Other Dimensions of Risk - Financial Management

This chapter has focused on various measures of variability in returns—either total variability, measured by the standard deviation and the coefficient of variation, or systematic variability, measured by beta. Although variability of returns is very important, it does not adequately consider another important risk dimension, that is, the risk of failure. In the case of an individual investment project, failure is a situation in which a project generates a negative rate of return. In the case of the entire firm, failure is the situation in which a firm loses money and is ultimately forced into bankruptcy.

For risk-averse investors, the risk of failure may play a large role in determining the types of investments undertaken. For example, the management of a firm is not likely to be eager to invest in a project that has a high risk of failure and that may ultimately cause the firm to fail if it proves to be unsuccessful. After all, the continued survival of the firm is tied closely to the economic well-being of management.

From a shareholder wealth maximization perspective, failure is a particularly undesirable occurrence. The direct and indirect costs of bankruptcy can be very high. Consequently, this failure risk is often an important determinant of investment risk. The risk and cost of failure can explain, in large part, the desire of many firms to diversify. In addition to reducing the overall risk of a firm, diversification can result in a lower probability of bankruptcy and thus lower expected costs incurred during bankruptcy. These costs include the following:

  • The loss of funds that occur when assets are sold at distressed prices during liquidation
  • The legal fees and selling costs incurred when a firm enters bankruptcy proceedings
  • The opportunity costs of the funds that are unavailable to investors during the bankruptcy proceedings (for example, it took over eight years to settle the Penn Central bankruptcy) Lower expected bankruptcy costs should increase shareholder wealth, all other things being equal.

Diversification may also reduce a firm’s cost of capital. By reducing the overall risk of the firm, diversification will lower the default risk of the firm’s debt securities, and the firm’s bonds will receive higher ratings and require lower interest payments. In addition, the firm may be able to increase the proportion of low-cost debt relative to equity in its optimal capital structure, further reducing the cost of capital and increasing shareholder wealth. Although we will focus primarily on return variability as our measure of risk in this book, the risk and cost of failure should also be kept in mind.

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