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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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THE VALUE OF RISK MANAGEMENT

Enterprise risk management can enhance firm value in many ways. ERM can reduce the volatility of assets and cash flows, leading to enhanced strategic liquidity, a lower cost of debt, increased debt capacity, and improved transparency.2

Strategic Liquidity

Cash flow volatility can lead to delays or even cancellation of strategic investments to help bridge cash shortfalls. This will impair growth prospects and future cash flows, reducing intrinsic value. Through risk management, a firm can reduce, or even eliminate, the probability of a cash shortfall that defers or reduces strategic investment. This enhances forward visibility and liquidity, improving managers’ ability to plan for the level of investment required (through a business cycle) to execute their strategy and build shareholder value.

For example, Merck has been a popular risk management case study where successful management of FX and interest rate risk helps to ensure strategic liquidity for the continuation of their multibillion dollar R&D investment program. The net economic exposure that gets hedged is based on an evaluation of natural offsetting exposures, volatilities and correlations, and the cost of hedging.

The Cost of Debt

Risk management can reduce cash flow volatility and the unsystematic portion of total risk, enhancing credit profile, debt capacity, and cost of debt. Unlike beta and the cost of equity, these elements of weighted average cost of capital (WACC) are influenced by ...

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