Chapter 2 Objective of Risk Management

Chapter 2 Objective of Risk Management I. Multiple Choice 1. The fundamental objective of risk management is: a. b. c. d. diversification minimize the cost of risk hedging loss control Answer: b Type: K 2. If unexpected increases in losses from price risk are not offset by cash inflows from insurance contracts, hedging arrangements or other contractual risk transfers, they will result in: a. b. c. d. an increased stock price a reduced stock price bankruptcy increased diversification Answer: b Type: K 3. Johnson Incorporated, located in California, had a $1 million uninsured loss due to an earthquake in 1997. What impact is this likely to have on the firm’s value? a. b. c. d. It will have no impact. The firm value will increase by $1 million. The firm value will decrease by $1 million. The firm value will probably decrease, but the amount of decline will depend on other factors such as the firm’s level of diversification of risk. Answer: d Type: A 132 4. The cost of risk may include all of the following except: a. b. c. d. the cost of insurance. the cost of raw materials. the cost of increased precautions to control losses. the cost of investments in information to reduce risk. Answer: b Type: A 5. Maximizing the value of the firm is the same thing as minimizing the cost of risk if: a. b. the managers are socially responsible. the cost of risk is defined to include all risk-related costs from the perspective of the firm’s shareholders loss control is used effectively the managers’ incentives are aligned with the incentives of the firm’s shareholders c. d. Answer: b Type: K 6. Which of the following factors helps to explain why managers of large firms have an incentive to maximize shareholder value? a. b. c. Shareholders do not do a good job of monitoring manager behavior. Managers of large firms generally have very high salaries. Managers are often excessively cautious in their risk management decisions, spending too much on insurance and loss control. Managers are often compensated with bonuses linked to the firm’s profitability or stock price. d. Answer: d Type: K 7. The cost of risk is equal to: a. b. c. d. the value of the firm without risk minus the value of the firm with risk. the value of the firm with risk minus the value of the firm without risk. the cost of direct losses that will be incurred by the firm due to the risk. the cost of loss control plus the cost of internal risk reduction. Answer: a Type: K 133 8. The cost of loss control for potential fire damage to a firm’s warehouses would include: a. b. c. d. the cost of fire insurance. the cost of damage to goods in the building. the cost of installing sprinklers. the potential loss of business that would occur if goods could not be shipped on time due to the fire. Answer: c Type: A 9. Which of the following statements is most correct. a. The amount of loss control that minimizes the cost of risk will generally result in a total elimination of the risk of loss. Increased expenditures on loss financing will also generally result in increases in direct loss costs. Firms should invest in risk reduction until the probability of loss is zero. Increased expenditures on insurance will reduce the cost of residual uncertainty. b. c. d. Answer: d Type: A 10. All of the following are important components of the cost of risk for a pharmaceutical company which is developing a new prescription drug for the treatment of AIDS except: a. b. c. d. the cost of testing the product for safety. the cost of marketing the product to doctors. the cost of product liability insurance. the cost of defending against and settling future liability claims. Answer: b Type: A 11. If the private cost of risk differs from the social cost of risk a. b. c. d. government regulation will be ineffective firms will tend to not maximize the value of the firm an efficient level of societal risk will not exist minimization of the total cost of societal risk will generally not coincide with firms maximizing their value Answer: d Type: K 134 12. By increasing spending on safety equipment Charly’s Meat Packing has reduced total worker injury costs by 15%. This is an example of the a. b. c. d. tradeoff between loss control costs and loss financing tradeoff between loss control costs and expected direct losses tendency of business firms to spend too little on loss control importance of loss control Answer: b Type: A 13. Which one of the following is not a determinant of value of a business firm? a. b. c. d. expected magnitude of the firm’s future cash flows expected timing of the firm’s future cash flows expected variability of the firm’s future cash flows all of the above are determinants of a firm’s value Answer: d Type: K 14. JoPro Inc. and Thron Company both have the same level of expected cash flows, with JoPro’s cash flows subject to greater variability. Which of the following statement best describes how risk adverse investors will view these shares? a. b. c. d. The investors will only be willing to purchase the shares of Thron Company. The investors will be willing to purchase all of the shares of Thron Company but only a few of the shares of JoPro Inc. The investors will pay a lower price for the shares of JoPro Inc. than they will for Thron Company’s shares, thereby increasing the expected return on the dollars invested in JoPro shares. The investors will pay a higher price for the shares of JoPro Inc. than they will for Thron Company’s shares, thereby increasing the expected return on the dollars invested in JoPro shares. Answer: c Type: A 135 15. Which one of the following is not an example of the cost of loss financing? a. b. c. d. expected direct/indirect losses the loading in insurance premiums transactions costs involved with making hedging arrangements opportunity cost of maintaining self-insurance loss reserves Answer: a Type: A II. Fill-Ins 1. The overall objective of risk management for “for-profit” businesses is minimize the cost of risk . to 2. The costs incurred by shareholders in monitoring managerial behavior are known as ___agency costs. 3. The cost of risk includes the expected cost of losses, the cost of loss control , the cost of loss financing , and the cost of internal risk reduction , and the cost of any residual uncertainty after the other risk reduction methods have been implemented. 4. In estimating the cost of risk, tradeoffs will normally exist between the expenditures on loss control and the cost of direct and indirect losses . 5. If a person facing two risky alternatives, whose expected outcomes are the same, chooses the alternative with less variability, this person is ____risk adverse____. III. Problems and Short Answer Questions 1. Managers may have incentives to take action that benefit themselves at the expense of the shareholders. What factors give them incentives to act consistently with shareholder value maximization? Answer: Factors that give managers incentives to act consistently with shareholder value maximization include: compensation linked to performance; takeover risk for firms that are undervalued; the potential for lower product prices when costs are not adequately controlled by management; monitoring by other stakeholders; and potential fiduciary liability. Type: K 136 2. When will minimizing the cost of risk also maximize the value of the firm. Answer: If the firm's cost of risk is defined to include all of the effects of risk and risk management on firm value - minimizing the cost of risk will maximize shareholder value. Type: K 3. Describe the most important components of the cost of risk that apply to the risk of shoplifting at a convenience store. Answer: The most important components of the cost of risk for the convenience store are: a) the expected cost of lost inventory; b) the expected cost of indirect losses such as reduction in profits; c) cost of loss control such as extra expenses of inventory management, mirrors, additional personnel; d) the cost of insurance or retention to cover lost inventory. Type: A 4. How does the overall objective of risk management differ for a non-profit organization, such as your local food bank, which does not have shareholders? Answer: Since non-profits do not have shareholders, they generally will be attempting to maximize the value of products or services provided to their customers or constituents. The cost of risk for such a firm will be the reduction in value of the firm’s activities to their constituents. The food bank will be trying to provide the largest amount of food to the largest number of people at the lowest cost they can. Minimizing the risk of losses due to food spoilage, theft, or liability claims will help to achieve this goal. Type: A 5. If all for-profit firms act to minimize the cost of risk and thereby maximize shareholder value, will this also minimize the societal cost of risk? Why or why not? Answer: If risk management decisions reflected all the costs that risk creates for other parties, then the individual firms’ risk management activities would also minimize societal risks. However, there are many risks that are imposed on society but are not reflected in the cost of risk for the individual firms. Since the private cost of risk differs from the social cost of risk, business value maximization will generally not minimize the total cost of risk to society. Type: K 137