Constantin Gurdgiev

Lecture 1: Overview of Financial

Management and Environment
Part 5: Cost of Capital in a VUCA Environment
Contents

§ Summary Parts 1 - 4

§ Part 5. Cost of Capital in a Risky / VUCA Environment

§ Part 6. Risk and Returns

2
Introduction

Summary of Part 1

§ Balance Sheet view of the firm

– VUCA-rich environment

Current Assets + Fixed Assets =

= Current Liabilities + Long Term Debt + Shareholders' Equity

3
Theory of the Firm

Summary of Part 2

§ Risk-Minimization Theory of the Firm: firm minimizes risks associated with pre-set level of profit
or return; risks that arise from agency problems and informational asymmetries
– Demand is uncertain, while supply is controlled by the firm

§ Theory of the Firm under Uncertainty: firm minimizes uncertainty associated with execution of
core strategic objectives of the firm
– Risk-averse firm & risk-averse investors face asymmetric information between managers and
capital providers, which leads to the firm’s capital view based on bankruptcy risk/uncertainty
– The individual is not viewed as capable of having a known/definable probability distribution
function over a set of possible outcomes, but a firm is

§ As a consequence there are 2 types of contracts within a firm:

– Contracts used for organizing (coordinating) production activity
– Contracts used for transferring income over time and across unforeseen events

4
Risk & VUCA

Summary of Part 3

§ All markets and markets

participants are subject to VUCA
environment
– Volatile, Uncertain, Complex &
Ambiguous

– Risk is formally measured by statistical measures of volatility (variance, covariance,

semi-variance, semi-covariance, etc), thus
Volatility in VUCA is the concept closest to Risk
– Uncertainty is a broader concept that includes
• Events that do not allow us to assign probability to their occurring, and/or do not
permit clear assignment of the measure of magnitude of the costs/payoffs that can
arise from such events
– Complexity in the VUCA environment reflects the fact that the dynamics and
interactions of risks and uncertainties can be compounded and enhanced by complex
nature of environments in which these risks and uncertainties evolve

– Ambiguity adds another dimension to uncertainty and relates to the lack of

informational transparency in, or informational incompleteness of the markets
5
Introducing Cost of Capital

Summary of Part 4

§ Two basic capital sources:

1. Debt: direct and intermediated
2. Equity

§ VUCA Pillar 1: Key risks faced by Funders / Providers of Capital:

– Own cost of capital
– Own risks to capital supply (liquidity)
– Maturity mismatch risk
– Currency mismatch
– Regulatory requirements & risks
– Recovery in default
– Repatriation of funds

§ Pillar 2: Key risks faced by Users of Capital

– Cost of capital (adjustable rates)
– Own risks associated with the project (cash flow risk)
– Maturity mismatch risk: maturity demanded by the project
– Currency mismatch
6
Introducing Cost of Capital

Summary of Part 4

§ An organization total cost of capital is a weighted average of different tranches of

capital raised from different sources, with weights corresponding to the share of each
type of capital in the total value of organization’s capital

§ WACC – Weighted Average Cost of Capital

(1.2)
𝑾𝑨𝑪𝑪 = 𝒘𝑬𝒒𝒖𝒊𝒕𝒚 ×𝒓𝑬𝒒𝒖𝒊𝒕𝒚 + 𝒘𝑫𝒆𝒃𝒕 ×𝒓𝑫𝒆𝒃𝒕 × 𝟏 − 𝒕
𝟏 = 𝒘𝑬𝒒𝒖𝒊𝒕𝒚 + 𝒘𝑫𝒆𝒃𝒕

7
Introducing Cost of Capital

Summary of Part 4

§ Pricing: benchmark and idiosyncratic risk premium

§ Define
– Benchmark rates for Debt and Equity as rD,Benchmark and rE,Benchmark
– Good Will weights: wGIA , wGPA , wGPO , wGWE , wBDG , wRI
– Risk premiums: rpP , rpOrg , rpLeg , rpFX , rpCov

§ Then, cost of Equity and Debt for a project starting at time t and terminating at time T (with
some simplifying assumptions) can be summarized as:

𝐶𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 𝑜𝑟 𝐷𝑒𝑏𝑡!"→$ = 𝐵𝑒𝑛𝑐ℎ𝑚𝑎𝑟𝑘 𝑅𝑎𝑡𝑒!"→(!&'))$ + 𝑆𝑢𝑚 𝑜𝑓 𝑎𝑙𝑙 𝑅𝑖𝑠𝑘 𝑃𝑟𝑒𝑚𝑖𝑎!"→$ −

𝑆𝑢𝑚 𝑜𝑓 𝑎𝑙𝑙 𝐺𝑜𝑜𝑑 𝑊𝑖𝑙𝑙 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑠!"→$ (𝑤* )
(1.3)

8
Introducing Cost of Capital

Summary of Part 4

§ Cost of Debt and YTM

– The cost of debt is the cost of debt financing to a company when it issues a bond or
takes out a bank loan or a private (peer-to-peer) loan
– Two methods to estimate the before-tax cost of debt, rd are - the yield-to-maturity
approach and debt-rating approach

• The yield to maturity (YTM) is the annual return that an investor earns on a
bond if the investor purchases the bond today and holds it until maturity
• It is the yield, rd, that equates the present value of the bond’s promised payments to
its market price
• If F = Face or Par Value, P = Bond Price, C = the semi-annual coupon interest, and
n = number of semi-annual periods left to maturity
⎛F−P ⎞
⎜ + C ⎟
⎝ n ⎠ (1.5)
semi − annual YTM =
⎛F +P⎞
⎜ ⎟
⎝ 2 ⎠
• F and C can be re-negotiable during loan life for private loans and hence pose a
source of major risk

9
Contents

§ Part 1. Introduction

§ Part 2. Theory of the Firm

§ Part 3. Risk and VUCA

§ Part 4. Introduction: Cost of Capital

§ Part 5. Cost of Capital in a Risky / VUCA Environment

§ Part 6. Risk and Returns

10
Introducing Cost of Capital

From Part 4, recall that risk enters the cost of capital:

§ Pricing: Cost of Preferred Equity based on expected dividend payouts

– The cost that a company has committed to pay preferred stockholders as a preferred
dividend (DP), when It issues preferred stock at price (PP) D
rP = P
(1.6)
PP
§ The dividend on preferred stock is not tax deductible by the company; therefore, there is no
adjustment to the cost for taxes

§ Problem is that preferred stock dividends are uncertain, volatile and can induce complex
inter-connection to ordinary dividends

§ Pricing: Cost of Common Equity (RE) is the rate of return required by shareholders

§ Key problem here is: what determines the returns expected by shareholders (residual claims)
relative to debt holders (creditors’ claims)
Cov(Ri , RM )
(
RE = RF + βi RM − RF ) for βi =
Var(RM )
(1.7)

§ This states that the expected returns on a stock, E(Ri), is the sum of the risk-free rate of
interest, RF, and a premium for bearing the stock’s market risk, bi(RM – RF)
11
Cost of Capital in a Risky / VUCA Environment

Taxonomy of Risks

§ Taxonomy of Risks and Uncertainty sources

– Two perspectives:

1. ERM (Enterprise Risk Management) framework: regulatory and strategic enterprise

functions à one way to view risk
• Risk is assessed, managed and monitored across enterprise functions and
systems
• Regulators’ main function is to ensure that risk management is fully developed
within enterprise

2. Financial markets / capital funders perspective à have a different view of risk and
expected returns
• Financial markets see risk as a ‘commodity’ for which investors get
paid/compensated
• Hence the common term is “pricing risk”

§ We can consider ERM and strategic view of risk and then use these to inform our financial
analysis
12
Cost of Capital in a Risky / VUCA Environment

Taxonomy of Risks

§ Organization level risks (‘micro’ risks or idiosyncratic)

– These are risks that are viewed from the firm-own level/perspective and they include:
• Hazard Risks and Uncertainty
• Financial Risks and Uncertainty
• Operational Risks and Uncertainty
• Strategic Risks and Uncertainty

13
Cost of Capital in a Risky / VUCA Environment

Systemic Risks

§ Systemic level risks (‘macro’ level or exogenous)

– These are risks that ser viewed from the system/industry/sector/economy/society

perspectives:
• Systemic agencies and counterparties risks and uncertainty (TBTF – Too Big To
Fail)
• Network risks and uncertainty (complexity, contagion)
• Macroeconomic risks and uncertainty (exogenous, e.g. monetary system effects on
MFIs)
• Policy and regulatory risks and uncertainty
• Sovereign and geopolitical risks and uncertainty

§ Now, let’s take a closer look at the above

14
Cost of Capital in a Risky / VUCA Environment

Enterprise Risks: Hazards

§ Hazard Risks

– Fire and other property damage

– Wind storms / sand storms, etc and other natural perils

– Theft and other crime, personal injury

– Business disruption / interruption

– Disease and disability (including work-related injuries and diseases)

– Liability claims

– War and terrorism, political

– Many are insurable, but in some cases, insurance results in overconfidence and
under-provision for internal mitigation measures
• Good example: cyber risks insurance (currently, dominant organizational response to
this type of risks)

15
Cost of Capital in a Risky / VUCA Environment

Enterprise Risks: Financials

§ Financial Risks

– Price (e.g. asset value, interest rate, commodity);

– Liquidity (e.g. cash flow, call risk, opportunity cost);
– Credit (e.g. default, downgrade);
– Inflation/purchasing power;
– Hedging/basis risk;
– Taxes, compliance costs, reporting costs, transaction taxes etc; and
– Currency fluctuations
– Other financial counterparty risks (e.g. credit downgrades to counterparties or sanctions
against counterparties, etc.)
– Some of these can be insured against (e.g. counterparty risks), other can be hedged
(e.g. currency fluctuations, credit risk and price risk)
• Some risks are non-insurable and hard to hedge (tax, regulatory etc)
• Interesting cases:
EU investigations into U.S. tech companies (Google, Facebook, Apple):
https://www.reuters.com/technology/european-regulators-crack-down-big-tech-2023-10-03/
NordStream pipeline explosions https://www.reuters.com/world/europe/qa-what-is-known-
about-nord-stream-gas-pipeline-explosions-2023-09-26/
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Cost of Capital in a Risky / VUCA Environment

Enterprise Risks: Operations

§ Operational Risks

– Business operations
• Human resources & Human Capital
• Product development, R&D, innovation
Europe: ESA 2010 treatment of R&D expenditure,
USA: changes to R&D expenditure treatment under the Tax Cuts and Jobs Act of
2017
• Capacity and utilization efficiency
• Product/service failure
• Channel management and Supply chain management (SCM) risks
• Business cyclicality and demand risks
• Complements risks (complements in production & consumption)
• Substitutes risks (substitutes in production & consumption)
• Insurable risks include HR risks, but not human capital risk, seasonality and
cyclicality
Hedging can help with seasonality and cyclicality risks

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Cost of Capital in a Risky / VUCA Environment

Enterprise Risks: Operations

§ Operational Risks

– Empowerment (e.g., leadership change, change readiness)

• Capture of Human Capital Example as Holmstrom-Tirole model extension:
http://www.tara.tcd.ie/xmlui/bitstream/handle/2262/59251/Exogenous%20Liquidity%20Supply%20
in%20Presence%20of%20Repudiation%20Risk%20and%20Private%20Asset%20Recovery.pdf;js
essionid=2B2687769304EC50AD3338AAC725AF6B?sequence=1 or http://bit.ly/2Bo7h3b

– Information technology, Information/business reporting and some cyber-security risks

• New research example:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3033950 or
http://bit.ly/2DCBdhi; less technical summary
http://blogs.lse.ac.uk/businessreview/2017/11/28/hacking-the-market-systemic-
contagion-from-cybersecurity-breaches/ or http://bit.ly/2E0Kopu

– Failure to properly document deals and transactions

• Quite common example: banks titles registry failures, e.g. INBS case
http://www.independent.ie/irish-news/missing-irish-nationwide-titles-hamper-sale-of-18bn-
in-loans-29992901.html or http://bit.ly/2BmHQ2c
• Ditto for other banks, including Anglo Irish Bank on actual loans documents

18
Cost of Capital in a Risky / VUCA Environment

Enterprise Risks: Strategic

§ Strategic Risks

– Reputational damage (e.g., trademark/brand erosion, fraud, unfavorable publicity,

sanctions, investigations etc.)
– Competition and failure to identify market trends
– Customer wants / preferences shifts (Gasoline (platinum) à diesel (gold) à gasoline
(platinum) & VW et al case impact)
– Demographic and social/cultural trends
• Retail@Google talk on demographic changes in retail sector or banking sector
http://trueeconomics.blogspot.com/2015/07/29715-retailgoogle-key-trends-on.html or
http://bit.ly/2n2oDhU
• A larger themed issue – changing preferences for democracy and liberal values:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3033949 or http://bit.ly/2eKiLFH
– Technological innovation
– Capital availability
– Regulatory and political trends
• For example: the above topic of political preferences migration, as well as privacy, security
risks etc. as in the Target big data issues, and broader:
http://www.slate.com/blogs/how_not_to_be_wrong/2014/06/09/big_data_what_s_even_cree
pier_than_target_guessing_that_you_re_pregnant.html or http://slate.me/1kV0KD5

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Cost of Capital in a Risky / VUCA Environment

Enterprise Risks: Counterparties

§ Investment Intermediaries Risks

– Main risks associated with investment flows
– Broadly speaking such risks can be grouped into two categories:
• Investment-related operational risks, and
• Pure investment risks

– Operational risks are risks associated with the investment process itself:
1) Trading Risks
2) Portfolio Management Risks
3) Systems Risks

– Investment risks are specific to market performance. These include:

1) Company-specific Risk
2) Systemic Risk
3) Economic & Political Risk
4) Corporate Governance and Regulatory Risk
5) Currency Risk
6) Correlation (Paradigm Shift) Risk
7) Index (Data Vendor) Risk
8) Portfolio Transition Risk

– All of these are relevant for financial assets investors, intermediaries & issuers
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Cost of Capital in a Risky / VUCA Environment

Conceptual Framework of Risk Management: How to?..

Risk Mapping Framework
Types of Risk

Process Steps Hazard Financial Operational Strategic

Establish Context For example: considering risks (VUCA) factors relating to a non-profit organization plan for scaling
VUCA Matrix preparation

operations and aligning these closer with for-profit partnering organizations

Identify Risks • Climate change • Loss of cost- • SCM disruptions • Inability to service
effects on crop yields management capacity key demand for
final goods

Analyze/Quantify • Likelihood = High • Likelihood = Moderate • Likelihood = High • Likelihood =

Risks • Financial cost/impact • Financial cost/impact • Financial & intan- Moderate
• Intangible • Intangible cost/impact gible cost/impact • Financial & intan-
cost/impact gible cost/impact
Assess/Prioritize • High likelihood • Moderate Likelihood • High Likelihood • Moderate
Risks • Slow rate of • Rapid rate of • Relatively fast Likelihood
evolution evolution rate of evolution • Relatively slow rate
• Distant in time • Immediate or short- • Immediate or of evolution
• High long-term term in time short-term in time • Medium- to distant
Model building

priority • Moderate impact • Moderately High in time

• Very high impact impact • Very high impact
Treat/Exploit Risks High long-term priority Moderate short-term High short-term High medium term
priority priority priority

Monitor & Review Long-term risks require semi-annual (high impact) or annual (low impact) monitoring & review;
moderately long-term risks require quarterly monitoring and semi-annual or annual reviews; short-
term risks with moderate impact require monthly monitoring and quarterly reviews; short term risks
21
with high impact require continuous monitoring and at least monthly reviews
Cost of Capital in a Risky / VUCA Environment

Risk Matrix (3x3 Simplified) No ‘symmetry’ between low

& high impact risks. Why?
Behavioural…

High

Impact Medium

Low
Can be treated as
‘Negligible’ or ‘Lowest Risk’ Low Medium High
in pure ERM
Likelihood
Legend
Negligible Risk Low Risk Moderate Risk High Risk Extreme Risk

§ So some qualifying questions:

– What should be prioritised?
– Can anything be ‘ignored’ or under-priced?
– If we take a N(*,*) distribution, can (High Impact, Low Likelihood) events be ignored?
– How about in the real world?
• In real world, the above assignments of risks are not stable over time and can migrate from
(L,L) cell to (H,H) cell – this is what we call timing (proximity) and velocity of risk
evolution
22
Cost of Capital in a Risky / VUCA Environment

Risk Prioritization across 4 dimensions

§ Risk Impact: level of

§ Likelihood of a risk damages that can occur § Proximity of risk
occurring when a risk occurs materialization
ü Very high (almost (enterprise-specific
certainty) timing) and Velocity of
ü Very High (threat to
risk evolution
ü High (likely) project / strategy /
enterprise success)
ü Medium (as likely to
ü High (substantial ü Immediate (now)
occur as not to
impact on time, ü Less than 3-6
occur)
quality and/or cost) months
ü Low (may occur ü Medium (notable ü 6-12 months
occasionally) impact) ü 12-24 months
ü Very low (unlikely to ü Low (minor impact) ü More than 24
occur) ü Very Low months
(negligible impact)

23
Cost of Capital in a Risky / VUCA Environment

More Evolved Risk Matrix (5x5)

§ More questions:
Behavioral asymmetry
– Why just 5 levels for each
dimension?

– How do we choose impact and

likelihood levels (1-5)?

– Can impacts be properly ranked?

• Continuous impacts vs discrete

• What’s the problem with failing to

distinguish?

– Where are the true / deeper

unknowns?

– How do we minimize adverse

effects of behavioral biases on our
prioritization?

24
Cost of Capital in a Risky / VUCA Environment

Evolved Risk Matrix: Still Discrete

§ The importance of Completeness
principle of risk / VUCA mapping

– Mapping of risks / VUCA factors

needs to be complete – cover all
possible factors that are ‘material’
§ This task is significantly complicated by
the hard-to-enumerate nature of risks and
VUCA factors
§ Take for example a political contest
between two political candidates:
Candidate A and Candidate B
– Linear analysis: there can only be 3
types of voters: those who prefer A to
B, B to A, and neither
– Non-linear analysis: there can be 8
permutations of preferences
– Q: How does one map these
preferences?

25
Cost of Capital in a Risky / VUCA Environment

Continuous Model: CAPM for Risk Management

Unattainable Possible Combinations

Combinations of of Risk & Return
Risk & Return
Average annual rate of return

Standard Deviation (risk) of annual returns on investment

26
Cost of Capital in a Risky / VUCA Environment

Continuous Model: CAPM for Risk Management

Expected Value of the Return

X
X
X
X X
X X
X X

Risk Appetite
X
X

Risk – standard deviation (variability)

§ So how do we know our own risk appetite?

– How do we relate own / manager risk appetite to organizational risk appetite?
– What determines our risk appetite? Returns to taking risk? Or much more?
27
Cost of Capital in a Risky / VUCA Environment

Continuous Model: CAPM for Risk Management

Lower
tolerance Expected Value of the Return
for risk X X
investors X
X Higher
X tolerance
X X for risk
X X

Risk Appetite
X Moderate
X tolerance
for risk

Risk – standard deviation (variability)

§ Usually, we cannot exactly pin down our own ‘required return’ and ‘risk tolerance’
– Instead, we think of groups or clusters of investors, e.g. three clusters shown above
– We then match ourselves to the reference group that applies
28
Cost of Capital in a Risky / VUCA Environment

Continuous Model: CAPM for Risk Management

Expected Value of the Return

X X Outlier in moderate group:
X at this combination of Risk-
X Return, an investor is
X actually much closer to the
X X low risk tolerance group
X X than to moderate group.
So is this investor mis-
assigned to the moderate
group or is there intrinsic

Risk Appetite
ambiguity in groups
X identification?
X
Overlap between two group
types à ambiguity

Risk – standard deviation (variability)

§ Conceptually, outliers are of interest
– Why do these occur?
– How can these be sustained/attained over time (as opposed to once)?
– If these are our peers, how do their decisions fit our strategic planning and analysis?
29
Cost of Capital in a Risky / VUCA Environment

Questions

§ Discussion: Consider the following article:

https://www.forbes.com/sites/arielcohen/2020/11/17/goldman-sachs-renewable-power-will-
become-the-largest-area-of-spending-in-the-energy-industry-in-2021/?sh=33a4a74563eb
§ The author makes a claim that “spending for renewable power projects will become the
largest area of energy spending in 2021, surpassing upstream oil and gas for the first time in
history”. And “main driver of this trend, cited by Goldman Sachs is the diverging costs of
capital. Hurdle rates – a measure of risk akin to weighted average cost of capital (WACC) –
for today’s fossil fuel projects are calculated around 10-20% whereas renewables are in a
much safer 3-5% range, and money likes to go where risk is lowest. These numbers are
consistent in the European Union and the United States.”
§ In addition, as “the oil and gas sector in the United States now faces a grim reality of
austerity and belt-tightening, the capital costs of renewable-sourced power projects have
dropped significantly between 2010-2019 – a trend which is expected to continue.”
§ In part, the decline in capital costs of renewables is down to multiple channels of fiscal
supports, ranging from Government directly investing in projects to accelerated regulatory
subsidies and contrasting tighter regulatory permitting processes for fossil fuels.
§ In 2022-2025 we are likely to witness central banks’ changing their monetary policies to
tighten interest rates, raising the base rate for WACC for all energy producers.
§ Q: Do you expect monetary policy tightening to further increase WACC-type incentives for
renewable energy producers compared to fossil fuels producers? Explain your answer.

30
Cost of Capital in a Risky / VUCA Environment

Current / News Flow

§ On the subject of systemic and strategic risks, see my recent talk on the three systemic risks
in the global economy

– Three Horsemen 2023 Talking Notes.pdf (with speaking notes)

– Three Horsemen 2023 Talking.pdf (slides alone)

31
Contents

§ Summary Parts 1 - 4

§ Part 5. Cost of Capital in a Risky / VUCA Environment

§ Next-up:
– Part 6. Risk and Returns

32