Risky Cash Flows Research Articles

Projects with no cost of capital

AbstractIt is generally accepted that any project has an appropriate cost of capital reflecting its riskiness and that this cost of capital can be employed to calculate the project's net present value (NPV). Consequently, any future cashflow with a positive expected value has some positive present value. We show that this is not generally true. A risky cashflow with a positive expected value may have a negative present value if the cashflow is correlated with market returns. Thus, there are many realistic projects for which no cost of capital exists. We suggest a simple test to screen out such projects.

Save It for a Rainy Day: Evidence from State Corporate Income Tax Rate Changes

ABSTRACT We examine the effect of state corporate income tax rate changes on firms’ liquidity management. Using a difference-in-differences design, we find that firms hold more cash when they are experiencing an increase in state corporate income tax rate. More specifically, on average, a 1 percent increase in state corporate income tax rate leads to a 2.51 percent increase in firms’ average cash holdings. We also find that the effect is stronger in firms with low and risky cash flows, more growth opportunities, and more financial constraints. We find no evidence of this relationship when the state corporate income tax rate decreases. Overall, these findings suggest that firms conserve more cash to mitigate tax-induced frictions, which is consistent with the precautionary motive of cash holdings. Our paper speaks to policymakers that the increase of state income tax rate has real effects on firms’ cash holdings. Data Availability: All data used in this study are from publicly available sources. JEL Classifications: H25; H710; M41; G33.

Optimal Investment and Financing Decisions Under Cost Uncertainty

In this paper, we employ the real options approach to study the impact of cost uncertainty on a firm’s optimal investment and financing decisions. The firm owns a perpetual right to an irreversible investment project, and the firm’s goal is to determine the optimal investment timing and level of coupon payments when the investment cost jumps upward at a random time. We find that the optimal investment threshold and level of coupon payments decrease with the jump intensity and the magnitude of the jump. The cost uncertainty gives the firm a stronger incentive to accept projects with risky cash flows. Furthermore, we examine the conflict of interests between the share- and bond-holders. We show that the debt overhang distortion and the asset substitution incentive decrease with the cost uncertainty. However, the effect of cost uncertainty on the incentive of asset substitution reverses in the region of low operating profits

Debt Maturity and the Dynamics of Leverage

Abstract This paper shows that short debt maturities commit equityholders to leverage reductions when refinancing expiring debt in low-profitability states. However, shorter maturities lead to higher transaction costs since larger amounts of expiring debt need to be refinanced. We show that this trade-off between higher expected transaction costs against the commitment to reduce leverage in low-profitability states motivates an optimal maturity structure of corporate debt. Since firms with high costs of financial distress and risky cash flows benefit most from committing to leverage reductions, they have a stronger motive to issue short-term debt. Evidence supports the model’s predictions.

The Bond, Equity, and Real Estate Term Structures

We construct a Stochastic Discount Factor (SDF) that prices bond, equity, and real estate portfolios sorted on cash flow duration. Using this SDF and the dynamics of cash flow yields in these three asset classes, we estimate the bond, equity, and real estate term structures monthly from 1974 to 2019. We find that while (nominally) safe and risky cash flows have risk premia term structures that are upward sloping on average and move together over time, the term structure dynamics are fundamentally different after we remove the safe component of the risky cash flows. Specifically, equity and real estate maturity-matched risk premia, on average, increase over short maturities but decline over long maturities. Moreover, their term structures comove positively with each other but negatively with the bond term structure.

Term structure of discount rates for firms in the insurance industry

There is strong evidence in the literature for the hypothesis that interest rates and the market risk premium are not constant during the business cycle. The beta risk of firms in the insurance industry is also time-varying. The major implication of these results is that discount rates for risky cash flows are time varying and must obey a term structure similar to the term structure of interest rates. The purpose of this paper is to estimate discount rates for cash flows with different time horizons for the U.S. insurance industry and for different insurance sectors. We find that the term structure cost of capital takes on different shapes depending on the business cycle. It is therefore meaningful for insurers to evaluate risky projects by selecting a discount rate most appropriate for the nature and the time horizon of each project.

On the use of the terminal-value approach in risk-value models

We extend risk-value models for valuing streams of risky cash flows by establishing the well-known concept of terminal value in this context. For a constant growth assumption we are able to derive upper and lower bounds for the terminal value in the case of a translation-invariant and in the case of a position-invariant risk measure. For both cases we also obtain an exact formula under a special growth assumption for the future cash flows. Furthermore, we provide results on the applicability of the general findings for the case that the log-return of the risky investment follows a Brownian motion.

Consistency between principal and agent with differing time horizons: Computing incentives under risk

Abstract In a parsimonious model, we analyze how to obtain consistent incentives when both principal and agent are risk-averse and when a setting prevails in which the agent may have a shorter time horizon than the principal. Intertemporal dependencies in risky cash flows are taken into account. Building on the fundamental results produced by Rogerson (Journal of Political Economy 105(4):770–795, 1997) and Reichelstein (Review of Accounting Studies 2(2):157–180, 1997), we establish a new risk allocation scheme, which enables consistent incentives to be achieved. Thereby, we demonstrate that the resulting performance measures correspond to an affine transformation of previous and current residual incomes or, alternatively, cash flows in such a way that information asymmetry between principal and agent is still possible. The risk allocation technique developed may prove useful in other contexts.

Disaster on the horizon: The price effect of sea level rise

Homes exposed to sea level rise (SLR) sell for approximately 7% less than observably equivalent unexposed properties equidistant from the beach. This discount has grown over time and is driven by sophisticated buyers and communities worried about global warming. Consistent with causal identification of long-horizon SLR costs, we find no relation between SLR exposure and rental rates and a 4% discount among properties not projected to be flooded for almost a century. Our findings contribute to the literature on the pricing of long-run risky cash flows and provide insights for optimal climate change policy.

The Influence of Stephen A. Ross: Reflections of an Empirical Finance Economist

This article describes the influence of Stephen A. Ross on research and practice in empirical asset pricing. Written by a doctoral student of Professor Ross, this article reviews his work on arbitrage pricing theory, the discounting of risky cash flows, option pricing, the term structure of interest rates, and the relationship between financial econometrics and portfolio analysis.

Valuing streams of risky cashflows with risk-value models

Based on risk-value models, we introduce a multiperiod approach to the valuation of streams of risky cashflows. The valuation is based on the (expected) value of the output's or input's magnitude and the risk of the output cashflow, as captured by a risk measure. We derive three formulas for valuing single cashflows and utilize the principles of separate valuation and of cumulating the cashflows to derive a multiperiod valuation method. In an axiomatic way, the paper sets out the foundations for a new approach and suggests several directions for its further development.

A Tool Kit for Discounted Cash Flow Valuation: Consistent and Inconsistent Ways to Value Risky Cash Flows

Abstract The DCF method or multiples are used to value companies in practice. Starting with the value additivity principle, the paper presents a general framework for DCF valuation. This framework allows defining stepwise and aggregated approaches to value risky cash flows and identifying inconsistent approaches. The framework helps to integrate sales, contribution margin, operating leverage, and financial leverage into valuation approaches and shows the assumptions implied when multiples are used.

Fundamental (versus Market) Risk and Capital Budgeting Decisions: Distinguishing between the Investment Hurdle Rate and the Cost of Capital

Employing a basic model of an economy comprising both the real and financial sectors, I show that the primitive risk measure for real investment decisions is earnings beta — defined as the (normalized) covariance between firm profitability (return on investment) and the aggregate profitability of all firms in the economy, not market beta. Earnings beta determines the risk premium required to convert a project’s risky cash flow to its certainty equivalent and is the basis for setting the hurdle rate for project selection. Earnings beta is also the origin of market beta for asset pricing, but the mapping of earnings beta into market beta is intervened by the profitability level of the underlying project. For a given earnings beta, a firm with higher expected profitability (hence higher market value) has a smaller market beta because investors holding the firm’s stock bear a smaller fraction of total firm risk per unit of investment capital they contribute. I show that the optimal hurdle rate for project selection which maximizes investor wealth is different from the cost of capital concerning a specific project except when the project has zero net present value. Finally, I demonstrate that the standard capital budgeting techniques prescribed in textbooks and widely adopted in practice — which are centered on the notion of market risk rather than fundamental risk — cause suboptimal decisions, and I offer remedies to correct the misvaluation problems.

Residual Inflation Risk

I decompose inflation risk into (i) a component that is correlated with factors that determine investors’ preferences and investment opportunities and real returns on real assets with risky cash flows (stocks, corporate bonds, real estate, commodities, etc.), and (ii) a residual inflation risk component. In equilibrium, only the first component earns a risk premium. Therefore, investors should avoid exposure to the residual component. All nominal bonds, including money-market accounts, have constant nominal cash flows, and thus their real returns are equally exposed to residual inflation risk. In contrast, inflation-protected bonds provide a means to avoid cash flow and residual inflation risk. Hence, every investor should put 100% of her wealth in real assets (inflation-protected bonds, stocks, corporate bonds, real estate, commodities, etc.) and finance every long/short position in nominal bonds with an equal amount of other nominal bonds or by borrowing/lending cash; that is, investors should hold a zero-investment portfolio of nominal bonds and cash. This paper was accepted by Neng Wang, finance.

A Tool Kit for Discounted Cash Flow Valuation: Consistent and Inconsistent Ways to Value Risky Cash Flows

The DCF method or multiples are used to value companies in practice. Starting with the value additivity principle, the paper presents a general framework for DCF valuation. This framework allows defining stepwise and aggregated approaches to value risky cash flows and identifying inconsistent approaches. The framework helps to integrate sales, contribution margin, operating leverage, and financial leverage into valuation approaches and shows the assumptions implied when multiples are used.

Disaster on the Horizon: The Price Effect of Sea Level Rise

Homes exposed to sea level rise (SLR) sell for approximately 7% less than observably equivalent unexposed properties equidistant from the beach. This discount has grown over time and is driven by sophisticated buyers and communities worried about global warming. Consistent with causal identification of long horizon SLR costs, we find no relation between SLR exposure and rental rates and a 4% discount among properties not projected to be flooded for almost a century. Our findings contribute to the literature on the pricing of long-run risky cash flows and provide insights for optimal climate change policy.

On Dynamic Decision Making to Meet Consumption Targets

We investigate a dynamic decision model that facilitates a target-oriented decision maker in regulating her risky consumption based on her desired target consumption level in every period in a finite planning horizon. We focus on dynamic operational decision problems of a firm where risky cash flows are being resolved over time. The firm can finance consumption by borrowing or saving to attain prescribed consumption targets over time. To evaluate the ability of the consumption in meeting respective targets, we propose the consumption shortfall risk (CSR) criterion, which has salient properties of attainment content, starvation aversion, subadditivity, and positive homogeneity. We show that if borrowing and saving are unrestricted and their interest rates are common, the optimal policy that minimizes the CSR criterion is to finance consumption at the target level for all periods except the last. For general convex dynamic decision problems, the optimal policies correspond to those that maximize an additive expected utility, in which the underlying utility functions are concave and increasing. Despite the interesting properties, this approach violates the principle of normative utility theory and we discuss the limitations of our target-oriented decision model.

Investment Incentives, Bankruptcies and Reverse Convertible Debt

The combination of risky cash flows, leverage and absolute priority rules in bankruptcy create a well known agency problem; shareholders face incentives to take risky, as opposed to value maximizing, investment projects. Recently, it has been argued that deviation from absolute priority rules in bankruptcy or workouts mitigates this problem. Working with the principle of contract theory that ex ante welfare gains can be maximized by pre-commitment (if contracts are resistant to re-negotiation), we consider efficiency gains from pre-commitment to such alternatives to absolute priority. The instrument is an inversion of convertible debt in which the conversion option is held by the owners. This instrument can be designed so that the conversion option is less costly ex post (i.e., after issue of debt) to bondholders than the default put implicitly embedded in non convertible debt. This design not only lessens the ex ante incentive problem but avoids the transaction costs of bankruptcies and workouts. Finally, we show that this form of debt is re-negotiation proof.

FVA, The Fake Debate: Why Are They Still Debating?

Funding Valuation Adjustment (FVA) has been introduced as the CVA and DVA after the default of Lehman Brother. After the subprime crisis, the basis spread was not negligible anymore, credit and liquidity risk became the first concern. In addition, regulators put in place reforms, which associate capital reserve for each of these new risks. It became natural to adjust the so called fair premium (price associated to risk neutral measure).In fact the debate is still opened, the industry is divided concerning its definition and its price adjustment status. The risk is real, academicians can argue but the fact is that default occur and occurred because of liquidity issues (in fact credit and liquidity are very linked to each other, as demonstrated in The Fear Pricing Theory: Credit and Liquidity Adjustment).In one hand, we have for non cleared trade a risk associated to unknown (risky) cashflow, in the other hand we have to answer to the margin call.We first introduce the problem and industry views, then in an objective maner we define FVA thanks to the analogy with the MLVA (Market Liquidity Valuation Adjustment) and establish the consequences of our approach in term of modeling and risks.

Outsourcing Supply Contracts, Human Capital and Firm Capital Structure

We examine the impact of outside purchase contracts on firm risk and firm capital structure. We find that firms with more outside purchase contracts have less risky cash flows. Despite these less risky cash flows, firms with these contracts also have less financial leverage especially when they operate in high value-added industries. Examining firm financing decisions, we document that firms with more outside contracts are more likely to issue private securities. Our results are consistent with firms with more outside purchase contracts using less leverage to decrease the expected costs of financial distress on their explicit and implicit contracting parties.