How To Structure Your Capital For Risk

The last decade has seen the world become increasingly conscious of the need to measure and control business risk. A diverse body of professionals - from fields as varied as finance, economics, physics, mathematics, business, banking, nuclear science - apart from regulatory agencies and government have contributed to making the measurement and mitigation of risk possible. In the next decade, one can expect to see accelerated growth in research in this field as well as solutions. This will make the world of business and finance a much safer place than what it was in the last 10 years.

Uncertainty exists in all spheres of life. If we were able to look into the future and rely fully on what we think to be the future, then this would not be the case. Hence, as a starting point we can say that in our crystal-ball we can see a few alternate states of the future. We are not certain which state of the future will unfold in our lives. This leads to uncertainty.

If it is uncertainty that we are examining here, then we know that it is related to the changing state of what we expect to be the future. If we were assured that the existing state would continue in the future for 50 years or so, then we will not be faced with any uncertainty of a great measure. Over the past few centuries this has been the case. Change has been along expected lines and spread over a long timeframe so that man has been able to adjust to the new scenario without having to suffer devastating upheaval. This luxury is not available to us in today's world.

When the pace of change accelerates and its impact magnifies, we have to start factoring in risks to our daily business decisions. To do this we have to measure it scientifically so that it can be incorporated into our decision-taking process.

Further, we would like to do away with risk completely if we can. Today we have techniques and instruments to do this to some extent. But we have to measure risk to the extent that it cannot be factored away so that we can at least manage it.

Management action results in decisions that have an impact. Their impact results from the deployment of resources that are made available to a business or those which it commands. The results involve a change from the existing situation to a different state of affairs. We expect this change to be beneficial to stakeholders. The stakeholders expect a return on the resources they have provided.

But again, not just any return. They know that they have taken a risk and hence they want a return commensurate with the risk they have taken.

It is this focused alignment of the risk and reward relationship that has been the greatest contribution of the thought process and research that we spoke about above. It is still evolving and will continue to do so well into the next decade also. Research over the last decade has crucially brought an enhancement and refinement to measurement and management of risk. Not only businesses, but research institutions, the financial sector and the government have now adopted these techniques in one form or the other.

Reward and returns have to be proportional to the risk undertaken for the investment to have been worthwhile. If increased risk is undertaken in further investments, then proportionately higher rewards are expected. If rewards do not match the risks then we either have to take measures to increase returns appropriately or reduce risk in the venture to a suitable level.

FUTURE IMPACT

All investments and returns have a bearing on the future. It is the future that is uncertain. Hence we have to work with an expected view of the future incorporating all the elements of risk on account of change, uncertainty, governmental regulations and actions as well as the national and international impact of actions of institutions and corporations.

Societal level changes have an impact too.

We are always looking at expected returns from any venture that we undertake. We expect these returns on the basis of a decision to deploy resources to achieve these returns. It follows that investment and returns interact with each other and affect each other. However, we expect our investment to increase in value over the years and this is dependent upon the returns it earns.

The value of an investment is the value of the future returns that it will generate as stated in present terms. If these returns deviate from their expected path then the value of our investment will also change. At any point in time the value of our investment could take any of the values that are dependent on any of the paths that the future returns could follow. Therefore, we could arrive at a function that will describe the frequency with which any of the values could be taken by our investment at any point in time. This will be based on the variability of returns and the probability of any combination of a state of affairs existing at any time in the future.

The value of investment is independently specified by the returns. How the investment is structured is an independent decision but not wholly divorced from the value of the investment. We could source an investment from either our own resources or from borrowed capital. Both could be either long-term or short-term sources. We expect all short-term resources to be repayable immediately. Hence we are left with the traditional sources of finance, i.e. debt and equity. This has been dealt with exhaustively in literature, including the optimum level of investment between debt and equity. But all this has been at a fixed level of returns.

The incorporation of risk and the variability of returns and firm valuations also lead to the question of the right capital structure. Quite obviously the right capital structure will be dependent on the level of risk associated and the steps taken to manage the same.

RISK CAPITAL

Debtors to a firm also look at the value of the firm since their claim on the assets is at a primacy to that of equity holders. Debtors also desire that the value of the firm be above the value of their debt so that they are not put to a loss. In fact, contemporary theory in this regard states that the owners of a firm will only default in payments to debtors when the value of the firm is less than the value of the debt.

But as the value of the firm can vary on account of the uncertainty associated with future returns, the debtors will look at not just the simple value of the firm but also factor in risk based on the variability of its value. Hence, their exposure relative to the risk can either increase or decrease the risk and they will base their exposure on its terms and conditions. Their consequent risk appetite will be based on their compensation for the risk being taken.

In any case, a lender will lend upto a level where he is compensated for the risk he shares and also, as importantly, where he can get his capital back. As such he wants his money back or he will stake his claim on the assets of the firm representing the residual value of the firm.

The reverse side of the coin is the case of equity. The entire residual risk is with the equity holder. This is why equity is referred to as risk capital. But the entire equity need not be risk capital. The risk capital can be minimised.

THE RIGHT CAPITAL STRUCTURE

It is in the equityholder's interest that the firm's capital is so structured that he does not lose control over the assets of the firm as that is not the purpose with which he made the investment. At any point in time the value of the firm is based on the future returns stated in present terms. At any point in time, this value can be shared between holders of debt and equity. Usually the book value of the debt will represent its actual value and hence it remains quite fixed relative to the value of the firm based on the outcome of future levels of expected returns. Therefore, equity values reflect the bulk of changes in the value of the firm being the reservoir of residual risk.

Therefore, the value of equity and debt represents the total value of the firm at any point of time. The value of the firm is a dynamic concept. Given an expected value at any point of time, the quantum of debt can be decided to optimise the value of equity. As debt is cheaper, increasing levels of debt will optimise the value of the remaining equity to a point.

Depending on the industry in which investments are made, and the overall level of returns in the market, equityholders will also expect a minimum return. It is this point that will optimise the value of equity. This is also subject to the all important issue of cash flows being able to service the debt and equity while at the same time being the final arbiter of the firm's value.

The volatility in the firm's value will determine the variations in the value of equity that can occur. After optimising the value of equity we will have to provide sufficient risk capital to account for and absorb the volatility of the firm's value to the level where we are comfortable that the firm will not fall into the hands of debtors. This level of confidence will determine the quantum of risk capital that will be required.

The risk capital has to earn returns superior to the returns being decided for equity based on the market and industry. To put it briefly, the quantum of risk capital will decide the level of returns for the balance equity so as to give returns on overall equity, including risk capital, to justify the market valuation of the same based on the firm's or industry's beta.

Hence, risk capital has to be the buffer to absorb adverse movements in the firm's value to give the risk bearer the desired level of confidence that he will not be at the mercy of debtors or in threat of loss to his assets. The size of the risk capital also affects the return to and the valuation of equity.

Therefore, if risks are better managed, the risk capital requirement will be lower and capital allocation will be efficient. Having adequate risk capital, as translated into the right capital structure to handle risk, will not only result in returns commensurate with risk but also in a level of financing that does not endanger the existence of the firm now or in the future. This leads to a much safer business and financial environment.

It is clear from the above that the quotient of the right capital structure at any point of time can be determined. Not that this will always exist but it is something that we have to work towards. This is now being discovered and specified by a business software developed for the purpose by FCG India, known as Business View, and is tracked by a capital correctness quotient named as RiskCapIndex.

A DYNAMIC WORLD

What has been stressed throughout this note is that the value of the firm is a dynamic measure that reflects the perceived future at any point of time. Hence the right capital structure is also dynamic. It is a value towards which a firm needs to keep making adjustments and alter strategy periodically so that it gets nearer to achieving the objective. It is also clear and acknowledged that in the real world such movements and adjustments are not always smooth and easy.

It is a target that we have to move towards to make ourselves a safer and more attractive investment, getting the optimum returns for our stakeholders. It is also a tool that on an equal basis decides how well a firm manages its risks as compared to the other players and pro-actively manages and protects the interests of stakeholders.

The author works in the field of financial risk management and is currently the managing director of FCG India Pvt. Ltd.

(This article appeared in the July 2002 issue of Indian Management magazine)