Risk Management in Turbulent Times

By Gilles Bénéplanc; Jean-Charles Rochet | Go to book overview

11
The Shareholder Value Function
The choice of investments and the way to finance them are crucial determinants of corporate value. But appropriate liquidity management is probably as important as investment selection and financing decisions. Even a very profitable firm can be jeopardized by liquidity problems:
Too little cash can provoke financial distress and liquidation of productive assets.
By contrast, holding too much cash reduces profitability.

In this chapter, we temporarily leave investment and financing decisions on the side and focus on the impact of liquidity shocks on shareholder value. This focus allows one to concentrate on cash reserves m as the crucial variable. In this chapter, the level m of cash reserves summarizes all relevant information for shareholders. In real-life situations, other variables are equally important, such as leverage, investment opportunities, expected profitability, and volatility of cash flows. By taking these variables as given, we can present our core methodology in a simple fashion. We derive the shareholder value function, which gives shareholder value as a function of the level of cash reserves. We then deduce from it precise guidelines for insurance and hedging decisions.


11.1 A TARGET LEVEL OF CASH

All else being fixed (particularly the value of productive assets and the level of debt), the variations in the level m of cash reserves held by a firm impact one-for-one on the book value of its equity E. Consider the simplified balance sheet:

Prodductive
assets (A)
Equity
(E)
Cash
reserves (m)
Debt
(D)

If A and D are fixed, then the book value of equity equals:

Thus, one more dollar of cash reserves increases book value by exactly one dollar.

By contrast, if we consider instead the market value of equity (which we call shareholder value and denote by SV), then the relation changes. Indeed, it is generally the case that one more dollar of cash reserves in the firm increases shareholder value by more than one dollar, especially if the level of cash reserves is low. The reason is that additional cash reserves decrease the probability that the

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