Chapter 20 Risk Management and Shareholder Wealth

Chapter 20 Risk Management and Shareholder Wealth I. Multiple Choice 1. The value of a firm is: a. b. c. d. the present value of the firm’s expected future cash flows. impossible to estimate. dependent on its capital structure. all of the above. Answer: a Type: K 2. Which of the following risks faced by a business firm is most likely to be nondiversifiable? a. b. c. d. explosion at the firm’s plant worker injury reduced earnings due to poor economic conditions a product liability claim Answer: c Type: A 3. Which of the following is not an advantage of purchasing insurance as compared to retaining the risk? a. b. c. d. Insurers can provide cheaper claim processing and loss control services. The price of the insurance is often less than the expected claim cost. Insurance reduces the likelihood of financial distress. Insurance can reduce a firm’s expected tax payments. Answer: b Type: K 4. Corporate insurance purchases can affect expected cash flows by: a. b. c. d. increasing net cash flows due to premium loadings. increasing net cash flows by providing cheaper claim processing. decreasing net cash flows by reducing the likelihood of financial distress. decreasing net cash flows by reducing expected tax payments. Answer: b 180 Type: K 5. Which of the following is a likely result of the risk of bankruptcy for an airline? a. b. c. d. Managers and employees demand higher levels of compensation. The cost of borrowing will be higher. Some potential customers will choose to do business with other airlines. All of the above. Answer: d Type: A 6. In estimating the net present value of a firm’s cash flows, the appropriate discount rate will be the risk-free rate plus a risk premium that takes into account: a. b. c. d. all the risk that the firm is subject to. firm-specific and market risk that the firm is subject to. diversifiable risk only. nondiversifiable risk only. Answer: d Type: K 7. Corporate risk reduction increases shareholder wealth by: a. b. c. d. increasing expected net cash flows. decreasing the corporate cost of capital. increasing the corporate cost of capital. none of the above. Answer: a Type: K 8. When deciding how much insurance to purchase, a firm must compare the insurance premium loading to: a. b. c. d. the cost of capital the expected loss the expected cost of raising new funds following a loss the costs of financial distress Answer: c Type: K 181 9. Financial distress: a. b. c. d. always results in bankruptcy. requires that a firm be legally reorganized to restructure the terms of its obligations. often imposes costs on parties who have contractual relationships with the firm. will not affect the firm’s expected cash flows unless it results in an actual bankruptcy. Answer: c Type: K 10. Watergate Inc. has a main office that is located in a flood plain. How will its lenders react if Watergate does not purchase flood insurance, a. b. c. d. its lenders will be indifferent its lenders will probably charge a lower interest rate its lenders will structure any loans to reflect the cost of a potential underinvestment problem none of the above. Answer: c Type: A 11. Which one of the following is a fundamental factor in determining the value of a firm? a. b. c. d. level of expected future cash flows timing of expected future cash flows opportunity cost of capital all of the above factors are fundamental determinants of a firm’s value Answer: d Type: K 12. The difference between a firm’s opportunity cost of capital and the risk-free rate is a. b. c. d. the firm’s risk premium always greater (in magnitude) than the risk-free rate always less (in magnitude) than the risk-free rate diversifiable risk Answer: a Type: A 182 13. Which of the following situations faces a potential underinvestment problem from experiencing a loss due to fire? a. b. c. d. debt financing, adequate insurance debt financing, no insurance no debt financing, adequate insurance no debt financing, no insurance Answer: b Type: A 14. PatCo Incorporated has just purchased property and liability insurance. Which one of the following will have a negative effect on expected cash flows? a. b. c. d. payment of the expense loadings in the insurance premiums bundling loss control services with the insurance purchase the altering of contractual terms with lenders and suppliers the change in expected bankruptcy costs Answer: a Type: K 15. Corporate insurance purchases will primarily affect the firm’s a. b. c. d. cost of capital risk premium expected net cash flows all of the above Answer: c Type: K II. Fill-Ins 1. Risk that can be eliminated by investors by holding diversified portfolios is called diversifiable (or firm-specific or idiosyncratic or non-systematic ) risk. 2. The underinvestment problem occurs when firms who have debt financing but no insurance have incentive to opt not to reinvest after a loss because the benefit of the reinvestment accrues to the lenders rather than to the shareholders. 3. Services provided by insurers such as claims processing and loss control are benefits of insurance that can offset the additional cost due to premium loading. 183 4. The risk premium is the amount of return in excess of the risk free rate which is demanded by providers of capital for bearing systematic or nondiversifiable risk. 5. The net present value of an investment is the present value of the benefits less the present value of the costs. III. Problems and Short Answer Questions 1. The Viable Company purchases commercial general liability insurance. What impact is this likely to have on the firm’s cost of capital. Explain. Answer: Liability risk is firm-specific and is therefore diversifiable by the firm’s shareholders. If Viable’s shareholders are well-diversified, the purchase of this insurance is unlikely to decrease the cost of capital. Type: A 2. In the question above, how might the purchase of insurance affect Viable’s cash flows? Answer: The loading on insurance policies generally means that the cost of insurance is greater than the expected value of losses. However, there may be other benefits that accrue to the firm such as reduced cost of claim processing and loss control services, reduced likelihood of incurring the costs of raising funds to finance a loss, reduced likelihood of financial distress, and reduced tax payments. Type: A 3. The Astute Insurance Company property insurance policy includes claims processing and loss control services. Explain why bundling the insurance with the services would be expected to result in lower claim costs. Answer: An insurer that provides loss control services and pays losses has additional incentive to identify and undertake cost-effective loss control measures. The claims processing function provides the insurer with the incentive and the means to identify and reduce the costs of fraudulent claims. Type: A 4. If the risk free rate is 5% and the risk premium for Bogie’s Stogies Inc. is 7%, what is the opportunity cost of capital for Bogie’s Stogies Inc.? Answer: The opportunity cost of capital = 5% + 7% = 13%. 184 Type: A 5. If Bogie’s Stogies Inc., in question #4 above, purchases insurance to cover its product liability risk, what impact will this have on the cost of capital? Explain. Answer: The purchase of insurance will not impact the cost of capital since product liability risk is a diversifiable risk. Type: A 6. If Bogie’s Stogies Inc., in question #4 above, hedges their currency risk exposure, what impact will this have on the cost of capital. Explain. Answer: Currency risk is diversifiable, so the hedging activity will likely reduce the firm’s cost of capital. However, the hedge will reduce corporate cash flows so that the benefits and costs may offset each other. Type: A 7. Shaky Bakey is a restaurant supply company that is experiencing financial distress. Without insurance, what impacts will the risk of bankruptcy have on Shaky’s contracts with other claimholders? Answer: Customers will be concerned about Shaky’s quality and reliability and may seek other sources for their supplies. Employees will demand higher compensation for the risk of losing their jobs. Shaky’s suppliers will demand higher prices to compensate for the risk of not being paid. Lenders will demand higher interest rates. Type: A 185