historical performances of a
stock are estimated, period by period, as a percentage change of its
market value. Furthermore, the market portfolio is generally
approximated to a sufficiently representative basket of securities
(stock index).
Beta measurement according to the market model
n
1i
2
mim
n
1imimjji
2
m
mj,
j
)R~
(R
)R~
)(Rkeke(
σ
σβ
p
p
Beta measurement according to the market model
n
1i
2
mim
n
1imimjji
2
m
mj,
j
)R(R
)R)(Rkeke(
σ
σβ
Original theory:
Approach based on subjective
probabilities
Market model
Approach based on historical
data (according to the practice
of analysts)
= Regression coefficient
a = Regression intercept
e = Standard error.
εRβα ke mjj
6.2-B 6.2-A
jke jke
j j
a
Rischio
specifico
mR mR
Regression analysis
Reward of
specific risk
Beta measurement according to the market model
2,1 0,0135
0,0161 β j
R-squared (R2) is a measure of how close the
data are to the fitted regression line. 1-R2 is a
measure of specific risk:
1-0,739 = 0,261
a
Beta measurement according to the market model
• The market model is not applicable in direct way in the case of
private firms: absence of data about past prices
• In the case of private companies the valuation problem regards
especially unlevered beta
• In the case of new business, the hypothesis of maximum
diversification is not realistic.
• The CAPM implicitly assumes the absence of liquidity risk of the
securities; risk that, instead, is normally present in the case of private
firms.
Applied problems of the market model in relation to private
firms
Beta measurement according to the market model
The easiest way to estimate the beta of a private firm is to use the
unlevered beta of the sector which the enterprise belongs.
The comparables approach
s(u)j(u) β β :Hypothesis RfR~
)t1(S
D1β Rf ke m
j
j
s(u)j
Nβ β N
1ii(u)j(s)
j(u) = Unlevered beta of the firm j
j(L) = Levered beta of the firm j
s(u) = Average unlevered beta of the
sector s
Dj = Debt of j
Sj = Equity of j
)t1(S
D1β β
j
j
s(u)j(L)
Example of comparables approach: New business in the filed of
Healthcare Support Services
The comparables approach
Source:Damodaran, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html
• The equality j(u) = s(u) occurs when, for instance, a large private
company is similar (in terms of size and strategies) - to a certain
cluster of public companies.
• However, such circumstances occur rather infrequently: in most
cases, unlisted companies differ markedly in terms of both structural
and strategic than those listed.
•The problem about a low comparability among companies listed and
unlisted arises even more clearly in the case of start-ups.
• The comparable beta can be assumed as the starting point; the final
result (j(u)) should be estimated taking into account the characteristics
of the new business.
Ipotesi:
The comparables approach
According to the bottom-up approach, the risk (specific and
systematic) comes from the combination between firm characteristics
and the volatility degree of a certain core business.
Equity cost = f (firm specific factors, intrinsic business risk, capital market volatility)
The bottom up approach: general framework
Motivations bottom up approach
• Analysis of the risk factors.
•Analysis about the effect of management decisions on risk (for instance
how a growth strategy affects the systematic risk)
• Evaluation of private firms
• Evaluation of market efficiency
The bottom up approach: general framework
The bottom up approach: general framework
Sector's
Volatility
Strategic
investments
Intrinsic
Business risk
Unlevered
Risk
Operating
Leverage
Fixed
Investments
Fixed
Costs Levered
Risk
Financial
Leverage
Levered
Risk = Intrinsic
Business Risk X Operating
Leverage
Financial
Leverage X
Unlevered Risk
Intrinsic business risk
Specific risk according to bottom up approach
Exogenous volatility
Price and demand volatility
caused by macroeconomic
factors
Endogenous volatility
Price and demand volatility
caused by strategic
decisions
Volatility in
revenues
V~
RE REV IBR2n
1iii
p
n
1iii REV V
~RE p
Degree of operating leverage (DOL)
Specific risk according to bottom up approach
REV
REV
Ebit
Ebit
REV
REV
Ebit
Ebit DOL
(t0)
(t0)(t0)(t0) D
D
DD
The value of DOL can be positive, null or negative. The use of
DOL in a risk return analysis requires a positive value:
REV
REV
Ebit
EbitDOL
2(t0)
(t0)
D
D
DOL measures that part of intrinsic absorbed by a
specific business
Unlevered risk (su), degree of operating leverage (DOL),
intrinsic business risk (IBR) and unlevered risk (su)
Specific risk according to bottom up approach
DOL = 1 su = IBR
DOL > 1 su > IBR
I~
ROROI σ2n
1iiiu
p
n
1iii ROII
~RO ;
NI
EBITROI p
Dall’approccio top down all’approccio bottom up (5/7)
Growing unlevered risk due to greater volatility in the competitive environment
Decreasing unlevered risk due to lower volatility in the competitive environment
Unlevered risk with a constant operating leverage
I~
RO I~
RO I~
RO
su = 0,1 su = 0,2 su = 0,4
I~
RO I~
RO I~
RO
Dall’approccio top down all’approccio bottom up (6/7)
Unlevered risk with a constant IBR
Growing unlevered risk due to greater DOL
DOL = 1 DOL = 2 DOL = 5
Decreasing unlevered risk due to lower DOL
DOL and fixed costs
Specific risk according to bottom up approach
Q(p)REV c);Q(pEbit0)FC 0;c 0;p( DDDDDDD
If price per unit (p), cost per unit (c) and fixed costs (FC) are
constants, the DOL depends on fixed costs:
Ebit
FC1 DOL
2
(t0)
(t0)
(t0)
(t0)
(t0)(t0)(t0)
(t0)(t0)
(t0)
(t0)
(t0) Ebit
FC1
FCVCREV
VCREV
ΔQ(p)
Q(p)
Ebit
c)ΔQ(p
REV
REV
Ebit
Ebit DOL
D
D
The increase endogenous risk depends on the increase in resources (+ FC) and / or
loss of efficiency (- Ebit)
Bottom up analysis of specific unlevered risk: static
approach
Constant values of price per unit, variable cost per unit, fixed
costs and net investments
ROIEBIT
CFO1
V
IBR ROIDOL
V
IBR σ 2
t0
2
t0
t0
t0t0
t0u
Specific risk according to bottom up approach
Specific unlevered risk: static approach
(Forecasting analysis)
Analysis phases :
;REV)V~
(RE Revenues Expected
;ROI)I~
(RO ROI Expected
i
n
1ii
i
n
1ii
p
p
T~
EBI
FC1)O
~(DL DOL Expected
;t~
Ebi)t~
(EbiEbit Expectedn
1ii
p
I~
ROL~
DOV~
RE
IBR σu
Specific risk according to bottom up approach
Specific risk according to bottom up approach
I~
ROL~
DOV~
RE
IBR σ
2
u
Specific risk according to bottom up approach
Specific unlevered risk: static approach
(Historical analysis)
ROIDOLV~
RE
IBR σ t0t0u
Specific risk according to bottom up approach
Specific risk according to bottom up approach
Bottom up analysis of specific levered risk
(sL) and financial risk: static approach
ROE decomposition:
NI
D-1
t1
NI
DiROI
Equity
incomeNet ROE
NI
D-1
t1
NI
DiROI
Equity
incomeNet ROE
Equity
NI
NI
Equity
1
NI
D-NI
1
NI
D-1
1
Equity
incomeNet
)t1(Equity
FC-EBIT)t1(
Equity
NI
NI
FC
NI
EBITROE
Specific risk according to bottom up approach
Bottom up analysis of specific levered risk
(sL) and financial risk: static approach
NI
D-1
t1ROIROE
DD
With i, t, D and NI constants
NI
D-1
t-1σ
NI
D-1
t-1 ROI
EBIT
CFO1
V
IBR σ u
2t0
2
t0
t0
t0L
1
NI
D-1
t-1 ROI
EBIT
CFO1
V
IBRσ- σrisk Financial 2
t0
2
t0
t0
t0uL
Bottom up analysis of unlevered risk: dynamic approach
In the case of no constant value of price per unit, variable
cost per unit, fixed costs and net investments, the unlevered
risk depends on the following ratios:
j
j
j
j
j
jNI
FCμ ;
NI
CMθ
CM = Contribution margin (Revenues – Variable Costs)
FC = Fixed costs
NI = Net investments
Specific risk according to bottom up approach
j
j
j
jj
jjjNI
Costs Fixed-
NI
Costs VariableREVμθROI
Bottom up analysis of unlevered risk: dynamic approach
Specific risk according to bottom up approach
Independent variables
• Variance of q (volatility of contribution margin). It affects in positive
way the unlevered risk (su).
• Variance of m (structural instability: volatility of the ratio FC/NI). It
affects in positive way the unlevered risk (su).
• Covariance q, m. It affects in negative way the unlevered risk (su).
Bottom up analysis of unlevered risk: dynamic approach
Specific risk according to bottom up approach
μθ,
22μj
σ2θj
σσ j(u) s
Managerial interpretation of sq,m
• sq,m >0 shows the managerial capability to compensate the growth
in investment and fixed costs with the increase in contribution
margin. It decreases the unlevered risk linked to growth strategies.
• sq,m 0 amplifies the unlevered risk caused by growth strategies
Specific risk according to bottom up approach
Combining static and dynamic approach according to a
managerial logic
Specific risk according to bottom up approach
l =DOLj/DOLs
X
=
sq(j),m(j)/sq(s),m(s)
X > 1 X < 1
l > 1
l < 1
North West North East
South West South East
Stability state: relative high
specific unlevered risk
Dynamic state: relative low
specific unlevered risk
Stability state: relative high
specific unlevered risk
Dynamic state: relative high
specific unlevered risk
Stability state: relative low
specific unlevered risk
Dynamic state: relative low
specific unlevered risk
Stability state: relative low
specific unlevered risk
Dynamic state: relative high
specific unlevered risk Pro
pensity t
o s
tructu
ral gro
wth
Avers
ion
to s
tructu
ral g
row
th
The bottom up approach may be used to rework the CAPM,
starting from the idea that the systematic risk of a specific
company includes an idiosyncratic component. In other words,
internal firm’s features produce an effect on its beta.
As consequence, first the beta level can be correct taking into
account operating and financial leverage; second the firm’s beta
partially depends on managerial decisions.
Reworking the CAPM according to bottom up approach
Assumptions
• Each industrial sector absorbs a share of market volatility
• Each firm absorbs a share of sector volatility
Beta of sector x Correction Factor = Firm’s Beta
Static approach: Correction Factor = f(ROI, DOL)
Dynamic approach: Correction Factor = f(sq, sm, sq,m)
Reworking the CAPM according to bottom up approach
Correction Factor
Static approach: Correction factor comes from the relationship
between the firm DOL and the sector DOL.
Dynamic approach: Correction factor comes from the relationship
between the drivers of firm risk in dynamic conditions (sq, sm, sq,m )
and the same variables referred to the sector.
Reworking the CAPM according to bottom up approach
The correction factor (f: static approach
j(s)
j(u)
2
S
j
s
j
jjj
β
β
I~
RO
I~
RO
L~
DO
L~
DOγλ
f
Constant values of price per unit, variable cost per unit, fixed costs
and net investments . In addition this formula assumes constant the
market quote of j.
S
)τ1(D1β β
j
j
bj(u)
β
js(u)
b
j(L)
f
Reworking the CAPM according to bottom up approach
The correction factor (f: static approach
Reworking the CAPM according to bottom up approach
The correction factor (f: static approach
72,0)69767,0)(0285633936,1()β)((
0285633936,1)8,0)(285704242,1(
8,015125,0
121,0
I~
RO
I~
RO
285704242,1769230,3
846115,4
L~
DO
L~
DO
j
j
S
j
s
j
sf
f
Reworking the CAPM according to bottom up approach
β
β
σ2σσ
σ2σσ
ρ
ρ
j(s)
j(u)
θsμs,
2
μs
2
θs
θjμj,
2
μj
2
θj
ms,
mj,
j
f
The correction factor (f: dynamic approach
Reworking the CAPM according to bottom up approach
The correction factor (f: dynamic approach
Reworking the CAPM according to bottom up approach
Trade-off between growth and conservation
s(u)
μjθj,
2
μj
2
θj
ms,
mj,
jj
sinvestment strategicWith
j(G)
strategicisinvestment
strategicWithout
jσ
σ-
ρ
ργλ
ssff
jj(G)
jj(G)
jj(G)
)
)
)
ff
ff
ff
c
b
a The strategic growth decreases the
unlevered beta
Short-term effects
The strategic growth doesn’t affect
the unlevered beta
The strategic growth increases the
unlevered beta
Reworking the CAPM according to bottom up approach
According to the CAPM the specific risk of a portfolio well diversified
doesn't matter in order to value the expected return.
A rational investor (who exploits the diversification benefits)
measures the risk-return profile of each single stock taking into
account the systematic risk only.
This behavior is really rational when the investor does not seek
control of companies.
The diversification issue and total beta
The CAPM considers pure financial investors. Normally they pay a
little attention to strategic perspectives of firms. Therefore they
consider the “diversification power” like the main way to optimize their
risk-return relationship.
However, there are other types of investors who look at the risk-
return relationship with a logic partially or totally different the
traditional financial logic. This happens when an operators has
interest in a long-term perspective.
For example: Typically the entrepreneur doesn’t diversify. He tends to
invest his capital in one business; The typical venture capitalist
doesn’t exploit the overall diversification benefits. In fact he tends to
combine the diversification benefits with specialization and network
benefits.
The diversification issue and total beta
The diversification issue and total beta
Moreover, "Real investors are influenced by where they live and
work. They tend to hold stocks of companies close to where they live
and invest heavily in the stock of their employer. These behaviors
lead to an investment portfolio far from the market portfolio
proscribed by the CAPM and arguably expose investors to
unnecessarily high levels of idiosyncratic risk". (Barber 2011)
The diversification issue and total beta
The total beta model has been developed by Damodaran and then
it has been deepen by other scholars.
In general, total beta model aims to overcome limits of CAPM in the
case of those investors who tend to concentrate their portfolio in
one or few sectors.
The diversification issue and total beta
For investors without any diversification, who invest just in firms belonging to a
given industry, the total unlevered beta can be calculated as an inverse function
of the industry correlation coefficient against market portfolio dynamic:
σ
σσβ
ρ
βTβ
ms,
mss(u)
ms,
j(u)
j(u)
rs,m correlation coefficient between the sector s and market portfolio (m)
s(u) average unlevered beta of sector s
ss,m covariance between the between the sector s and market portfolio (m)
ss st. deviation of sector s
sm st. deviation of m
An other way proposed by Damodaran to overcome the
diversification issue is to correct betas through the correlation
coefficient between the investor’s portfolio and market ones.
In the case of perfect correlation, there is no beta’s correction.
In the case a correlation coefficient lower to 1 the beta’s correction
depends on the reciprocal value of the correlation coefficient.
The diversification issue and total beta
Total Beta (T) – Damodaran’s model
σ
σσβ
ρ
βTβ
mk,
mkj(L)
mk,
j(L)
j
rk,m correlation coefficient between the portfolio of investor (k) and market portfolio (m)
sk,m covariance between the portfolio of investor and market portfolio
sk st. deviation of portfolio k
sm st. deviation of m
The diversification issue and total beta
Total Beta (T), business life cycle and equity cost
The diversification issue and total beta
Beta
Total Beta
Equity cost
Diversification grade
of shareholders
Entrepreneurial
firm
Public
company
Risk premium
as function of
specific risk
only
Risk premium
as function of
systematic risk
only
Risk premium
as function of
both specific
and systematic
risk
Strengths and limits of T
• The T is the main model in order to take into account kinds of investors who have a low
propensity to diversify.
• The T formalizes the higher equity cost of private firms.
• The T arises like a powerful way to maximize speculative profits for those investors who
have a dominant position against their firms target
•The T violates the principles of the CAPM (Butler, Schurman, 2011).
• The T causes the transfer of risk due to the characteristics of the investor
(low diversification) towards the firm. This implies that two similar firms in terms of market,
size, intrinsic business risk and so on may operate with a different opportunity cost of
capital.
• The T could be a good tool just in the subjective perspective of the investor.
• The T doesn’t work well in the case of valuation done by an independent professional.
The diversification issue and total beta
L ρ
1
S
)τ1(D1β RfRmRfke
)4(
j
jTβ
)3(
mk,
anlysis up Bottom
bj(L)
β
)2(
j
j
bj(u)
β
)1(
js(u)j
factorCorrectionfactor
CorrectionfactorCorrection
factorCorrection
f
Lj measures the premium linked to the illiquidity risk
Reworking of CAPM according to four correction factors
The premium linked to the illiquidity risk comes from the opportunity
cost caused by the wait necessary to demobilize an activity.
The waiting time causes four main disadvantages :
1) Not maximize the capital gain by quickly selling the stock at the
best time;
2) Not exploit new investment opportunities by using cash in flow
coming from the stock selling;
3) Transaction costs;
4) Limitation in order to make personal expenses.
Reworking of CAPM according to four correction factors
The fourth correction (Lj)
The premium linked to the illiquidity risk comes from the opportunity
cost caused by the wait necessary to demobilize an activity.
The waiting time causes four main disadvantages :
1) Not maximize the capital gain by quickly selling the stock at the
best time;
2) Not exploit new investment opportunities by using cash in flow
coming from the stock selling;
3) Transaction costs;
4) Limitation in order to make personal expenses.
Illiquid assets valuation should imply a higher discount rate against
the case of liquid assets valuation
Reworking of CAPM according to four correction factors
The fourth correction (Lj)
Tow general ways to face the illiquidity issue:
1) Illiquid assets valuation should imply a higher discount rate
against the case of liquid assets valuation;
2) To value illiquid condition as inability to exploit a sort of put option:
inability to sell when the price of the underlying asset goes up
Reworking of CAPM according to four correction factors
The fourth correction (Lj)
Basic issues about systemic risk
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
292
The financial crisis 2007/2008
Real systemic risk
Systemic risk concept
The concept of systemic risk
293
The systemic risk is a macro system “wide-risk” related to financial
and/or real economic instability coming from: interconnections
between economic operators; interconnections between specific
defaults; collapses of macro areas of economic system; etc.
The systemic risk matters at macro and micro level:
• At macro level the systemic risk is the main driver of both
regulations (especially in the financial system) and
macroeconomics analyses about macro economic and financial
instability;
• At micro level the systemic risk awareness should influence the
risk management manners of single units
294
Systemic
risk
Macro level implications:
-News regulations about
systems stability more
based on a holistic view
(emphasis on economic
and financial networks);
- New public policies
against wide- collapses;
- Analyzing micro-risks
as drivers of macro-
risks.
Micro level implications:
-Enlargement of risk
management tools;
- Greater emphasis on
compliance risks;
- Increasing role of
corporate governance
systems in relation to
risk management
processes;
- New challenges in
terms of idiosyncratic
risk assessment.
The concept of systemic risk
295
Two kinds of systemic risk
1) The systemic risk coming from a domino effect: a single unit failure
causes a cascade failures
2) The systemic risk coming from correlated disasters: a single event (or
the combination of multiple events) causes the simultaneous collapse of
a macro system in each its components (or in the most part of them).
The concept of systemic risk
296
The systemic risk as consequence of network interconnections
The systemic risk coming from both a domino effect and correlated
disasters depends on network interconnections.
Network interconnections have always been the basis of the
transmission mechanisms necessary for the functioning of the
economic and financial systems.
In the last decades, economic and financial interconnections have
increased more and more as a result of the following three phenomena:
1) Diffusion of digital technologies;
2) Globalization of markets;
3) Outsourcing strategies.
The concept of systemic risk
297
According to traditional economic and financial studies macro systems based on ring
interconnections are weaker and less efficient against those systems based on network
conjectures. Starting from the financial crisis of 2007/08 an efficient network is seen as a
systemic risk amplifier (Battiston et al., 2009, Blume et al. 2011). “More densely connected
financial systems are more prone systemic risk” (Acemoglu D., 2012, presentation of
“Systemic Risk: Insights From Networks” at The American Finance Association, Chicago).
Ring interconnections , network interconnections and systemic risk
Ring interconnections Network interconnections
Higher efficiency without
strong shocks
Higher systematic
risk exposure
The concept of systemic risk
298
The concept of systemic risk
“Rings” are stable and incomplete networks. They generate a linear systemic risk
based on interconnections coming from input-output relationships.
Complete networks are unstable. They generate a no-linear systemic risk based
on simultaneous interconnections coming from wider relationships.
Ring interconnections , network interconnections and systemic risk
299
1) The mixing of macro and micro has caused a financial crisis
which was not generated by the stock market. In fact, in the in
the period 2002-2006 there was a gradual reduction in the
average price / earnings ratio.
2) The main macro cause of financial crises has been an excess of
liquidity favored by monetary policy.
3) According to Shiller, the emergence of subprime mortgages is
attributable, on the one hand, to Federal Reserve unawareness
of the real estate bubble risk, on the other to the “contagion” that
characterizes the euphoria phases (behavior economics).
What did we learn from the financial crisis (2007/2008)?
The financial crises (2007/2008)
300
4) According to some scholars, rules aimed to favor financial
stability (e.g. Basel 2) have been a cause of financial instability:
The minimum capital requirements (Basel 2) led financial
institutions to finance activities that in a given period presented
a high market value, thus fueling the formation of speculative
bubbles (pro-cyclic behavior);
The financial stability rules have increased conflict of interests
between banks and rating agencies;
The financial stability rules led financial institutions to externalize
their risks.
What did we learn from the financial crisis (2007/2008)?
The financial crises (2007/2008)
301
5) Corporate governance models led managers to aim short run
goals.
6) The end of the time factor: the “profits formalization” before their
actual realization.
7) Financial instrument studied for covering risk have become
drivers of both micro and systemic risk.
What did we learn from the financial crisis (2007/2008)?
The financial crises (2007/2008)
302
"We all agree that the technology of new cars has been aimed at
increasing the security level. The problem arises when we don't
use this technological advantage to increase our security but to
increase speed at which we travel or to travel in adverse
weather conditions“ (Synthesis of the Interview with Merton
made by Gianfrate, "Economia e Management“, 2008).
Why did derivatives and other financial engineering instruments amplify
the crisis of 2007/08?
The financial crises (2007/2008)
303
The most part of systemic risk studies focused on financial system. It depends on
three main factors: 1) the interconnections inside financial system (or its specific
parts, e.g. bank system) arise in a clearer way against the case of real economy
system; 2) the financial system is governed by authorities (BCE, Federal
Reserve, SEC etc.) which have the task of aiming for macro-financial stability; 3)
In the last decades financial systemic risk occurs with more frequently
(1999/2000; 2001; 2007/2008; 2011/2012)
However, in last years scholars and public decision makers pay a
higher attention real systemic risk in terms of:
-The double relationship between financial systemic risk and real
systemic risk;
- Infra-sector real systemic risk;
- Inter-sector real systemic risk
Real systemic risk
304
Real systemic risk
The double relationship between financial systemic risk and real systemic
risk
Financial
system
collapse
Failure of a
no-financial
firms
number
Real
economic
system
collapse
Real
economic
system
collapse
Failure of a
financial
firms
number
Financial
system
collapse
305
Real systemic risk
Intra and inter-sectors interactions
F1
F4 F2
F3
S1
S4 S2
S3
Intra-sector
interactions
Inter-sectors
interactions
306
Real systemic risk
Leontief’s model: linear inter-sector interactions
Inputs
Outputs
ai,k = technical coefficient which measures the quantity of the product i needed to produce a
unity of the k product.
Industries S1 S2 S3 S4 … Sn
S1 a1,1 a1,2 a1,3 a1,4 … a1,n
S2 a2,1 a2,2 a2,3 a2,3 … a2,n
S3 a3,1 a3,2 a3,3 a3,4 … a3,n
S4 a4,1 a4,2 a4,3 a4,4 … a4,n
… … … … … … …
Sn an,1 an,2 an,3 an,4 … an,n
Vector matrix of the technical coefficients
307
Real systemic risk
Leontief’s matrix: linear inter-sector interactions
Inputs
Outputs
Industries S1 S2 S3 S4 … Sn
S1 a1,1X1 a1,2X2 a1,3X3 a1,4X4 … a1,n Xn S S1
S2 a2,1X1 a2,2X2 a2,3X3 a2,4X4 … a2,nXn S S2
S3 a3,1X1 a3,2X2 a3,3X3 a3,4X4 … a3,nXn S S3
S4 a4,1X1 a4,2X2 a4,3X3 a4,4X4 … a4,nXn S S4
… … … … … … … …
Sn an,1X1 an,2X2 an,3X3 an,4X4 … an,nXn S Sn
Xi = produced quantity of the product i
SSi = Total production of industry i
308
Real systemic risk
How we can use the Leontief’s matrix for analyzing the real systemic risk
-An interruption of one or more input/output interconnections may produce a real economy
collapse.
-Causes of the above interruption may come from a domino effect and correlated disasters
as well.
-For estimating the real systemic risk we need to find a measure about current intensity
sectors interconnections.
- We need to figure out how new technologies may change the intensity sectors
interconnections.
Firm’s risks and enterprise risk management (ERM)
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
310
Decision making under risk, uncertainty and ambiguity
conditions
The risk management role
The ERM framework
Firm’s risk classification
Decision making under risk, uncertainty and ambiguity
conditions
311
Main definitions of risk
1. Risk equals the averege expected volatility
2. Risk equals the expected loss (Willis, 2007).
3. Risk equals the expected disutility (Campbell, 2005).
4. Risk is the probability of an adverse outcome (Graham and Weiner, 1995).
5. Risk is a measure of the probability and severity of adverse effects (Lowrance 1976).
6. Risk is the fact that a decision is made under conditions of known probabilities (Knight,
1921).
7. Risk is the combination of probability of an event and its consequences.
8. Risk is defined as a set of scenarios, each of which has a probability and a consequence
(Kaplan and Garrick 1981; Kaplan 1991) Risk Management theory: the integrated
perspective and its application in the public sector 92 ISSN 0717-6759
9. Risk is equal to the two-dimensional combination of events/ consequences and associated
uncertainties (will the events occur, what will be the consequences) (Aven 2007).
10. Risk refers to uncertainty of outcome, of actions and events (Cabinet Office 2002).
11. Risk is an uncertain consequence of an event or an activity with respect to something
that human’s value.
Source: Ignacio Cienfuegos Spikin (2013)
Decision making under risk, uncertainty and ambiguity
conditions
312
Firm’s decisions and risks
The decision-making process is strongly influenced by the decision maker's
subjective degree of risk appetite. Risk-averse operators (managers,
entrepreneurs, investors, etc.) tend to set low profitability objectives, thus incurring
opportunity costs due to the waiver of high returns on capital.
On the other hand, risk-inclined operators tend towards maximizing expected
profitability and are therefore willing to face particularly uncertain expected
performances.
With specific reference to businesses, the risk appetite also depends on the internal
structural characteristics of the organization and on the financial and equity
capacity to bear economic imbalances induced by particularly risky decisions.
Decision making under risk, uncertainty and ambiguity
conditions
313
Firm’s decisions and risks
A low propensity to take risk implies taking the risk of "not doing". For example, the
renunciation of investments aimed to make innovation eliminates the risk
associated with innovation processes, but generates the risk of losing development
opportunities.
In recent decades, companies that have not invested in knowledge have often
increased strategic and operational risks.
In the knowledge economy the firm needs find a right trade-off between the
mitigation of the risk linked to complex investments and that caused by their non-
realization.
Decision making under risk, uncertainty and ambiguity
conditions
314
Business opportunities and the rational behavior against firm’s risk
according to an adaptive logic
No new expected
Business opportunities
Expected stability of the
competitive context
Current stability of the
competitive context
No new current
opportunities Increase in
efficiency and
firm’s risk
minimization
New expected
business opportunities
Expected instability of the
competitive context
Current instability of the
competitive context
New current
opportunities
Temporary efficiency
reduction,
increase of risk
associated to new
strategic
investments,
minimization
of "not do" risk
Decision making under risk, uncertainty and ambiguity
conditions
315
Business opportunities and the rational behavior against firm’s risk
according to an proactive logic
No new expected
business opportunities
Managerial orientation:
the competitive
environment stabilization
Increase in
efficiency and
firm’s risk
minimization
Temporary efficiency
reduction,
increase of risk
associated to new
strategic
investments,
minimization
of "not do" risk
No new current
business opportunities
Behavior of a leading company operating in a stable market
New expected
business opportunities
Entrepreneurial
orientation:
destructive innovations
New current
business opportunities
The behavior of the innovator: breaking down the existing
competition rules
The risk seen as a danger than consolidated advantages
The risk seen as an opportunity for creating new advantages
Decision making under risk, uncertainty and ambiguity
conditions
316
Firm’s decisions and risks: the risk culture issue
In the most part of firm’s (especially SMEs) managers and entrepreneurs are not
aware of risk concept and how firm’s risk may be analyzed and managed.
This issue comes from come from risk is intrinsic to each business. In other words
risk is seen as natural condition that each firm can’t face in terms of scietific
management.
Decision making under risk, uncertainty and ambiguity
conditions
317
Firm’s decisions and uncertainty
The selection of choices based on risk, both in case of an adaptive and proactive
logic, can be formalized through an explicit analysis of the probability distribution
about expected events.
The quantification of the risk, however, is often accompanied by the inadequacy of
the information available, by a poor ability to interpret the observed reality and / or
by an objective indeterminacy of the relevant factors. This causes, in the context of
the forecast estimates, the impossibility of including all possible changes in the
scenario, the set of interpretative variables and the changing relevance that these
can assume over time. Therefore forecast analyzes often cause provisional and
partial or even completely wrong results.
When the subjective and/or objective information and knowledge are not sufficient
to define a probability distribution the decision maker moves for risk conditions to
uncertainty.
Decision making under risk, uncertainty and ambiguity
conditions
318
Firm’s decisions and uncertainty
According to Knight (1921) risk and uncertainty differ markedly: while the risk expresses
a measurable volatility, the uncertainty concerns unpredictable events, or for which it is
not, in any case, possible to define a probability distribution.
Risk and knowledge: “you don’t know for sure what will happen”
Uncertainty and knowledge: “you don’t even know the odds of what will happen”
(Adams, 2005 in Hermans et al., 2012)
Decision making under risk, uncertainty and ambiguity
conditions
319
Firm’s decisions and uncertainty
Subjective uncertainty of an individual
or organization:
- Lack of skills;
- Inability accessing relevant information;
- Too much information and inability to
manage big date;
- etc.
Objective
uncertainty:
- Unpredictable events;
- Predictable but too unlikely events;
- Exogenous events than the economic
system;
- etc.
Decision making under risk, uncertainty and ambiguity
conditions
320
The risk is a complicated issue that may be solved through a set of models and
techniques
Firm’s decisions and uncertainty
The uncertainty is complex issue that can never be completely resolved, because to face
complexity means to generate new complexity.
Decision making under risk, uncertainty and ambiguity
conditions
321
Business decisions can be optimized, in terms of expected
profitability and the risk they incorporate, only to the extent that it is
possible to attribute weight to future events. This possibility
decreases with increasing environmental instability, to be
understood as rapid changes within the competitive environment in
which the company operates.
In this regard, Stacey (1996) analyzes the relationship between
environmental dynamism and decisional complexity according to
three types of changes:
1) closed change;
2) limited change;
3) open change.
Firm’s decisions and uncertainty
Decision making under risk, uncertainty and ambiguity
conditions
322
The closed change identifies a variability that has already
occurred in the past and, as such, characterized by a low or even
zero level of decision-making complexity.
The limited change refers to an event that has already happened,
the current manifestation of which, however, presents elements of
differentiation compared to past ones.
Open change occurs when unique situations emerge and have
unpredictable consequences (positive or negative).
Firm’s decisions and uncertainty
Decision making under risk, uncertainty and ambiguity
conditions
323
The proposed distinction between risky and uncertain phenomena
must not be considered in absolute terms: on the one hand a
phenomenon can include elements of both calculable risk and
pure uncertainty, on the other, it can alternate between high and
low uncertainty over time.
Firm’s decisions and uncertainty
Decision making under risk, uncertainty and ambiguity
conditions
324
The ambiguity issue arises when the decision maker has more
beliefs (or probabilities) in his/her mind in order to predict future
events.
The decisional ambiguity leads to move from maximization to
minimization goals.
Firm’s decisions and ambiguity
Decision making under risk, uncertainty and ambiguity
conditions
325
The ambiguity level tends to increase in the case in which the
decision maker is a group of people, as in the case of a firm board,
that assumes strategic decisions . It is a sort of “group ambiguity ”,
in the sense that each member of the decisional group is the
source of a personal beliefs bout expected events.
Firm’s decisions and ambiguity
Decision making under risk, uncertainty and ambiguity
conditions
326
Firm’s decisions and ambiguity
Decision making under risk, uncertainty and ambiguity
conditions
327
Combination between uncertainty and ambiguity
Decision making under risk, uncertainty and ambiguity
conditions
328
According to some scholars, the combination of uncertainty and
ambiguity determines the following two effects: a greater aversion
to undertake innovative initiatives, or in any case, characterized by
discontinuity with respect to the past; the transition from a
maximizing logic, based on the search for the objectively better
solution, on a minimizing logic, based on the search for the best
result in the context of the minimum hypothesis.
However, uncertainty and ambiguity in business decisions also
produce growing opportunities connected with the discontinuity of
the context (Fiocca, 2007, p. 7.). The difficulty in fully quantifying the
risk and the decision-making errors that derive from it amplify, that
is, the spaces for the development of innovative projects and the
emergence of new entrepreneurial subjects devoted to innovation.
Combination between uncertainty and ambiguity
Decision making under risk, uncertainty and ambiguity
conditions
329
For example, the birth and development of Microsoft (in the late 70s
and early 80s) would not have been possible if the main competitor
(IMB) would have owned a set of information and sufficient
knowledge to consider a wide range of future scenarios and to
assign them a unique probability of occurrence.
Combination between uncertainty and ambiguity
Firm’s risk classification
330
-Financial risks
- Strategic risks (or business risk)
- Investment projects' risk
- Technological risk
- Operational risks
- Compliance risks
- Pure risks
Firm’s risk classification
331
- Liquidity risks
- Credit risks
- Market risks
Financial risks are easier to indentify against other risk kinds. Their
evaluation and treatment is partially regulated. The most part of
quantitative risk management models focus on financial risks.
Financial risks
Firm’s risk classification
332
Firstly, liquidity risk arises from the illiquidity of one or more assets:
difficulty to sell one or more assets at a price close to the initial
price (low marketability).
Secondly, the liquidity risk depends on the waiting time necessary
to transform one or more assets into cash.
Thirdly, this type of risk relates to the firm's inability to generate
cash flows at the right time.
Financial risks – Liquidity risks
Firm’s risk classification
333
The credit risk regards losses due default or insolvency of
commercial or financial borrowers.
Non Performing Loans (NPLs):
NPLs are generally banks' exposures to operators who (due to a
worsening of their economic and financial situation), are unable to
meet their obligations in terms of debt service.
The Bank of Italy divided the NPLs into three main categories:
1) Credits that have expired or exceeded the credit limits for more
than 90 days and beyond a certain threshold;
2) Credits which according to the bank's analysis will not (fully or
partially) be respected;
3) Credits given to operators in a state of insolvency.
Financial risks – Credit risk
Firm’s risk classification
334
Financial risks – Strategic resolution of NPLs: Turnaround
NPLs can be due to strategic and/or liquidity causes. Strategic crises and
liquidity crises can affect each other. When according to the financial backer the
firm’s insolvency cannot be solved with a firm’s radical change, the NPL
resolution in based on formal procedures.
Instead, in the case the borrower (firm) has a potential margin to overcome the
crises (strategic/economic crisis and related insolvency), the resolution of a
NPL could be based on a turnaround process. This process leads to a
corporate radical change.
First the turnaround process is based on an assessment aimed to identify the
reasons for failing performance.
Second, the turnaround process needs a planning activity to save the firm in
trouble and returns it to solvency.
Often a turnaround process meets the unwilling of firm’s owner (or
management) and/or problems due organizational rigidity.
Firm’s risk classification
335
Financial risks – Strategic resolution of NPLs: Turnaround
The turnaround stages in brief
- Assessment stage: analyzing current weaknesses and current/potential strengths. This
initial stage becomes the final stage if the assessment results show the impossibility to
make a turnaround process.
-Management of change: changing the firm’s philosophy and spread it to financial and
non-financial stakeholders; aligning the change to the expectations of internal and
external stakeholders; tying every internal and external actor to the same set of goals.
- Emergency action stage: focusing on cash and assets/liabilities management to save
the firm’s live in the short period.
-Business restructuring stage: restructuring the business by finding new profitability
sources; adapting the organization structure to new internal processes; implementing an
internal control process.
- Return to normal stage: institutionalizing the changes in corporate culture. Appling
changes to achieve proper level of competitive advantage, profitability, cash flows etc.
Firm’s risk classification
336
Market risks depend on fluctuations in the value of aaset/liabilities
caused by:
- stocks’ prices dynamic;
- interest rates dynamic;
- currency exchanges’ dynamic;
- commodities’ prices’ dynamic.
Financial risks – Market risks
Firm’s risk classification
337
The strategic risks concern:
- The possibility of losing the current competitive position. A part of
this risk kind depends on potential changes in the specific
competitive environment where the firm is working; an other part
comes from changes in public institutions, laws, macro-economy
etc;
- The irreversibility degree of strategic decisions.
Both the risk of losing the current competitive position and that
coming to irreversibility decisions are negatively correlated with
strategic flexibility.
Strategic risks (or business risk)
Firm’s risk classification
338
Strategic risks – Sector risk: 5 competitive forces (Porter 1985)
Firm’s risk classification
339
Strategic risks investments – Strategic investments, ex ante and
managerial flexibility
The ex ante flexibility regards the faculty to make strategic investments
before the occurrence of the expected changes. For example, the firm makes
an investment to improve its productivity in the perspective of a demand
growth.
The managerial flexibility regards the possibility to change the investment
strategies after the occurrence of new scenarios. For example, an investment
aimed to improve the productivity could be reduced, when the real growth of
the demand is lower than the potential growth estimated before the
investment decision. The exploitation of managerial flexibility may consist in
an adaptation to changes in the environment, to reduce endogenous
uncertainty and/or to affect the environment to firm’s favor (Sanchez, 1993;
Sanchez & Mahoney, 1996).
Firm’s risk classification
340
Strategic risks – Strategic investments, ex ante and managerial flexibility
Drivers of ex-ante
flexibility:
- Prediction capacity;
- Propensity towards changing;
- Innovation propensity;
-Low sunk costs;
- Current economic and financial
strengths;
- Previous knowledge investments;
- Current internal resource;
- etc.
Drivers of
managerial flexibility:
- Intrinsic flexibility of strategic
investments;
-Dynamic capabilities;
- Multi-use resources;
- Low sunk costs;
- Flexible knowledge;
- No-linear strategic plans;
- etc.
Increasing in
symmetrical
volatility
Increasing in up side
volatility; decreasing in
down side volatility
Firm’s risk classification
341
Strategic risks – Strategic investments, ex ante and managerial flexibility
The combination of these two flexibility kinds (ex ante and
managerial flexibility) allows:
• To realize investments aimed to exploit expected changes
• To correct investment decisions, once verified the effective
dynamic of several independent variables.
Firm’s risk classification
342
Technological risks
• Risks linked to the existing technologies
• Risk of switching costs of new technologies
• Risk linked to new technologies adoption
Firm’s risk classification
343
Technological risks - Switching costs
Often, the adoption of a new technology requires further investments, as
those one made for compatibility among products.
For instance :
• A new software could require further investments to update already
existing software;
• A new plant could require additional investments for human resources
training
• There could be penalties due to previous suppliers in case of switching.
Moreover, the innovative technology could increase the supply risk, if it’s
a real risk or just a difference in risk perception.
Firm’s risk classification
344
Technological risks – Technology adoption Two drivers:
1)Intrinsic value: the adoption degree is linked to the economic dimension of a specific innovation (e,g. new machinery that allows lower production costs)
1)“Bandwagon” behavior: the adoption degree of an individual (or a firm) depends on the behavior of other individuals (or firms)
Firm’s risk classification
345
Technological risks – Technology adoption
Innovation Users
Value
maximization
To be similar
to the others
Adoption
motivation Adoption
Behavior
Rational
Imitation
Intrinsic value
Bandwagon
Firm’s risk classification
346
Technological risks – Technology adoption
Intrinsic value logic
Risk of possible
mistakes about
effective economic
utility
Bandwagon logic
Risk of unawareness
about effects coming
from a new technology
Firm’s risk classification
347
Operational risks
Operational risks are the risks of losses
inherent in business operations, arising
from:
• Human errors;
• Incorrect functioning of processes;
• Illegal behavior connected with
fraudulent conduct of managers, of
employees or external subjects;
• Risk of change in one or more laws;
• Risk of legal disputes
• Inadequate in conduct with customers and suppliers; etc..
Firm’s risk classification
348
Compliance risks
• The risks of conformity deriving from failure compliance with laws, internal
regulations and external regulations.
• These risks can give rise to effects negatives related to penalties, penalties,
fines, economic losses and, in cases more serious, to damage to reputation
corporate with consequent losses, compensation claims etc.
Firm’s risk classification
349
Compliance risk: the role of corporate governance
Compliance risks and corporate governance framework are closely connected.
This produces two effects:
-A decisive role of firm’s board in order to define risk management goals;
- Standardization of risk management process
Firm’s risk classification
350
Compliance risk: the role of corporate governance
Compliance
risk
mitigation
Ensuring compliance
with funders terms
and conditions
Compliance with
current
legislation
Corporate governance
rules and actions
Firm’s risk classification
351
Pure risks
Pure risks are linked to external events that can negatively influence company.
They are "insurable" risks fall into this category, that is associated with events
such as natural disasters, damage, injuries or accidents that in generally they
can cause damage to third parties, as well as terrorist acts, robberies, thefts,
etc..
The risk management role
352
• The implementation of Risk Management (RM) allows the
company to make informed decisions, mitigating the effects of
potential negative events.
• The RM activity is one of the 2 level controls
• The RM activity plays a cross-cutting role in the organization as
whole.
The risk management role
353
Risk management process
Step 1 Step 2
Risk
Identification
Risks
quantification
Risks
management
Step 3
Risks
monitoring
Define and
identify all
sources of
risk; actual,
anticipated,
and perceived
Estimate the
financial
impact on the
firm of all
pure and
speculative
risks identified
Decide how
to manage
pure and
speculative
risks (through
loss control,
loss financing,
risk reduction)
Track and
assess the
performance
of the risk
management
strategy in
light of actual
experience)
Step 4
Feedback Source: Erik Banks, Chapter 3
The risk management role
354
External role of risk management
Risk
Identification
Risks
quantification
Risks
management
Risks
monitoring
Communication about: -the risk profile of the company;
- the ways adopted to face the risk;
- the effectiveness of the RM process;
- how to improve the MRI process.
Financial and
non-financial
stakeholders
The risk management role
355
Firm's reaction than its risks
-Avoid risk by rejecting risky actions as much as possible.
- Loss prevention.
- Separation.
- Diversification.
- Risk financing through mechanisms of transfer or retention.
The risk management role
356
Thre
e leve
ls o
f R
M
Risk pooling Risk transfer
Hedging: Risks are not pooled as
such, but transactions undertaken
which have the economic effect of
selling (or transferring) the risk.
Risks are exchanged (transferred)
from one party to another
Diversification: Risks are placed into
portfolios and the aggregated risk is
less than the sum of the individual
risks
Insurance: Assumed risks, as in the
case of insurance, may be pooled at
the aggregate level and hence risk
taker may get benefits of
diversification
No risks are transferred: risk
reduction is obtained through portfolio
effects
Risks are sold (transferred) from the
buyer to the seller. Seller assumes all
future uncertainty about value
Source: Moles P. (2016)
Risk pooling and risk transfer
The risk management role
357
An enlargement of risk transfer concept
-Risk transfer through insurance companies
- Risk transfer through hedging operations
- Risk transfer through risk sharing agreements
- Risk transfer through unilateral changes of remuneration of employees and /
or suppliers.
The risk management role
358
Causes of risk management failure
- Weak transmission mechanisms between corporate governance and the risk management
area.
- Poor involvement of internal and external stakeholders in order to define strategies and
goals of RM.
- Each risk kind is considered in a stand alone way.
- Lack of management supports.
- Different ways of considering risk.
- Different levels of risk appetite.
- Failure to share information.
- Low level of risk culture.
- Aversion to RM: RM is considered as a set of mandatory but not useful procedures.
- The entrepreneur (or the management) looks at risk as an inevitable thing inherent in the
life of a company.
- Difficulties to combine quantitative and qualitative risk assessment tools.
359
The corporate governance concept
Corporate Governance Management
Corporate governance definition:
“The corporate governance is the action, the way, the fact or the function to
dominating and controlling the firm” (Oxford Dictionary)
The risk management and corporate governance
360
How and when start the Corporate Governance:
- the firm acquire legal personality (Corporation of capital or partnership of individual. In this way there is a separation of responsibilities between the ownership and the firm. The legal personality introduced the firm’s constitutions
- the increase of the firm’s size. The growth of the size determined the born of delegation mechanism. The owner delegates some functions to manager. For this reasons It becomes necessary to monitor the actions of managers.
The risk management and corporate governance
An example of presence of the delegation mechanism between owner and manager in the public company: large companies with a growing number of shareholders interested only equity return.
The shareholders delegate their governance rights to managers.
The manager becomes the “King”. Perfect Management firm
The managers aim to provide returns for shareholders increasing the price of the shares.
It 'important to identify the mechanisms witch protect the ownership of opportunism manager. (Agency theory)
Delegation mechanism
The risk management and corporate governance
362
The Independent Directors role
The Independent Directors
The importance of
the independent directors is
affirmed with the rules of
good governance
related to the reform of
company law
It establishes a minimum
limit of presence of independent
board member
In 2012 the average
proportion of independent directors on the boards is
36% (Assonime,
2013). Today the percentage is much higher
The risk management and corporate governance
363
The reform provides the formation of the internal Board Committees (Nomination, Remuneration Committee, and Risk Control Committee).
The Corporate Governance Code recommends that the office of President of Control Risks and Remuneration Committees is covered by an independent director.
The legislation says that committees have a majority of independent directors.
The international literature suggests an exclusive presence of independent directors on committees
The growing importance of risk management in the corporate governance
system
The risk management and corporate governance
The growing importance of risk management in the corporate governance
system
Shareholders
meeting
Board of
directors or
single
administrator
Control and risk
committee
Remuneration
committee
Appointment
committee
The risk management and corporate governance
365
Internal control and risk management system (Corporate Governance
Code)
-The Corporate Governance Code is a set of principles and recommendations
that can be voluntarily adopted by companies listed on the main stock markets.
-The adoption of the Corporate Governance Code entails a specific report. This
report must be spread, so it is public document usable by internal and external
stakeholders.
- The principles and recommendations Corporate Governance Code are the
base on which the above report is built taking into account characteristics of
each individual company in terms of strategic objectives, organizational
structure, operational processes and so on.
A part of Corporate Governance Code regards issues about internal
control and risk management system.
The risk management and corporate governance
366
Internal control and risk management system (Corporate Governance
Code)
“Controls system is one of the critical issues of a listed company governance.
Its components are rather diversified and range over from the so-called “line
control” (or “first level control”) carried out by persons in charge of operational
areas to the so-called “management control”, relating to business planning and
controlling, up to internal auditing, that is the global assurance on design and
functioning of internal controls” Banca D’Italia 2018.
The risk management and corporate governance
367
Internal control and risk management system (Corporate Governance
Code):
- Each issuer shall adopt an internal control and risk management system
consisting of policies, procedures and organizational structures aimed at
identifying, measuring, managing and monitoring the main risks. Such a system
shall be integral to the organizational and corporate governance framework
adopted by the issuer and shall take into consideration the reference model and
the best practices that are applied both at national and international level.
- An effective internal control and risk management system contributes to the
management of the company in a manner consistent with the objectives defined
by the Board of Directors, promoting an informed decision-making process. It
contributes to ensuring the safeguarding of corporate assets, the efficiency and
effectiveness of management procedures, the reliability of the information
provided to the corporate bodies and to the market and the compliance with
laws and regulations, including the by-laws and internal procedures.
The risk management and corporate governance
368
Internal control and risk management system (Corporate Governance
Code):
The internal control and risk management system involves each of the following
corporate bodies depending on their related responsibilities:
a) the Board of Directors;
b) The Internal Audit;
c) the other roles and business functions having specific tasks with regard to
internal control and risk management, depending on the company’s size,
complexity and risk profile;
d) the Board of statutory auditors.
Each issuer must provide for coordination methods between the above
mentioned bodies in order to enhance the efficiency of the internal control and
risk management system and reduce activities overlapping.
The risk management and corporate governance
369
Internal control and risk management system (Corporate Governance
Code):
In order to control the firm’s risks and implement a risk management system,
The Board of Directors (BD) acts according the following principles and
recommendations:
- BD defines the general rules in order to align the internal control and risk
management system with the company's strategies;
- BD defines principles aimed at maximizing the effectiveness of the system
itself, reducing duplication of control activities and ensuring proper system's
functioning;
- BD indicates manners to check and assess functioning of internal control and
risk management system ;
- the CEO (chief executive officer) is responsible for establishing and
maintaining the internal risk control and management system.
The risk management and corporate governance
370
Internal control and risk management system (Corporate Governance
Code)
The BD establishes the Control and Risk Committee , whose task is that to
support the assessments and decisions of the BD relating to the internal risk
control and management system and approval of the financial and non-financial
periodical reports.
The risk management and corporate governance
371
The Internal Audit (IA) :
- the IA office is responsible for verifying that the internal control and risk
management system is functional and in line with what is defined as defined at
DB level.
- the IA verifies the compliance system than both specific characteristics of the
company and international best practices, through continuous checks and
periodic analyzes.
- the IA defines the audit plan, based on a risk analysis process and
identification of the most significant risks. This plan to be approved by the BD.
The risk management and corporate governance
372
Expected
shocks in
revenues
Unlevered
Risk: volatility
of operating
profit
Degree of
operating
leverage
Decreasing
of enterprise value
Risk management, corporate governance and income smoothing
Income
smoothing
Avoid
The risk management and corporate governance
373
Risk management, corporate governance and income smoothing
Expected
shocks in
revenues
Potential volatility
of operating profits
caused by
operating leverage
degree
Corporate
governance
Risk
management
Unlevered Risk
transfer towards
suppliers and
employs
Operating income
smoothing
Compliance of risk
management with corporate
governance rules
Creation or stabilization
of enterprise
value
De
cre
ase
s
of e
ffectiv
e
op
era
ting
leve
rag
e
The risk management and corporate governance
374
Income smoothing and inter-temporal risk transfer
A firm can achieve the income smoothing by accounting techniques (artificial
smoothing) and/or by real changes in its operations (real smoothing).
Both real and artificial smoothing imply an inter-temporal transfer of unlevered risk,
considered as a one period risk externalization which may increase and reduce
symmetrically the remuneration of both suppliers and employees. Risks that a firm
cannot eliminate by diversifying its sales activities can be “averaged over time in a way
that reduces their impact on individual welfare. One hedging strategy for non-
diversifiable risks is the use of the intergenerational risk sharing, which spreads the
risks associated with a given stock of assets across generations with heterogeneous
experiences” (Allen & Gale, 1997, p. 525).
The risk management and corporate governance
375
Income smoothing and inter-temporal risk transfer
The extent of income smoothing that is achieved by managers of firms by acting on the
cost of goods purchased, which implies a transfer of unlevered risk linked to revenue
volatility towards suppliers, is likely to be greater in the cases of larger-sized
corporations affiliated with a business group than in smaller-sized corporation
unaffiliated with a business group.
On the one hand the firm’s size allows income in terms of contractual power, belong to
a business allows the risk transfer inter-group on other hand, thanks technological,
financial and/or commercial interactions.
The risk management and corporate governance
376
Income smoothing and inter-temporal risk transfer
Big
com
panie
s
Sm
all
com
panie
s
Groups Single companies
Structural interactions
North West
High inter-temporal transfer of
unlevered risk towards
suppliers
Low/Medium inter-temporal transfer of
unlevered risk towards
employees
North East
High /Medium inter-temporal transfer of
unlevered risk towards
suppliers
Low inter-temporal transfer of
unlevered risk towards
employees
South West
Low/ Medium inter-temporal transfer of
unlevered risk towards
suppliers
Medium inter-temporal transfer of
unlevered risk towards
employees
South East
Low intertemporal transfer of
unlevered risk towards
suppliers
Medium inter-temporal transfer of
unlevered risk towards
employees
Firm
siz
e
Source: Renzi, Vagnani, 2020
The risk management and corporate governance
377
Income smoothing and inter-temporal risk transfer
The risk management and corporate governance
Big
com
panie
s
Sm
all
com
panie
s
Groups Single companies
Structural interactions
North West
Transfer of
unlevered risk towards
Suppliers: 76,2%
Transfer of
unlevered risk towards
employs: 7,90%
North East
South West South East
Transfer of
unlevered risk towards
Suppliers: 71,17%
Transfer of
idiosyncratic risk toward
employs : 3,62%
Transfer of
unlevered risk towards
Suppliers: 68,14%
Transfer of
unlevered risk towards
employs : 8,51%
Transfer of
unlevered risk towards
Suppliers: 11,55%
Transfer of
unlevered risk towards
employs : 5,96%
Firm
siz
e
Source: Renzi, Vagnani, working in progress
The risk management and corporate governance
At the individual companies level, strategies aimed for reducing unlevered risk could
become sources of systemic risk in the real economy. This paradox could be
amplified when the constraint to be compliant with corporate governance rules leads
risk managers for finding an operating incomes smoothing through a transfer of
unlevered risk.
Conclusion and research perspectives
Income smoothing, inter-temporal risk transfer and systemic risk
380
Income smoothing, inter-temporal risk transfer and systemic risk: linear
process
The risk management and corporate governance
Real systemic risk
381
Income smoothing, inter-temporal risk transfer and systemic risk:
network process
The risk management and corporate governance
Real systemic risk
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382
Definition and motivations of ERM
The ERM arises as a “natural” evolution of traditional RM.
The ERM is defined as wide approach to risk management where the main focus is
to figure out ways for integrating risks’ analysis and their treatment, taking into
account the firm’s vision and risk appetite according to guidelines coming from
corporate governance and external institution.
The ERM aims to achieve two interacted general goals:
1) Making actions to protect the firm against adverse conditions;
2) Maximizing firm’s value in the long run.
The enterprise risk management (ERM) framework
383
From a silo approach and systemic approach
Financial
risks Strategic
risks
Operat.
risks
Comp.
risks
Tech.
risks
Pure
risks
ERM
Financial
risks
Strategic
risks
Comp.
risks
Pure
risks
Tech.
risks
Operat.
risks
Silo approach Systemic approach
The enterprise risk management (ERM) framework
384
Definition and motivations of ERM
The need of a higher integration depends on:
• compliance issues;
• the growing role of corporate governance than RM processes;
• the need to fit strategies with the firm's vision and its risk appetite;
• finding ways to combine qualitative and quantitative approaches in risk analysis;
• providing risk management reports that allow internal and external analysts to link
"points" of risk and their drivers deriving from the company's decisions,
characteristics of the internal structure and those of the external environment.
The enterprise risk management (ERM) framework
385
The ERM challenge
The ERM is a challenge that has not yet been completely overcome. Its basic idea
is to combine several managerial issues in a holistic manner. It entails to analyze
each risk like a part of a unique risk.
From a theoretical viewpoint, this risk management challenge is in contrast with the
traditional scientific management and fits those studies which looks at organizations
like a complex set of dynamic and interrelated components.
The implementation of a ERM system causes transversal changes across all
organization and imposes new ways of making strategic as well as operating
decisions.
The enterprise risk management (ERM) framework
386
The ERM challenge
The ERM challenge fails when:
-There is a lack of risk culture;
- The culture of risk is too specialized and fragmented;
- The investment in ERM is too low;
- Organizational routines prevent a higher interactions between several firm’s areas;
- The ERM implementation is just done in formal terms and/or aims to improve the
firm’s imagine only;
- The firm doesn’t own a proper information system;
- The several firm’s areas are adverse for sharing information to each other;
- The complexity of ERM is a source of entropy, rather than a value driver.
The enterprise risk management (ERM) framework
387
Reducing the ERM complexity and the flexibility issue
Typically holistic managerial approaches and models are based on a too high
complexity. This often causes a gap between theoretical principles and their real
application.
Therefore the ERM becomes as an effective risk management tool by framing its
holistic view into a defined framework of actions.
To maintain the holistic view it is necessary to enlarge as much as possible the
ERM framework in terms of its contents.
Anyway, the application of each managerial approach or model needs a given level
of standardization degree.
The best hypothesis arises when a set of ERM standards may be used with a
flexibility margin in order to adapt the ERM actions to new events, emerging
knowledge, new technologies, etc.
The enterprise risk management (ERM) framework
388
Reducing the ERM complexity
In the last years public and private institutions tried to reduce the ERM complexity
through easy to understand models (but not always easy to apply), based first on a
“visual” representation of what ERM is about, second by framing in a sequential
way the crucial steps of an ERM process.
The most popular ERM models come from the following organizations :
-ISO: International Organization for Standardization;
- CoSO: Committee of Sponsoring Organizations of the Treadway Commission,
private organization.
The enterprise risk management (ERM) framework
389
ISO 31000
ISO 31000 provides general principles and guidelines about risk management. It
can be used by any kind of organizations (firms, public institutions, associations etc)
belonging in any sectors.
The enterprise risk management (ERM) framework
390
ISO 31000
General principles of ISO 31000:
- The risk management must aim not only to avoid (or mitigate) risks but also to
create value;
-The analysis and treatment of risk must be integrated in the all organization;
- The risk management acts as a support and constrain than firm’s decisions;
- The risk management process must be adapted to characteristics of each
organization, even taking into account human and culture factors;
- The risk management actions must be transparent;
- The risk management must be faced according to the logic of continuous
improvement (similarity with Total Quality Management logic).
The enterprise risk management framework
391
Committee of Sponsoring Organizations of the Treadway Commission
(CoSO) report
"A process, activated by the Board, management and the entire corporate
structure, oriented to the application of the strategy defined by the company,
aimed at identifying potential events that could compromise
company performance and risk management within the defined
risk appetite, and who provides reasonable insurance of
achievement of business objectives "
The enterprise risk management framework
392
Committee of Sponsoring Organizations of the Treadway Commission
(CoSO) report
The CoSO ERM framework implies a multi-discipline logic. According to CoSO
the ERM considers the firm as whole:
The enterprise risk management framework
393
Internal environment
The internal environment depends on the tone of an organization
which determines: how risk is viewed by managers and workers;
the risk appetite and risk management philosophy; ethical values.
The organizational tone may be defined as the atmosphere that is
created in the workplace by the organization's leadership.
The enterprise risk management framework
394
Internal environment
Internal
environment
↓
Organizational
tone
Risk appetite
Propensity
towards risk
management
Ethical values
The enterprise risk management framework
395
Objective strategy-setting according to CoSO ERM
The ERM helps in alignment risks linked to potential alternative strategies as well as
already adopted strategy with decisions taken at higher level coming from the board of
directors.
Risks
alignment
ERM Principles and rules
Ex a
nte
support
Ex post control
Select one or more strategies
among several alternatives
The enterprise risk management framework
396
Objective strategy-setting according to CoSO ERM
Risk misalignment and strategy rejecting
According to CoSO ERM a risk misalignment must lead the management to
reject a strategy, even when it achieves its goals.
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397
Identification of risk events
-Identification of events capable of influencing company performance positively
or negatively.
-Analysis of interdependencies between events.
Typical techniques for identifying:
-Brainstorming;
- Event inventories and loss event data;
- Interviews and self-assessment;
- SWOT analysis;
- Scenario analysis
The enterprise risk management framework
398
Identification of risk events – Brainstorming
The brainstorming allows to combine different a knowledge flows among teams with
specific skills about organization’s areas and related risks.
Facilitating a brainstorming session takes special leadership skills, and, in some
organizations, members of the internal audit and ERM
In general, a brainstorming is not simple meeting to achieve opinions and idea.
Therefore, participants have been trained and certified to conduct risk brainstorming
sessions.
The enterprise risk management framework
399
Identification of risk events – Event inventories and loss event data
This techniques is often used into risk brainstorming. It improves the brainstorming
quality.
For instance event inventories and loss event data may regard the industry where
the firm works.
The enterprise risk management framework
400
Identification of risk events – Event inventories and loss event data
The enterprise risk management framework
401
Identification of risk events – Interviews and self-assessment
“This technique combines two different processes. Each individual of the
organizational or operating units is given a template with instructions to list the key
strategies and/or objectives within his or her area of responsibility and the risks that
could impede the achievement of the objectives. … Each unit is also asked to
assess its risk management capability using practical framework categories such as
those contained in the CoSo ERM framework” (Institute of Managment Account).
The enterprise risk management framework
402
Identification of risk events – SWOT analysis
SWOT analysis is a traditional tool used in strategic planning to identify the
strengths, weaknesses, opportunities and threats associated with a business or a
specific strategy.
The enterprise risk management framework
403
Identification of risk events – Scenario analysis
Four types of scenario
• Exploration scenarios
• Forecast scenarios
• Descriptive scenarios
• Normative scenarios
The enterprise risk management framework
404
Identification of risk events – Scenario analysis
Exploration scenarios vs. forecast scenarios
•Exploration scenarios are based on past and current phenomena.
They assume, on the one hand, the recurrence of phenomena, on the
other, stable relationships between the independent variables and
dependent variables. It’s possible to associate to each cause one or
more effects: causes effects.
• Forecast scenarios are based on the hypothesis of strong spread
between past phenomena and future phenomena. This spread could
be depend on new phenomena and/or new relationships between the
independent variables and dependent variables: effects causes
The enterprise risk management framework
405
Identification of risk events – Scenario analysis
Exploration scenarios vs. forecast scenarios
CAUSE EFFECT
For instance, the analysis of past
has demonstrated that the primary
demand of a certain product
changes of - 20% than oil price
changes
EFFECT CAUSE
For instance, each target about
expected market share requires
a specific change in price
The enterprise risk management framework
406
Identification of risk events – Scenario analysis
Descriptive scenarios vs. normative scenarios
Descriptive scenarios have no contsrains: there are not limits in relation to positive
or negative correlations. The analyst simply describes causal relationships.
In the case of normative scenarios the causal relationships are limited within
constraints system: For instance, a change in demand can be assumed as scenario
taking into account constraints that come from internal resources.
The enterprise risk management framework
407
Identification of risk events – Scenario analysis
Descriptive
Normative
Given the causes,
what will be the
effects?
Exploration Forecast
Given the effect,
what will be the
causes?
Given the resources,
which target can be
reached ?
Given the targets ,
what resources target
can be mobilised?
Source: Martelli A. (2014), Model of scenario, Palgrave
The enterprise risk management framework
408
Risk assessment: Qualitative and quantitative assessment
Normally the risk assessment is based on two stages:
1) Qualitative risk assessment;
2) Quantitative risk assessment.
Qualitative risk assessment focuses on each risk and opportunity according
to descriptive scales.
The output of qualitative risk assessment is often used as the input of
quantitative risk assessment aimed to achieve impact and likelihood of potential
events. Moreover, quantitative risk assessment regards both the risks
correlation analysis and, especially in the case of financial risks, the VaR (value
at risk) measurement.
In many cases, non-financial firms can’t make a quantitative risk assessment. It
depends on a lack about data.
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409
Strengths Weaknesses
- Enlarge the analysis field beyond measurable
risks.
- Are easy to learn from a conceptual viewpoint.
- Facilitate collaboration between different
business areas.
- Allow to pay more attention on strategic risks.
- Allow to exploit better experiences gained
working (learning by doing).
- Allow a bigger flexibility to face new risk issues.
-Make shadow the relationship between risk and
economic value.
- Provide limited differentiation between levels of
risk.
- Make difficult to measure the correlations
between different types of risk
- Are influenced by a high subjectivity.
- Are not fit with the financial culture and mindset
of financial backers . Qualit
ative a
naly
sis
te
chniq
ues
Quantita
tive a
naly
sis
te
chniq
ues
- Numerically explain the relationship between
risk-opportunity and value
- Fit the financial culture and mindset of financial
backers.
- Their results are less subjective.
- Summarize a direct way the results of the
assessment process.
- Are fit with the goal to analyze correlations
between risks.
-They are not easily understood by most
members of an organization.
- Reduce collaboration between different
business areas.
- Don’t take into account experiences of
managers and workers.
- Often are based on rigid assumptions.
- Only in part can be used to assess strategic
risks
The enterprise risk management framework
410
Risk assessment: : Impact/probability matrix
The probability and impact matrix helps define priorities in terms of treatment
and risk response
The enterprise risk management framework
411
Risk assessment: risks correlation matrix
Source: Makky, 2013
Dynamic risk/value analysis of new projects: real
option approach
Performance Measurement and Enterprise Risk Management
Prof. Antonio Renzi
Agenda
413
The Real Option Approach: general logic
The real options classification
The extended NPV
The real options and ERM
Binomial model assessing strategic investments
The certainty equivalent method
Differences between financial options and real options
Contextualize the evaluation of real options than the firm's
structural characteristics
During the 70s, several studies highlighted the inadequacy of the
DCF logic.
These studies have shown that the traditional approach based on a
linear actualization implies an underestimation of investment
decisions. This phenomenon is due to several factors.
An important factor about the underestimation phenomenon is that
the DCF result doesn’t include the component of managerial flexibility
value.
The Real Options Approach (ROA): general logic
The role of managerial flexibility is double:
• It is a "cushion" on the negative side of the uncertainty;
• It is a leverage to exploit the positive side of the uncertainty.
This implies asymmetric risk conditions, in the sense that the investor
has the faculty to give up on a given investment when its real
performance is lower than the initial expectations. At the same time,
the investor has the possibility to exploit as much as possible the
benefits linked to a positive volatility, when the real performance is
higher than the average expected return.
The Real Options Approach (ROA): general logic
The idea that the decision maker has the faculty to change strategies
in place, after the observation of one or more phenomena, has led to
the development of non linear models.
This has entailed new ways to capture the value
The Real Options Approach (ROA): general logic
Risk and value of flexibility
The value of managerial flexibility is positively correlated with the risk:
The increase in the risk of investment increases the utility
function of the managerial flexibility.
This positive correlation is similar to that between risky securities and
the value of financial options.
The Real Options Approach (ROA): general logic
Risk and value of flexibility
This similarity (between the managerial flexibility related to
investments in real assets and flexibility produced by financial
options) has resulted in the ROA.
The main goal of the ROA is to enlarge the logic of DCF, thanks
to a dynamic risk valuation linked to the possibility to defer
decisions to the future or modify those already approved.
The Real Options Approach (ROA): general logic
General definition
Real options represent elements of managerial flexibility that allow the
correction, the postponement or abandonment of investment, after the
observation of one or more events.
The Real Options Approach (ROA): general logic
Real option and market discipline
In the traditional financial perspective of the allocative efficiency of
resources is seen as necessary to create value.
Instead, according to a strategic perspective the strategic resources
potentially exploitable in future assume the role of positive drivers of
value.
The ROA can be an important tool, to bring out, even in the eyes
of financial investors, the shadow value related to a portfolio of
strategic resources.
The Real Options Approach (ROA): general logic
The real options classifications
Options tied to the time factor:
• Options to defer
• Options to temporarily suspend
Options tied to the investment size:
• Expansion Options
• Reduction Options
• Growth Options
Options tied to opportunities to change:
• Switching Options;
• Options to abandon
First Classification:
Real options and flexibilities
Second Classification:
Real options assimilated to financial options
European Real Options:
• European call options;
• European put options
American Real Options:
• American call options;
• American put options
• The option to defer the start of a project reduces the sunk cost
problems
• The option to delay the investment decision is a real call option.
• The strike price is equal to the initial investment
• This real option implies an opportunity cost equal to the profits lost in
the waiting period. So that if the entrepreneur (or the investor) is
certain to realize the new business, the late entry only produces
economic damage.
The real options classifications
Options to defer and new business
The decision to realize the business under any circumstance
could depend on:
• Non rationality of the entrepreneur;
• Negative observations (down side market) , in a limited period, could
be insufficient to tell if the business will fail.
The real options classifications
Why do some new entrepreneurs reject options
to defer?
“By formulating an integrated strategy that combines the creation and exercise of real options
together with other risk management techniques, management can reduce risk and thereby
increase firm value.
For example, a company that is in a position to delay investing without losing its competitive
edge, to abandon a project that becomes unprofitable, or to adjust its operating strategy at
low cost can avoid risks and exploit profitable opportunities. …. An integrated risk
management approach requires a careful process of diagnosing a company's risk exposure.”
(Triantis, 2000)
The Real Options and ERM
A real option (or a portfolio of real options) can:
- change the risk appetite;
- change the risks identification;
- enlarge strategies that are compliant with the ERM framework
- improve the flexibility in the risk assessment;
- show the relationship between internal resources, value and risk;
- improve the sustainability of the risk.
The Real Options and ERM
The extended NPV (NPVE)
ueOption val
NPV
10E OPWacc1FCFFINPV
N
t
n
t
Symmetrical distribution of NPV and asymmetrical distribution of
NPVE
Expected
Average
NPV
Option value
OPVANVAN0E
The possibility of exploiting risk asymmetric conditions allows
a risk immunization process
Expected
Average
NPVE
The extended NPV (NPVE)
The double effect of the risk on NPVE
The volatility of the expected cash flows increases both the
cost of capital and the value of real options.
The extended NPV (NPVE)
Present value as
discounted cash
flows
Real
option
value Risk
(+) (-)
(+)
Cost of capital
(+)
Utility of flexibility
s
The double effect of the risk on NPVE
The extended NPV (NPVE)
Value
NPV
NPVE
Manag
erial
fle
xib
ility
= Value of real option j
The certainty equivalent method
Both in the case of forward contracts and in the financial options for
each expected value in uncertainty conditions there is a certainty
equivalent:
Present value of j in uncertainty conditions
=
Present value of j in certainty conditions .
This logic is the base to estimate both financial and real options
One period analysis
(QJ1)(1+ RJ)-1 = QJ0 = (S1)(1+ Rf)-1 = S0
QJ1 - S1 = (QJ0)(1+ RJ) - (S0)(1+ Rf)
(QJ1) = Expected value in uncertainty conditions
QJ0 = Present value of QJ1
RJ = Risk free rate + risk premiun
S1 = Forward price
S0 = Present value of forward price
Rf = Risk free rate
The certainty equivalent method
One period analysis
The certainty equivalent method
p = objective probability in the up state
1- p = objective probability in the down state
q = intrinsic probability in the up state
1- q = intrinsic probability in the down state
Tempo 0 1 Probabilità oggettive Probabilità soggettive
QJ1u 100 0,5 0,409
QJ1d 60 0,5 0,591
RJ = 0,1
QJ0 = 0,5(100 + 60)(1,1)-1
72,727
Rf = 0,05
QJ0 = (0,409(100) + 0,591(60))(1,05)-1
72,727
Objective
probabilities
Intrinsic
probabilities
One period analysis
The certainty equivalent method
Binomial Model for assessing strategic investments
The binomial model is based on discrete process, where the price of
underlying asset could become period by period one of two values:
• Up state value;
• Down state value.
The up state value depends on a multiplying factor (u)
The down state value depends on a reductive factor (d)
Factors “u” and “d”
u = multiplying factor> 1
d = reductive factor = 1/u
u = es
d = e -s
s = ln(u)
ln = Natural logarithm
e = Base of natural logarithm
s = standard deviation of underlying asset
Binomial Model
One period analysis - Discrete discounting
Binomial Model for assessing strategic investments
Continuous discounting
Binomial Model
Base of natural logarithms
Discounting factor
Binomial Model
Multiple period analysis – “Tree" dynamics of the underlying asset
Multiple period analysis and reverse analysis
Binomial Model for assessing strategic investments
Multiple period analysis and reverse process (three stages)
Stage
3
Binomial Model for assessing strategic investments
Stage
3
Stage
2
Stage
1
Multiple period analysis
Binomial Model for assessing strategic investments
Q0 = Present value 1000
u 1,0617966
d 0,9418
q 0,5198
1 – q 0,4802
E = Initilal investment 900
Rf (per year) 0,05
Rf (per month) 0,0042
Months
Reverse process
Binomial Model for assessing strategic investments
The binomial tree as a decisional tool
Decision during
the option life (T > 0)
Decision at the end of
the option life (T= 0)
Waiting
Waiting Waiting
Waiting
Yes
Yes
Yes Yes
Yes
Yes
Exploitation
Abandon
Waiting
Waiting
Binomial Model for assessing strategic investments
Equivalent Portfolio
The equivalent portfolio model allows to identify equivalences
between the option payoff and a virtual financial portfolio of the
underlying asset, partially financed with a riskless debt.
For each future scenario the option value is given by:
Option Value
=
Amount invested in the underlying asset x
Price of the underlying asset
–
Riskless debt
Equivalent Portfolio
Amount invested in the underlying asset
Amount of riskless debt
Dis
cre
te d
isco
un
ting
Co
ntin
uo
us d
isco
un
ting
Differences between real options and financial options
Time to maturity
Volatility
Price of und.
asset
Interest rate
Strike price
Dividends
It is contractually
defined
Volatility about the
underlying financial
asset
Price of the
underlying financial
asset
Risk free
rate
Value of the
underlying financial
asset
Dividends lost during the
waiting period
Time required for the
knowledge formation
Volatility about the
underlying real
asset
Present value
as summation of
discounted cash flows
Risk free
rate
Initial
investment
Cash flows lost during
the waiting period
Financial options (Call) Real options (Call) The 6 variables of
the call option value
Differences between real options and financial options
Financial options Real options
They are contractually
defined
They are traded on regulated
markets
They are easy to
classify
Their margin of exploitation does not
depend on the quality of individual
operators
Their value tends to change
in a continuous way
Normally they are not contractually
defined
They can’t traded on regulated
markets
They are not easy to
classify
Their margin of exploitation could
depend on firm
characteristics
Their value tends to change
in a discrete way
Real options value, direct and indirect costs
The value of real options come from observing what happens in the real world
and adapting the firm’s behavior to increase its potential upside from the
investment and to decrease the possible downside.
Normally, flexible investments involve a higher initial cost compared to rigid
investments (option premium).
Exploiting the flexibility of one or more investment projects requires adequate
strategic resources. This explains why the strategic flexibility of investments
made by small businesses is often exploited by other companies especially
through M&A operations.
Contextualize the evaluation of real options and the firm's
structural characteristics
Real options according to a path dependence logic
Contextualize the evaluation of real options and the firm's
structural characteristics
New flexible
investments
Exiting strategic
resources
Real
options
Potential managerial
flexibility
Exploitation degree
of flexibility
New strategic
resources
Slack and options according to a path dependence logic
Three slack’s definitions
Contextualize the evaluation of real options and the firm's
structural characteristics
Slack “A cushion of actual or potential resources which allows an organization to
adapt to internal pressures for change in policy, as well as
to initiate changes in strategy with respect to external environment” (Bourgeois,
1981)
Slack “As resource intentionally kept by a firm beyond those needed by an organization to meet its known commitments” (Sharfman et al., 1998, Sharfman
and Dean, 1997)
Slack “as pool of resorces in an organization that is in excess of the minimum necessary to produce a given level of organizational output” (Nohria,
Gulati, 1997).
Slack and options according to a path dependence logic
Kinds of slack
Contextualize the evaluation of real options and the firm's
structural characteristics
-Financial slack;
-Relational slack;
-Human resource slack;
-Knowledge slack;
-Operative slack;
-…
Inefficiency in
short run
Agency costs
Potential strategic
reserve in long run
Potential
innovation
driver
Slack and options according to a path dependence logic
Financial and knowledge surplus as unabsorbed slack and multi-source of real options
Contextualize the evaluation of real options and the firm's
structural characteristics
Op(n)
Financial slack
Knowledge slack
Op(1)
Op(2)
Op(3)
Op(4)
…
Slack and options according to a path dependence logic
Absorbed/unabsorbed slack
Contextualize the evaluation of real options and the firm's
structural characteristics
Absorbed slack Flexible conservative
investments
Operating
real
options Exploitation of managerial flexibility
through a reduction of absorbed slack
Potential managerial flexibility
Unabsorbed slack Flexible strategic
investments
Strategic
real
options Exploitation of managerial flexibility
through a reduction of unabsorbed slack
Potential managerial flexibility
Consistency
Consistency
Potential NPVE and actual NPVE: A path dependence
logic
Potential NPVE
Actual NPVE
Potential real
option value
Actual real
option value
NPV
Inconsistency of internal resources
s
Value
Contextualize the evaluation of real options than the firm's
structural characteristics
In
trin
sic
fle
xib
ility
of a
New
str
ate
gic
investm
ent
Availability
of strategic resources
H L
L
H
A
Low NPVE
High efficiency before
the new investment
B
High NPVE
Low efficiency before
the new investment
C
NPVE NPV
High efficiency before
the new investment
NPVE NPV
Low efficiency before
and after
the new investment
D
The maximization of the NPVE causes a risk of inefficiency
Contextualize the evaluation of real options than the firm's
structural characteristics
Real options and internal risk drivers
Analysis of real options
Shadow options mapping
Analysis of managerial flexibility Internal Risk drivers
Intrinsic business risk
Degree of operating leverage
Degree of financial leverage
Contextualize the evaluation of real options and the firm's
structural characteristics
Real options and internal risk drivers
Contextualize the evaluation of real options than the firm's
structural characteristics
For example: measuring the multiplying factor and reductive
as functions of intrinsic risk and DOL
d
u
t0t0
t0t0
ROIDOLV
IBR
ROIDOLV
IBR
e
eMultiplying factor
Reductive factor
Normally the DOL size in positively correlated with both absorbed and
unabsorbed slack
Shadow options
Contextualize the evaluation of real options than the firm's
structural characteristics
A shadow option is an option that a firm already holds, but it is not aware of
it.
In other terms, it hasn’t discovered the option, yet.
To discover the already existent option, a firm need to focus or re-focus its
attention.
A shadow option is a real option which is not in being. Hence, it is its
antecedent.
Beside attention (for the opportunities to be discovered), an option
requires resources for its execution.
Those resources are slack resources, that act as knowledge
inventories: "to create inventories of competencies that might be used
later without knowing precisely what future demands will be"
(Levinthal, March, 1993).
Shadow options
Contextualize the evaluation of real options than the firm's
structural characteristics
A shadow option is latent because of:
•Lack of additional resources required for option execution;
•Lack of market opportunity;
•Lack of awareness;
The process for what an option passes from shadow to real follows some
steps, that are:
• noticing, thanks to focusing attention;
•matching with relevant strategies;
• commitment through Investments.
At this point, the options becomes real.