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The Strategic CFO pp 9–29Cite as

Linking Strategy to Finance and Risk-Based Capital Budgeting

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Abstract

Today’s strategic business decisions require a thorough picture of both the firm’s risk environment and the linkage to financial performance. Thus, senior management cannot pursue a silo approach and consider the company’s capital budgeting and risk management decision as separate and distinct activities. The purpose of this chapter is to highlight that all risk management activities need to be an integral part of the overall business strategy and must be ultimately aligned with the firm’s financing decisions. We present Cash Flow at Risk (CFaR) as a powerful and versatile management tool enabling the firm’s top executives to comprehensively integrate strategic, financial and risk considerations in uniform decision framework.

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Notes

  1. 1.

    Bessis (2010), Duffie and Pan (1997), Gregoriou (2009), Holton (2003), Jorion (2007), and Saita (2007) provide a more in-depth overview of the VaR methodology.

  2. 2.

    A discussion about time-varying correlation matrices is provided by Engle (2009).

  3. 3.

    Hovakimian et al. (2001) provide evidence that “profitable firms are more likely to issue debt rather than equity and are more likely to repurchase equity rather than retire debt”. López-Gracia and Sogorb-Mira (2008) empirically confirm the pecking order theory showing that internal resources represent the main source of financing for small and medium enterprises.

  4. 4.

    In case a corporation issues new equity, this activity could potentially signal to the market that the stock is overvalued from the firm’s perspective. Hovakimian et al. (2004) empirically strengthen this argument showing that during periods of high stock returns the probability of equity issuance increases.

  5. 5.

    However, the application of a strategy-based risk management approach is still not common practice in today’s business world (see Deloitte (2007); Andersen (2005) for further reference).

  6. 6.

    An incorrect application of financial derivatives to manage longer-term exposures may even lead to significant losses jeopardizing the firm’s financial stability (Mello and Parsons 1995).

  7. 7.

    The trading of financial instruments – such as futures, options, or swaps – for instance becomes also a very costly risk management strategy if applied to mid-and long-term exposures.

  8. 8.

    In general, EaR tends to be used more frequently by practitioners, whereas CFaR represents the more valuable measure from an economic perspective.

  9. 9.

    The CFaR measure can be calculated as the maximum shortfall of net cash generated, relative to a specified target that could be experienced due to the impact of market risk on a specified set of exposures, for a specified reporting period and confidence level.

  10. 10.

    There exist a few contributions applying the CFaR technique to certain companies and industries. LaGattuta et al. (2000) present a top-down approach evaluating the changing risk environment for the U.S. electricity industry. Jankensgård (2008) uses the bottom-up approach to derive a CFaR measure for Norsk Hydro ASA, an integrated aluminum company headquartered in Oslo, Norway.

  11. 11.

    “Equity risk transfer products effectively provide what amount to options on paid-in capital – that is, the firm receives the funds only in specific circumstances, such as the decline of the LIBOR below the fixed rate in a pay floating/receive fixed swap” (Culp 2002a).

  12. 12.

    Culp (2002a) provides an illustrative example of a Contingent Capital contract offered by Swiss Re to the French tire manufacturer Michelin.

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Authors and Affiliations

  1. Strategic Finance Institute (SFI), EBS Business School, Wiesbaden, Germany

    Ulrich Hommel & Mathias Gerner (Research Assistant)

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  1. Ulrich Hommel
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  2. Mathias Gerner
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Correspondence to Ulrich Hommel .

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Editors and Affiliations

  1. und Recht i. Gr., EBS Business School, EBS Universität für Wirtschaft, Gustav-Stresemann-Ring 3, Wiesbaden, 65189, Germany

    Ulrich Hommel

  2. EquityGate Advisors GmbH, Mainzer Str. 19, Wiesbaden, 65185, Germany

    Michael Fabich

  3. EquityGate Advisors GmbH, Mainzer Str. 19, Wiesbaden, 65185, Germany

    Ervin Schellenberg

  4. Ackeranlagen 7, Schwäbisch Hall, 74523, Germany

    Lutz Firnkorn

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Hommel, U., Gerner, M. (2011). Linking Strategy to Finance and Risk-Based Capital Budgeting. In: Hommel, U., Fabich, M., Schellenberg, E., Firnkorn, L. (eds) The Strategic CFO. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-04349-9_2

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  • DOI: https://doi.org/10.1007/978-3-642-04349-9_2

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