CF chapter 30 Flashcards
Uncontrollable risks should
be managed, in the interests of shareholders, by
reducing the firm’sexposure, using
Insurance
covers the costs/losses due to specific events, e.g.
◦ Property insurance: fire, storm, earthquakes, etc.
◦ Business liability insurance: the company is liable for a third party claim
◦ Business interruption insurance: loss of earnings due to fire, accident, product recall, etc.
◦ Key personnel insurance: compensates the firm for the loss or unavoidable absence of crucial
employees in the firm
Insurance premium
The fee a firm pays to an insurance company for the purchase of an insurance policy
Actuarially fair insurance premium
When the NPV from selling insurance is zero, i.e. when
Insurance premium = present value of the expected payment
What is the value of insurance in perfect capital markets
Insurance is a zero-NPV transaction that has no added value
◦ As always, the value of insurance comes from reducing the cost of market imperfections
tax rate fluctuations (value of insurance)
If the corporate tax code has different brackets (such as in NL), insurance can provide a tax saving if the firm is in a higher tax bracket when it pays the premium compared to the tax bracket it is in when it receives the insurance payment in the event of
a loss
Debt capacity (value of insurance)
Insurance reduces the risk of financial distress, so the tradeoff between leverage and financial distress costs is relaxed,
allowing the firm to increase its use of debt financing
Managerial incentives (Value of insurance)
Insurance reduces the volatility of earnings due to perils outside management control
The choice to insure such perils turns the firm’searnings and share price into much more informative indicators of
management’sperformance
Risk assessment (value of insurance)
Insurance companies specialize in assessing risk and will often be better informed about the extent of certain risks faced by
the firm than the firm’sown managers
Cost of insurance
Administrative and overhead costs of transferring the risk to an insurance company
Adverse selection: firms desiring insurance may signal having above-average risks
Moral hazard, agency costs: purchasing insurance may reduce a firm’sincentive to avoid risk
◦ E.g. cut fire prevention costs
Vertical integration
Refers to a merger of a firm with its supplier (or a firm with its customer)
◦ Commodity price increase raises the firm’scosts and the supplier’srevenues, so that they may offset
each other
◦ May add value if combining the firms results in important synergies
◦ Vertical integration is not a perfect hedge
Long term storage
E.g. airliner could purchase a large quantity of fuel today and store it until it is needed, so that the
cost of fuel is locked in
◦ Storage costs may be too high for this strategy to be attractive
◦ Inventory storage requires a substantial cash outlay upfront
Hedging with long-term contracts
Current fuel prices are low, because the oil price is
currently low (say, $23 per barrel)
◦ It fears that oil and fuel prices may be substantially higher
in the future
◦ The airliner may enter into a fuel supply contract,
guaranteeing a price for its fuel equivalent to an oil price
of 23 per barrel
◦ Fuel/oil prices may indeed go up, but may also go down
◦ This type of commodity hedging smoothes earnings
Disadvantages of supply contracts
They expose each party to the risk that the other party may default and/or fail to live up to the terms
of the contract
◦ Although supply contracts insulate the firms from commodity price risk, they expose them to credit risk
◦ They cannot be entered into anonymously: the buyer and seller know each other’sidentity
◦ This may have strategic disadvantages
◦ The market value of the contract at any future time may be difficult to determine
◦ It is therefore difficult to track gains and losses
◦ It may be difficult or even impossible to cancel the contract if necessary
◦ A lot of investors are only interested in the commodity price movement, and do NOT want any actual
delivery of commodities
Futures contract
agreement to trade an asset on some future date at a price
that is locked in today
