Creating Value with Risk Management

[ckyeh]

Dear David:

On your webinar 「2010-1[1].b-Foundations」, page 27, and spreadsheet「1_b_4_Stulz_bankruptcy_taxes_debt_v1」:

Explain how risk management can create value moving income across time and reducing taxes.
How do you come out with tax 75(for future 450)、25(for forward 350)?
I couldn’t figure it out from the tax schedule.

On your webinar 「2010-1[1].b-Foundations」, page 32, and spreadsheet「1_b_4_Stulz_bankruptcy_taxes_debt_v1」:
……and explain how risk management can increase firm value by reducing the probability of debt overhang.

You simply change the investment cost. Is there anything to do with the probability of debt overhang?
I don’t see any change for the probability of debt overhang.

Thanks

 

[David Harper CFA FRM]

Hi ckyeh,

These are both Stulz's examples. The tax schedule is 0% for income (cash flow) below 300 and 50% tax on *incremental* income above 300. So:
Tax on 250 is 0;
Tax on 450 = (450-300)*50% = 75.
Tax on 350 = 350 (350-300)*50% = 25.

Re debt overhang example (also straight from Stulz; all I did was quantify his narrative), there is no probability associated with the new investment: it cost -$5 and produces (returns) + $10 at the end of the year (profitable!). The probabilities, rather, are in regard to gold price and (in this highly simplified example) therefore firm price. So, 50%/50% probability that gold (firm) will end the year at value of $250 or $450.

The example then shows how, as long as there is a significant probability that firm ends the year underwater (i.e., equity value = 0) even *after* the benefit of the investment, the shareholder are not keen on the expected (probability weighted) loss of their investment.

So, the meaning of "reducing the probability of debt overhang" is simply the reduction in the probability that the future firm is underwater (equity = 0). For example, we can change from 50%/50% to 30% (250) and 70% (450) and then the spreadsheet reflects the underinvest problem has been eliminated: it is still possible (30%) the firm will experience debt overhang, but as the probability of debt overhang is lower, *expected* (average) equity value increases rather than dilutes, so now the shareholders want the project.

Hope this helps, David