As noted at the beginning of this chapter, each company has a WACC, which is a measure of the cost of its funding and is, therefore, directly related to the risks it assumes. On the other hand, when a company is evaluating the possibility of developing a new investment project, it must estimate its expected return, discounting the expected cashflows of the project through the WACC of that project, which need not coincide with that of the company.
The WACC of the project must be calculated based on how much the company has to pay to finance this project with the capital structure (debt–equity ratio) necessary to carry it out. That is, the method used to calculate the WACC for a specific project is the same as the one used for the company in general, the only difference being that theKe, Kd, CAA, DandTparameters are linked not only to the company in question but also to the specific project. Thus, this WACC will depend not only on the
company developing it, but also on the type of investment project being developed and on the country where it is being developed.
Following the same line as the previous section, the risk premium of an investment project can be defined as the difference between the WACC of this project and the risk-free interest rate, a premium which, logically, includes all systematic risks associated with the project.
17.3.1 Risk-Adjusted Cash Flows
When evaluating an investment project according to the criteria of the NPV, what matters is not the cashflows themselves but the risk-adjusted cashflows, that is, the cashflows updated at the WACC rate. Thus, if an investment project provides estimated cash flows of deC0, C1, . . .Cn
over the next n years, then its NPV will be:
NPVẳ C0ỵ C1
1þWACCþ:::þ Cn 1þWACC
ð ịn
Logically, the higher the risk of the project is, the greater the WACC will be and the lower the risk-adjusted cashflows will be, and it is for this reason that the riskiest investment projects are required to provide signif- icantly higher returns, WACC and cashflows than less risky projects. In particular, as discussed in Chapter 15, projects developed in countries outside the Organisation for Economic Co-operation and Development (OECD) are required to provide significantly higher returns, WACC and cashflows due to country risk than similar projects developed in OECD countries (not only because of this risk, but also due to others such as equity, commodity, credit, counterparty, operational, etc.).
In this sense, if the cash flows are compared without adjusting to account for risk, it can be concluded that riskier investment projects are required to provide much higher cashflows than less risky ones; however, if the risk-adjusted cash flows are compared, the differences are not so great.
18
Conclusions
As stated in the Introduction, in recent times risk analysis and manage- ment has gained great importance in the world of business due to a sharp increase in the size and complexity of business models. Compared to only a few years ago, there are many large multinational companies with very complex business models operating in many (and very diverse) sectors and countries.
Unfortunately, as highlighted by the recent deep economic crisis, their management has not been sufficient. From my point of view, this has been the result of several factors. One reason, as discussed in the Intro- duction, is that risk assessment is not always carried out using purely financial criteria, mainly due to the ignorance of it in certain areas. I hope this book has clarified the subject.
As stated above, the concept of risk refers to the degree of uncertainty regarding future net returns which are obtained by making an investment.
This book started with a discussion of the most important risk for many companies, which is market risk. It is easy to understand why market risk is so important for many companies, since it is the uncertainty that exists about future earnings arising from changes in market conditions (share prices, interest rates, exchange rates, commodity prices, etc.). In other
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F.J. Población García,Financial Risk Management, DOI 10.1007/978-3-319-41366-2_18
words, market risk is the uncertainty that exists regarding all economic andfinancial variables which affect the result of a company.
Consequently, this market risk is the most“natural”risk in an indus- trial company because it affects production input prices andfinal product prices, which determine the company profit margin. Moreover, it also affects all kinds of companies, since exchange rate risk and interest rate risk are part of market risk.
After market risk, the other big risk is credit risk; however, credit risk is limited to companies which lend money in one way or another. As stated above, credit risk arises from the possibility of borrowers, bond issuers or counterparties in derivative transactions not meeting their obligations, which includes counterparty risk. Since credit risk is a dichotomous phenomenon, the study of credit risk is more complex than, and very different to, that of market risk, where risk originates from market vari- ables, generally prices, which can take a continuum of values, usually between zero and infinity.
After these two big risks there are many others, the most important among them being operational, liquidity and country risks. The improve- ments made in new technology and the increasing complexity and glob- alisation of companies has led to increased concern about operational risk.
Many recent examples of operational risk events have been presented. On the other hand, the liquidity risk of a company can be defined as the loss that may occur due to events that affect the availability of resources needed to meet their liability obligations. In other words, liquidity risk is caused by the fact that the company has to make recurring payments, but the timing of these payments does not usually coincide with receiving income and their wealth is not stored as money but, conversely, part of it is kept in assets.
Country risk refers to the probability of afinancial loss occurring due to macroeconomic, political or social circumstances or due to natural disas- ters in a certain country. Country risk has become an important subject of study in the research and risk management departments of banks, rating agencies, insurance companies andfinancial system regulators, especially since Organisation for Economic Co-operation and Development (OECD) countries in the eurozone have also presented country risk.
Although other kinds of risk exist, for the sake of brevity they have not been presented in this book.
To conclude this summary, the last two chapters can be said to examine how these risks affect the value of a company’s shares and how they affect the value of the company as a whole, including both shares and debts.
One interesting issue that is outside the scope of this book is the correlation among risks. In this book each risk has been studied in isolation, but all of them are related, especially during times of crisis. At such times, regardless of the risk that triggered the crisis, all risks come into play. For example, if the crisis has been triggered by a credit risk event like the 2008financial crisis, there are not only credit risk issues, but also other risk issues. In other words, since borrowers stop paying, it is logical that banks suffer credit risk events; however, the consequences do not stop there. Since banks are in trouble, there are credit constraints which affect the rest of the economy and commodities and companies’ stock exchange quotations go down, which is a market risk event. Moreover, since uncertainties arise in markets, economies and countries, liquidity evapo- rates and country risk increases.
In other words, once a risk event triggers a crisis, all risks are affected and the snowball effect doesn’t stop until suitable measures are taken and confidence is restored.
What can be concluded from this book? As stated in the Introduction, I have attempted to show that risk is not something negative but quite the opposite, something very positive, as it is the inevitable consequence of freedom. Since this is a technical book in the risk management/finance field I haven’t explained in depth why I think this. However, this final chapter is a good opportunity to expand on the idea.