Financial Risk Management

Chris DroussiotisOctober 2011

Lecture Series #3

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Table of Contents

Managerial Strategies Return, Risk, Asset Allocation and Time Fundamental Analysis Technical Analysis Behavioral Analysis

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Managerial Strategies – Value Creation

ENTRYPOINT

EXIT POINTEconomic Environment

Determinants of Value Cash Flow Timing of Cash Flow Risk

VALUE CREATION – MANAGERIAL / INVESTMENT STRATEGIES

Entry Point•Startup – Build

•Economic Studies•Acquiring Initial Funds (Equity/Debt)•The Right Price / Cost as compared to Future Cash Flows•Going Private/Public

Exit Point•Terminal Value

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Managerial Strategies – Value Creation

ENTRYPOINT

EXIT POINT

Risk #1: VolatilityStandard Deviation (σ)

Standard Deviation (σ)

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Value Creation - Managerial Strategies

Operating Strategies – Grow internally – manage Revenue, Expenses & Cash Flow –– Manage Systematic Risk / Credit Risk / Market Risk / Operational Risk

Transactional Strategies – Grow through acquisitions– Joint Ventures

Financial Strategies – Refinancing / Optimum Structure– Foreign Exchange Strategies – Hedge against FX moves – International– Lease or Buy (Equipment, Buildings, Trucks)

Social Responsibility / Ethical – Corporate Governance– Shareholders – Employees– Community– Bankers/Creditors– Environmental

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Financial Risk Management

Seeking Return

Identifying Risk

Achieving Diversification via Asset Allocation

Time is important

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Seeking Return - Return Basic Analysis

RISK RETURN – Traditionally, when you define return you refer to a bank savings account (risk free) plus a risky portfolio of US stocks. Today, investors have access to a variety of asset classes and financial engineered investments

HPR = (Ending Price – Beg. Price + Div) / Beg. Price

Example: Current Price = $100, expected price to increase to $110 in a year. Within the year you are expected to receive $4 dividend, therefore the HPR=(110-100+4)/$100 = 14%

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RISK and Return

HOW DO WE QUANTIFY THE UNCERTAINTY OF INVESTMENT

To summarize risk with a single number we find VARIANCE, the expected value of the squared Deviation for the mean, first. (I.e. the expected value of the squared “surprise”: across scenarios.)

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RISK and ReturnHOW DO WE QUANTIFY THE UNCERTAINTY OF INVESTMENT

STANDARD DEVIATION DEFINITION: The Standard Deviation (σ) is a measure of how spreads out numbers are. (Note: Deviation just means how far from the normal). So, using the Standard Deviation we have a "standard" way of knowing what is normal, and what is extra large or extra small.

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VOLATILITY vs RETURN

Sharpe Ratio:

Risk Premium over the Standard Deviation of portfolio excess return

(E(r p) – r f ) / σ

8% / 20% = 0.4x. A higher Sharpe ratio indicates a better reward per unit of volatility, in other words, a more efficient portfolio

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VOLATILITY Vs RETURN and ASSET ALLOCATIONBuilding the Optimal Portfolio

+ Optimal Risky Portfolio (P)+ Proportion of the Investment budget (Y) to be allocated to it.+ The remaining portion (1-Y) is to be invested is the Risk-free Asset (rf)+ Actual risk rate of return by rp on P by E(rp) and Standard Deviation + The rate on risk-free asset is denoted a rf

+ The portfolio return is E(rc)E (rp) = 15%σ = 22 %Rf = 7 %E(rp – rf) = 8%

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RISK,RETURN, ASSET ALLOCATION AND DIVERSIFICATION

DIVERSIFICATION AND PORTFOLIO RISK

From one stock to two stocks to three stocks….. sensitivity to external factors (i.e. oil, non-oil stocks) – But even extensive diversification cannot eliminate risk – MARKET RISK

Other Names for Market risk: Systematic risk, non-diversifiable risk

The Risk that can be eliminated by diversification is called: – Unique Risk– Firm-specific risk– Non-systematic risk– Diversifiable risk

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RISK,RETURN, ASSET ALLOCATION, DIVERSIFICATION AND CORRELETION

Relationship between the return of two assets (-1 TO 1) Tandem Opposition

E(rb) = 6.0% E(rs) = 10% σb= 12% σs= 25% Pbs = 0 Wb=0.5 Ws=0.5

σp^2= (Wb*σb)^2 + (Ws*σs)^2 + 2 (Wb*σb) (Ws*σs)* Pbs

σp^2=(0.5*12)^2 + (0.5*25)^2 + 2(0.5*12)(0.5*25)*0

σp = SqRt of 192.25 = 13.87%

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RISK,RETURN, ASSET ALLOCATION, DIVERSIFICATION AND CORRELETION

ParametersE (rs) = 10E (rb) = 6

σs = 25σb= 12

Psb = 0

Exp Return Std Dev.Ws Wb E(rp) % σp %0.0 1.0 6.00 12.000.1 0.9 6.40 11.090.2 0.8 6.80 10.820.3 0.7 7.20 11.260.4 0.6 7.60 12.320.5 0.5 8.00 13.870.6 0.4 8.40 15.750.7 0.3 8.80 17.870.8 0.2 9.20 20.140.9 0.1 9.60 22.531.0 0.0 10.00 25.00

Minimum VarianceStocks 18.7256%Bonds 81.2744%

Portfolio Weights

Ws=(σb^2 - σb σs p) / (σs^2 + σb^2 - 2*σb σs p)Wb = 1 - Ws

E(r) Vs Std Dev with 0 correlation

0.00

2.00

4.00

6.00

8.00

10.00

12.00

0.00 5.00 10.00 15.00 20.00 25.00 30.00

Std Dev

E (r

)

100% Stocks

100% Bonds

Stocks 18.73%Bonds 81.27%

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WHAT ARE THE IMPLICATIONS OF PERFECT POSITIVE CORRELATION BETWEEN BONDS & STOCKS??

• Let’s say the correlation is 1 or Pbs = 1 (so far we used 0 correlation)

σp^2 = Wb^2 σb ^2 + Ws^2 σs^2 + 2 Wb*σb Ws*σs * 1 = Wb*σb + Ws*σs

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WHAT ARE THE IMPLICATIONS OF PERFECT POSITIVE CORRELATION BETWEEN BONDS & STOCKS??

• Let’s say the correlation is 1 or Pbs = - 1

σp^2 = (Wb*σb – Ws*σs)^2

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WHAT ARE THE IMPLICATIONS OF PERFECT POSITIVE CORRELATION BETWEEN BONDS & STOCKS??

THE OPTIMAL RISKY PORTFOLIO W/ A RISK-FREE ASSET

• Let’s add Risk Free in our portfolio (bringing what we discussed before regarding CAL line)

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Comparing Volatility to the Market: BETA COEFFICIENT

First Step: understanding CAPM:

E(rs) = rf + b * p + e

The model that predicts the relationship between the risk and equilibrium expected returns on risky assets

Second Step: Defining Beta

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Comparing Volatility to the Market: BETA COEFFICIENT

Defining Beta

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Comparing Volatility to the Market: BETA COEFFICIENT

Defining Beta

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Valuation Methods – Private Company

DCF Analysis– Transaction Sources & Uses

Capital markets– Debt (Loans. Mezzanine and Corporate Bonds)– Equity (Private & Public)

Initial Valuation – purchase price / Cost of investment WACC / CAPM concepts

– Debt Schedule Payments Principal & Interest

– Floating Rate– Fixed Rate

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DCF Analysis – Transaction Sources & Uses

TRANSACTION SOURCES & USES

Sources:

Debt Capacity

(EBITDA x)Amount % Capital

Expected Return

Expected Return

(After Tax)

WACC (After Tax)

EBITDA Multiple

Bank Loan 2.5x 50,000,000 40.5% 5.364% 3.433% 1.39% 2.5xMezzanine Note 30,000,000 24.3% 9.000% 5.760% 1.40% 1.5x Total Debt 4.0x 80,000,000 64.7% 2.79% 4.0x

Equity 43,600,000 35.3% 20.00% 20.00% 7.05% 2.2x Total Sources 123,600,000 100.0% 9.84% 6.2x

Uses:

1st Year'sEBITDAMultiple

Amount

% of Total Uses

WACD = 4.305%

Purchase Price (EV - including Debt) 6.0x 120,000,000 97.1%

Transaction Fees & Expenses 3.0% 3,600,000 2.9% Tax Rate= 36.0% Total Uses 123,600,000 100.0%

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DCF Analysis – Applying CAPM : E (re) = rf - β . Pe + ε

COST OF DEBT AND EQUITY CALCULATIONS        

COST OF BANK DEBT CALCULATION(Floaring Rate)

Equity Risk Premiums (1926-2006)(CAPM Model)

3M-LIBOR Assumptions

Loan Spread Initial All -In Decile Mkt Cap $MM Risk Prem.

0.30% 4.00% 4.30% 1 524,351 7.03%

   

COST OF MEZZANINE NOTE CALCULATION 2 10,344 8.05%

  9.00%   3 4,144 8.47%

4 2,177 8.75%

COST OF EQUITY CALCULATIONE (re) = rf - β . Pe + e 5 1,328 9.03%

6-year Treasury Note [ rf ] 1.95% 6 840 9.18%

Beta for Publicly Traded Hotel [ β ] 1.633x 7 538 9.58%

Equity Premium [ Pe ] 11.05% 8 333 9.91%

Firm Specific Risk Premium [e] 0.0% 9 193 10.43%

Cost of Equity   20.00% 10 85 11.05%

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DCF Analysis – Debt Schedules

DEBT ASSUMPTIONS & RETURN ANALYSIS

Bank Loan Information Debt IRR Terms 2010 2011 2012 2013 2014 2015 2016Amount Outstanding (End of Year) 50,000,000 47,000,000 42,000,000 37,000,000 31,000,000 24,000,000 15,000,000 - Schedule Principal Payments 7 years 3,000,000 5,000,000 5,000,000 6,000,000 7,000,000 9,000,000 15,000,000 Interest Payment (Calc based on last Year's Outs) 5.36% 2,150,000 2,256,000 2,226,000 2,331,000 1,953,000 1,512,000 945,000 Total Financing Payment 5.364% (50,000,000) 5,150,000 7,256,000 7,226,000 8,331,000 8,953,000 10,512,000 15,945,000 LIBOR RATE 0.30% 0.30% 0.80% 1.30% 2.30% 2.30% 2.30% 2.30% LIBOR Rate Increase Assumptions 0.00% 0.50% 0.50% 1.00% 0.00% 0.00% 0.00%

Corporate Bond InformationAmount Outstanding 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 30,000,000 Schedule Principal Payments 10 Years - - - - - - - Interest Payment (Calc based on last Year's Outs) 9.00% 2,700,000 2,700,000 2,700,000 2,700,000 2,700,000 2,700,000 2,700,000 Total Financing Payment 9.000% (30,000,000) 2,700,000 2,700,000 2,700,000 2,700,000 2,700,000 2,700,000 2,700,000

Total Financing 7,850,000 9,956,000 9,926,000 11,031,000 11,653,000 13,212,000 18,645,000 Total Debt Outstanding 77,000,000 72,000,000 67,000,000 61,000,000 54,000,000 45,000,000 30,000,000

Debt Money Terms:

• Amount

• Interest Rate (Floating – LIBOR Rate and Fixed Rate)

• Maturity

• Amortization

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DCF Analysis – Building up the Projections

CASH FLOW & EQUITY RETURN ANALYSIS

Company Projections Operating Entry Year Year 1 Year 2 Year 3 Year 4 Year 5 Exit YearAssump. 2009 2010 2011 2012 2013 2014 2015 2016

Revenues 5.00% growth 40,000,000 42,000,000 44,100,000 46,305,000 48,620,250 51,051,263 53,603,826 Cost of Revenues 35.0% % of Revenue (14,000,000) (14,700,000) (15,435,000) (16,206,750) (17,017,088) (17,867,942) (18,761,339) Operating Costs 15.0% % of Revenue (6,000,000) (6,300,000) (6,615,000) (6,945,750) (7,293,038) (7,657,689) (8,040,574) EBITDA 50.0% 20,000,000 21,000,000 22,050,000 23,152,500 24,310,125 25,525,631 26,801,913 Less Depreciation 3.00% % of Revenue (1,200,000) (1,260,000) (1,323,000) (1,389,150) (1,458,608) (1,531,538) (1,608,115) Less Amortization of Fees 7 years (514,286) (514,286) (514,286) (514,286) (514,286) (514,286) EBIT 18,285,714 19,225,714 20,212,714 21,249,064 22,337,232 23,479,808 25,193,798 Less Interest (Unlevered for DCF Analysis) - - - - - - - EBT 18,285,714 19,225,714 20,212,714 21,249,064 22,337,232 23,479,808 25,193,798 Less Taxes (adj out Interest Exp) 36.0% % of EBT (6,582,857) (6,921,257) (7,276,577) (7,649,663) (8,041,403) (8,452,731) (9,069,767) Plus Depreciation & Amortization 1,714,286 1,774,286 1,837,286 1,903,436 1,972,893 2,045,824 1,608,115 Less Working Capital 1.00% % of Revenue (400,000) (420,000) (441,000) (463,050) (486,203) (510,513) (536,038) Less Capex 3.00% % of Revenue (1,200,000) (1,260,000) (1,323,000) (1,389,150) (1,458,608) (1,531,538) (1,608,115) Cash Flow Before Financing (CFBF) 11,817,143 12,398,743 13,009,423 13,650,637 14,323,912 15,030,850 15,587,992

Less Financing ( P + I ) (7,850,000) (9,956,000) (9,926,000) (11,031,000) (11,653,000) (13,212,000) (18,645,000) Equity Cash Flows 3,967,143 2,442,743 3,083,423 2,619,637 2,670,912 1,818,850 (3,057,008)

Terminal Value EBITDA Multiple Method (initial purchase multiple) Growth 6.0x 153,153,788

Perpetuity Method (using WACC + growth) 3.50% 9.84% 245,812,934

Average Terminal Value 199,483,361

Debt Outstanding 45,000,000 Equity Value (TV - Debt) 154,483,361

Equity Cash Flows (43,600,000) 3,967,143 2,442,743 3,083,423 2,619,637 2,670,912 156,302,211

x x x x x x$ 1 PV Table (Expected Equity Rate) 20.00% 0.8333398 0.6944552 0.5787172 0.4822680 0.4018931 0.3349135

PV Table (Expected Equity Rate) 61,471,300 3,305,978 1,696,376 1,784,430 1,263,367 1,073,421 52,347,728

Initial Investment (43,600,000) Equity Return Scenarios Given Different EBITDA MultiplesNPV= 17,871,300 5.5x 6.0x 6.5x 7.0x

IRR= 27.9% 36.4% 27.9% 22.1% 17.9%

Based on Next Year's CF

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Reviewing Financial Risk Management

Fundamental Analysis– Financial Ratio Analysis– DCF Valuation Analysis

Technical Analysis– Portfolio Analysis Approach

Historical Returns / Standard Deviation / Correlations

Behavioral Analysis

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Behavioral Analysis Concepts

ARE MARKETS EFFICIENT? EMH Concept

Looking for behavioral motivations for buying/selling: • High Exposure• Risk Appetite• Tax motivation• Resource allocation

Behavioral Finance - People are people and they make decisions differently“Irrational Exuberance” – Greenspan 12/2006 – affected the stock markets around the world after he mention that word (Tokyo was down 3.0%, Hong Kong was down 2.0%, UK down 3.0%, U.S. down 2.0%)

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Behavioral Analysis Concepts

ARE MARKETS EFFICIENT? EMH Concept

INFORMATION PROCESSING• Forecasting Errors – High multiples• Overconfidence – “Irrational Exuberance” • Conservatism – the article of banks – in Leverage Cycle

BEHAVIORAL BIASES• Bluffing – Game theory – “All-in” has nothing, betting slow could have a good hand.• Mental Accounting – managing other people’s money versus your own• Regret Avoidance – unconventional choices Vs. acceptable choices when wrong• Prospect theory - as wealth increases more risk averse.