Cash Flow Risk Management – FAQ | IFRS

Cash Flow Risk Management

The risk that companies must identify and manage is their cash flow risk, meaning uncertainty about their future cash flows. Finance theory is, for the most part, silent about how much cash flow risk a company should take on. Company Cash Flow Risk Management

In practice, however, managers need to be aware that calculating expected cash flows can obscure material risks capable of jeopardizing their business when they are deciding how much cash flow risk to accept. They also need to manage any risks affecting cash flows that investors are unable to mitigate for themselves. Company Cash Flow Risk Management

Deciding how much cash flow risk to take on What should companies look out for? Consider an example. Project A requires an up-front investment of $2,000. If everything goes well with the project, the company earns $1,000 per year forever. If not, the company gets zero. (Such all-or-nothing projects are not unusual.) To value project A, finance theory directs you to discount the expected cash flow at the cost of capital. But what is the expected cash flow in this case? If there is a 60 percent chance of everything going well, the expected cash flows would be $600 per year. At a 10 percent cost of capital, the project would be worth $6,000 once completed. Subtracting the $2,000 investment, the net value of the project before the investment is made is $4,000.

But the project will never generate $600 per year. It will generate annual cash flows of either $1,000 or zero. That means the present value of the discounted cash flows will be either $10,000 or nothing, making the project net of the initial investment worth either $8,000 or –$2,000. The probability of it being worth the expected value of $4,000 ($6,000 less the investment) is zero.

Rather than knowing the expected value, managers would be better off knowing that the project carries a 60 percent chance of being worth $8,000 and a 40 percent risk of losing $2,000. Managers can then examine the scenarios under which each outcome prevails and decide whether the upside compensates for the downside, whether the company can comfortably absorb the potential loss, and whether they can take actions to reduce the magnitude or risk of loss. The theoretical approach of focusing on expected values, while mathematically correct, hides some important information about the range and exclusivity of particular outcomes. Company Cash Flow Risk Management

Moreover, some companies don’t apply the expected-value approach correctly. Few companies discuss multiple scenarios, preferring a single-point forecast on which to base a yes-or-no decision. So most companies would simply represent the expected cash flows from this project as being $1,000 per year, the amount if everything goes well, and allow for uncertainty in the cash flow by arbitrarily increasing the discount rate. While you can get to the “right” answer with this approach, it has two flaws. First, there is no easy way to determine the cost of capital that gives the correct value. In this case, using a 16.7 percent cost of capital instead of 10 percent results in a project value of $6,000 before the investment and $4,000 after the investment, but the only way to know that this was the correct value would be to conduct thorough scenario analysis. Companies sometimes arbitrarily add a risk premium to the cost of capital, but there is no way for them to know whether the amount they add is even reasonably accurate. Second, the decision-makers faced with a project with cash flows of $1,000 per year and a 16.7 percent cost of capital are still not thinking through the 40 percent risk that it generates no cash at all. Company Cash Flow Risk Management

How should a company think through whether to undertake the project with an upside of $8,000, a downside of –$2,000 and an expected value of $4,000? Theory says take on all projects with a positive expected value, regardless of the upside-versus-downside risk. But following the theory could be problematic. Company Cash Flow Risk Management

What if the downside possibility would bankrupt the company? Consider an electric power company with the opportunity to build a nuclear power facility for $15 billion (not unrealistic in 2009 for a facility with two reactors). Suppose the company has $25 billion in existing debt and $25 billion in equity market capitalization. If the plant is successfully constructed and brought online, it will be worth $28 billion. But there is a 20 percent chance it will fail to receive regulatory approval and be worth zero. As a single project, the expected value is $22 billion, or $7 billion net of investment. Another way to put this is that there is an 80 percent chance the project will be worth $13 billion ($28 billion less $15 billion investment) and a 20 percent chance it will be worth –$15 billion. Furthermore, failure will bankrupt the company, because the cash flow from the company’s existing plants will be insufficient to cover its existing debt plus the debt on the failed plant. In this case, the economics of the nuclear plant spill over onto the value of the rest of the company. Failure will wipe out all the equity of the company, not just the $15 billion invested in the plant.

We can extend the theory to say that a company should not take on a risk that will put the rest of the company in danger. In other words, don’t do anything that has large negative spillover effects on the rest of the company. This caveat would be enough to guide managers in the earlier example of deciding whether to go ahead with project A. If a $2,000 loss would endanger the company as a whole, they should forgo the project, despite its 60 percent likelihood of success. But by the same token, companies should not try to reduce risks that don’t threaten the company’s ability to operate normally. For example, profitable companies with modest amounts of debt should not worry about interest rate risk, because it won’t be large enough to threaten to disrupt the business.

Deciding which types of risk to hedge There are also risks that investors positively want companies to take. For example, investors in gold-mining companies and oil production companies buy those stocks to gain exposure to often-volatile gold or oil prices. If gold and oil companies attempt to hedge their revenues, that effort merely complicates life for their investors, who then have to guess how much price risk is being hedged and how and whether management will change its policy in the future. Moreover, hedging may lock in today’s prices for two years, the time horizon within which it is possible to hedge those commodities, but a company’s present value includes the cash flows from subsequent years at fluctuating market prices. So while hedging may reduce the short-term cash flow volatility, it will have little effect on the company’s valuation based on long-term cash flows. Company Cash Flow Risk Management

Some risks, like the commodity price risk in the earlier example of gold and oil companies, can be managed by shareholders themselves. Other, similar looking risks—for example, some forms of currency risk—are harder for shareholders to generalize. The general rule is to avoid hedging the first type of risk, but hedge the second if you can. Company Cash Flow Risk Management

Consider the effect of currency risk on Heineken, the global brewer. Heineken produces its flagship brand, Heineken, in the Netherlands, and ships it around the world, especially to the United States. Most other large brewers, in contrast, produce most of their beer in the same national markets in which they sell it. So for most brewers, an exchange rate change affects only the translation of their profits into their reporting currency. For example, a 1 percent change in the value of the currency of one of their non-home markets translates into a 1 percent change in revenues from those markets and a 1 percent change in profits as well. Note that the effect on revenues and profits is the same, because all the revenues and costs are in the same currency. There is no change in operating margin. Company Cash Flow Risk Management

Heineken’s picture is different. Consider Heineken’s sales in the United States. When the exchange rate changes, Heineken’s revenues in euros are affected, but not its costs. If the dollar declines by 1 percent, Heineken’s euro revenues also decline by 1 percent. But since its costs are in euros, they don’t change. Assuming a 10 percent margin to begin with, a 1 percent decline in the dollar will reduce Heineken’s margin to 9 percent, and its profits reported in euros will decline by a whopping 10 percent. Company Cash Flow Risk Management

Because Heineken’s production facilities are in a different country and it is unable to pass on cost increases because it is competing with locally produced products, its foreign exchange risk is much larger than that of other global brewers. Hedging might be critical to Heineken’s survival, while the other global brewers probably would not benefit from hedging, because the impact of exchange rate changes on their business is not material. See below the Heineken extensive disclosure on market risks: Company Cash Flow Risk Management

Heineken Annual Report 2018

 

Heineken Annual Report 2018

Company Cash Flow Risk Management

Leave a comment