RSS FeedBy M. Isi Eromosele
A firm should maximize its shareholders’ wealth by targeting an A agencies rating. Equity capital provides a financial buffer that absorbs adverse shocks, forestalling a company’s default. For any company, a probability of default corresponds to the level of equity capital. As such, as the company chooses a specific level of equity capital, it selects its possibility of default. A company with an A rating has a probability of default of 0.16 percent during a one year period of time. To achieve that rating, a company must have enough capital to maintain its default probability at 0.16 percent. If the company defaults, all of its equity will be burnt up. As such, the probability of default provides a company with a way to determine the amount of equity to have in light of its current risk.
The probability of default is usually a complex function of a company’s individuality, including its amount of equity. A company will become bankrupt if the it’s value at the end of a fiscal year falls below a set threshold level. Subsequently, the company would need a certain amount of equity capital to forestall the probability of its value falling below the 0.16 percent threshold. If that percentage corresponds to the principal amount of the firm’s debt plus interest due, then the amount of equity capital the firm would require is an amount such that there is still a 0.16 percent chance the company value will fall by more than this amount, give the risk it is currently carrying.
It is possible for a company to go beyond a particular rating threshold. First, it should identify various scenarios that are considered expensive to the company. These components could include volatility of earnings and capital and other key risk indicators that may not materially influence ratings but affect the overall risk and ultimately, the necessary level of capital. Target probability levels should be set for these scenarios and acceptable tolerances identified. The company can then manage its volatility risk to maintain the probability of the various scenarios at the set probability levels.
At the end of this process, the company could find that its present company value volatility requires it to have an equity capital of, say $8 billion to achieve its target probability of default. It needs to be stated that reducing risk has costs. A company’s decision to reduce risk through hedging will have it incur hedging costs. If the company seeks to reduce risk through the elimination of certain projects, it gives up projected profits forecasted to result from these projects.
Equity capital also has its costs. To acquire less equity, a company could increase its leverage to benefit from that increase. A decrease in equity capital may increase the shareholder value because they would be less exposed to the possibility that the company could use its equity capital to finance poor investments. At the margins, the company has to be oblivious to choosing between decreasing risks and increasing capital. This approach to risk management would enable the company to assess the possible impact of risk of default and financial distress on projects. As project risk increases, the company would require more capital to hold up the risks. The cost for additional capital is a measure of how the project contributes to the company’s total risk.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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