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Principles of Finance

20.1 The Importance of Risk Management

Principles of Finance20.1 The Importance of Risk Management

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Describe risk in the context of financial management.
  • Explain how risk can impact firm value.
  • Distinguish between hedging and speculating.

What Is Risk?

The job of the financial manager is to maximize the value of the firm for the owners, or shareholders, of the company. The three major areas of focus for the financial manager are the size, the timing, and the riskiness of the cash flows of the company. Broadly, the financial manager should work to

  • increase cash coming into the company and decrease cash going out of the company;
  • speed up cash coming into the company and slow down cash going out of the company; and
  • decrease the riskiness of both money coming in and money going out of the company.

The first item in this list is obvious. The more revenue a company has, the more profitable it will be. Businesspeople talk about “top line” growth when discussing this objective because revenue appears at the top of the company’s income statement. Also, the lower the company’s expenses, the more profitable the company will be. When businesspeople talk about the “bottom line,” they are focused on what will happen to a company’s net income. The net income appears at the bottom of the income statement and reflects the amount of revenue left over after all of the company’s expenses have been paid.

The second item in the list—the speed at which money enters and exits the company—has been addressed throughout this book. One of the basic principles of finance is the time value of money—the idea that a dollar received today is more valuable than a dollar received tomorrow. Many of the topics explored in this book revolve around the issue of the time value of money.

The focus of this chapter is on the third item in the list: risk. In finance, risk is defined as uncertainty. Risk occurs because you cannot predict the future. Compared to other business decisions, financial decisions are generally associated with contracts in which the parties of the contract fulfill their obligations at different points in time. If you choose to purchase a loaf of bread, you pay the baker for the bread as you receive the bread; no future obligation arises for either you or the baker because of this purchase. If you choose to buy a bond, you pay the issuer of the bond money today, and in return, the issuer promises to pay you money in the future. The value of this bond depends on the likelihood that the promise will be fulfilled.

Because financial agreements often represent promises of future payment, they entail risk. Even if the party that is promising to make a payment in the future is ethical and has every intention of honoring the promise, things can happen that can make it impossible for them to do so. Thus, much of financial management hinges on managing this risk.

Risk and Firm Value

You would expect the managers of Starbucks Corporation to know a lot about coffee. They must also know a lot about risk. It is not surprising that the term coffee appears in the text of the company’s 2020 annual report 179 times, given that the company’s core business is coffee. It might be surprising, however, that the term risk appears in the report 99 times.3 Given that the text of the annual report is less than 100 pages long, the word risk appears, on average, more than once per page.

Starbucks faces a number of different types of risk. In 2020, corporations experienced an unprecedented risk because of COVID-19. Coffee shops were forced to remain closed as communities experienced government-mandated lockdowns. Locations that were able to service customers through drive-up windows were not immune to declining revenue due to the pandemic. As fewer people gathered in the workplace, Starbucks experienced a declining number of to-go orders from meeting attendees. In addition, Starbucks locations faced the risk of illness spreading as baristas gathered in their buildings to fill to-go orders.

While COVID-19 brought discussions of risk to the forefront of everyday conversations, risk was an important focus of companies such as Starbucks before the pandemic began. (The term risk appeared in the company’s 2019 annual report 82 times.4) Starbucks’s business model revolves around turning coffee beans into a pleasurable drink. Anything that impacts the company’s ability to procure coffee beans, produce a drink, and sell that drink to the customer will impact the company’s profitability.

The investors in the company have allowed Starbucks to use its capital to lease storefronts, purchase espresso machines, and obtain all of the assets necessary for the company to operate. Debt holders expect interest to be paid and their principal to be returned. Stockholders expect a return on their investment. Because investors are risk averse, the riskier they perceive the cash flows they will receive from the business to be, the higher the expected return they will require to let the company use their money. This required return is a cost of doing business. Thus, the riskier the cash flows of a company, the higher the cost of obtaining capital. As any cost of operating a business increases, the value of the firm declines.

In the following sections, you will learn about some of the types of risk that firms commonly face. You will also learn about ways in which firms can reduce their exposure to these risks. When firms take actions to reduce their exposures to risk, they are said to be hedging. Firms hedge to try to protect themselves from losses. Thus, in finance, hedging is a risk management tool.

Certain strategies are commonly used by firms to hedge risk, which is part of corporate financial management. Many of these same strategies can be used by economic players who wish to speculate. Speculating occurs when someone bets on a future outcome. It involves trying to predict the future and profit off of that prediction, knowing that there is some risk that an incorrect prediction will lead to a loss. Speculators bet on the future direction of an asset price. Thus, speculation involves directional bets.

If you are concerned that the price of hand sanitizer is going to rise because people are concerned about a new virus and you purchase a few extra bottles to keep on your shelf “just in case,” you are hedging. If you see this situation as a business opportunity and purchase bottles of hand sanitizer, hoping that you can sell them on eBay in a few weeks at twice what you paid for them, you are speculating.

In the popular press, you will often hear of some of the strategies in this chapter discussed in terms of people using them to speculate. In upper-level finance courses, these strategies are discussed in more depth, including how they might be used to speculate. In this chapter, however, the focus is on the perspective of a financial manager using these strategies to manage risk.

Footnotes

  • 3Starbucks. Starbucks Fiscal 2020 Annual Report. Seattle: Starbucks Corporation, 2020. https://s22.q4cdn.com/869488222/files/doc_financials/2020/ar/2020-Starbucks-Annual-Report.pdf
  • 4Starbucks. Starbucks Fiscal 2019 Annual Report. Seattle: Starbucks Corporation, 2019. https://s22.q4cdn.com/869488222/files/doc_financials/2019/2019-Annual-Report.pdf
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