The strategic CFO creating value in a dynamic market

Furthermore, he is a PhD candidate at the endowned chair for corporatefinance and capital markets at the European Business School EBS, with researchfocus on corporate finance and corpora

The Strategic CFO

.

Ulrich Hommel • Michael Fabich

Ervin Schellenberg • Lutz Firnkorn

Editors

The Strategic CFO

Creating Value in a Dynamic Market Environment

Prof Dr Ulrich Hommel

EBS Universita¨t fu¨r Wirtschaft

65185 WiesbadenGermanyfabich@equitygate.de

74523 Schwa¨bisch HallGermany

firnkorn@gmx.de

ISBN 978-3-642-04348-2 e-ISBN 978-3-642-04349-9

DOI 10.1007/978-3-642-04349-9

Springer Heidelberg Dordrecht London New York

Library of Congress Control Number: 2011939762

# Springer-Verlag Berlin Heidelberg 2012

This work is subject to copyright All rights are reserved, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilm or in any other way, and storage in data banks Duplication of this publication

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Printed on acid-free paper

Springer is part of Springer Science+Business Media (www.springer.com)

The Strategic CFO: New Responsibilities and Increasing

Job Complexity 1Michael Fabich, Lutz Firnkorn, Ulrich Hommel,

and Ervin Schellenberg

and Corporate Financing

Linking Strategy to Finance and Risk-Based Capital Budgeting 9Ulrich Hommel and Mathias Gerner

Linking Strategy, Operations and Finance with Simulation-Based

Planning Processes 31Michael Rees

Risk-Return Management of the Corporate Portfolio 49Ulrich Pidun and Matthias Kru¨hler

Capturing the Strategic Flexibility of Investment Decisions

Through Real Options Analysis 69Johnathan Mun

Exposure-Based Cash-Flow-at-Risk for Value-Creating Risk

Management Under Macroeconomic Uncertainty 85Niclas Andre´n, Ha˚kan Jankensga˚rd, and Lars Oxelheim

Capital Markets 2.0 – New Requirements for the Financial

Manager? 109Holger Wohlenberg and Jan-Carl Plagge

v

Evolving Capital Markets and the Changing Role of the CFO 127Hady Farag, Frank Plaschke, and Marc Rodt

Integrated Capital Structure Management – Value Improvement

by Overcoming the Silo Approach of Financial Institutions 143Michael Fabich, Ervin Schellenberg, and Katinka Wo¨lfer

Managing Cash Flow and Control Risks of Financial

Contracting 171Petri Ma¨ntysaari

The CFO’s Information Challenge in Managing

Macroeconomic Risk 189Lars Oxelheim, Clas Wihlborg, and Marcus Thorsheim

Capacity-Adjustment Decisions and Hysteresis 211Benoıˆt Chevalier-Roignant and Arnd Huchzermeier

Linking Strategy to the Real World: Working Toward Risk

Based Supply Chain Optimization 227Wilhelm K Kross

Dealing with Recent Challenges in Cash Flow Management:

Commodity Volatility and Competitive Pressure 249Lutz Firnkorn, Arno Gerken, Sven Heiligtag, Konrad Richter,

and Uwe Stegemann

How Climate Change Impacts the Role of the CFO 265Thomas Ru¨schen and Markus Eckey

Capturing the Impact of Market Dynamics on Firm Value

for Service-Driven Enterprises 285Diem Ho

Creating Corporate Value with the Exposure to Financial

Innovations: The Case of Interest Rates 295Marcus Schulmerich

Authors Biography

Niclas Andre´n is an associate professor of the Department of Business tration, Lund University School of Economics and Management, Lund, Sweden Heholds a PhD in business administration Niclas Andre´n is the Director of the masterprogram in Corporate and Financial Management and former Director of the masterprogram in Finance, both at Lund University He has extensive teaching experiencewithin corporate finance, esp in corporate risk management, valuation, and financialrestructurings He has specialized in interactive and applied teaching pedagogics,not least case-based teaching His research interests are corporate risk management,behavioral corporate finance, and asset pricing

Adminis-Per-Olof Bjuggren has a Master of Political Science from Lund University andtook his PhD in Economics at Lund University in 1986 The PhD thesis is aboutvertical integration in the Swedish pulp and paper industry A new theoreticalparadigm, the transaction cost approach, is used It is one of first studies that usethis approach empirically In 1994 he was appointed associate professor of Eco-nomics at Linko¨ping University Since July 1995 he is Associate Professor ofEconomics at Jo¨nko¨ping International Business School His own research includesstudies in the fields of industrial organization, law and economics and corporategovernance He has published articles in journals such as the International Review

of Law and Economics, Small Business Economics, Geneva Papers of Risk andInsurance and Family Business Review Several articles have also been published

in refereed international books He has together with Arne M Andersson and OlleOhlsson published industrial organization textbooks (in Swedish)

Dr Benoıˆt Chevalier-Roignant graduated in business administration from YON Business School and WHU – Otto Beisheim School of Management inSeptember 2007 and subsequently joined the Munich office of L.E.K Consulting,

EML-a globEML-al consulting firm with focus on privEML-ate equity EML-advisory services From 2009

to 2011, he completed a doctorate at the Department of Production Management at

vii

WHU under the supervision of Arnd Huchzermeier, PhD and Lenos Trigeorgis,DBA In September 2011, he joined the University of Texas at Dallas as postdoc-toral fellow under the supervision of Dr Alain Bensoussan His research deals withapplication of stochastic control theory and differential games to the analysis of realoptions in competitive settings Benoıˆt co-authored Competitive Strategy withLenos Trigeorgis (forthcoming at the MIT Press) and has published in leadingacademic journals such as theEuropean Journal of Operational Research.

Dr Diem Ho is manager of University Relations for IBM Europe Middle East andAfrica He is in charge of research collaborations, skill development, and technologyaccess with/for the academic community and driving higher education reforms tomeet industry needs and societal challenges in a service dominant economy Diemhas held many different positions in IBM, from research, consulting to manage-ment He has successfully led management consulting engagements at more than

16 leading European banks and financial services companies throughout Europe

He was elected to the IBM Academy of Technology in 1995 He is an associateeditor of the Journal ofComputational Economics and has been guest editor for anumber of journal special issues Dr Ho is also a member of the peer review teamsfor the EFMD-EQUIS and EPAS accreditation programmes (European Foundationfor Management Development – European Quality Improvement System andProgramme Accreditation System) and a member of the EPAS committee and hasinvolved in a number industry group initiatives such as the Career Space Consor-tium (ICT skills and new University curricula for the 21st Century Economy) andthe European Learning Industry Group (ELIG) He’s supervised PhD candidatesand published widely in Engineering, Physics, Mathematics, Remote Sensing,Image Processing, Optimization, Finance and Business Intelligence He is also afrequent invited contributor to the OECD and UNESCO conferences and publica-tions Diem obtained 2 M.S degrees and a Ph.D degree from Stanford University,California

Dr Markus Eckey is a Vice President in Deutsche Bank´s Global Credit Tradingdivision where he originates and executes structured asset finance transactions.Before, he worked in Deutsche Bank´s Corporate Development department focus-sing on principal M&A transactions and strategy-related projects Prior to joiningDeutsche Bank, Markus worked in the Investment Banking Division of Goldman,Sachs & Co., specialising in M&A and IPO transactions across a variety ofindustries Markus holds a diploma in Business Administration from the University

of Mannheim and a Ph.D from the European Business School (ebs)

Michael Fabich is co-Founder and Managing Partner of EquityGate Advisors GmbH

in Wiesbaden (Germany) With over 25 years of professional experience, Michael heads EquityGate’s corporate finance team He has previously been Head of theGerman investmentbanking division of Salomon Smith Barney (Citigroup), Member

co-of the Board at Salomon Brothers AG in Frankfurt, and Member co-of the Global andEuropean Investmentbanking Committees Previously he was Co-Head of M&A

Germany at Dresdner Kleinwort Benson Michael founded and headed Schro¨derMu¨nchmeyer Hengst Corporate Finance GmbH Before setting up EquityGate, hewas Chairman of the German Advisory Board of Duke Street Capital in London.Michael graduated from the University of Applied Sciences in Mainz, and is aMember of the Advisory Board of the Strategic Finance Institute (SFI) at EuropeanBusiness School (EBS) International University.

Dr Hady Farag is a Principal in the Frankfurt office of The Boston ConsultingGroup (BCG) He is a core member of the Corporate Development practice area andthe Corporate Finance Task Force He has supported clients across a wide variety ofindustries and geographies, including Europe, Southeast Asia, and South America,focussing on capital market and M&A-related projects Prior to joining BCG, Dr.Farag served as researcher and later Head of University Development at theEuropean Business School (EBS), where he earned a doctorate degree in businessadministration He also holds master-level degrees from both EBS and the Joseph

M Katz Graduate School of Business (University of Pittsburgh)

Lutz Firnkorn is a Project Manager in McKinsey & Company’s Frankfurt office,where he focuses predominantly on risk management for European financial insti-tution Furthermore, he is a PhD candidate at the endowned chair for corporatefinance and capital markets at the European Business School (EBS), with researchfocus on corporate finance and corporate risk management Lutz Firnkorn holds aMasters degree (Diplom Grande Ecole) from the ESCP-EAP in Paris

Mathias Gerner is a Research Assistant and Doctoral Candidate at EuropeanBusiness School (EBS) International University in Germany In addition, he was

a Visiting Scholar at The University of Texas at Austin (UT) during the summer

2009 He completed his studies in Industrial Engineering at The University ofKarlsruhe (TH) including a semester abroad at the Mathematics and StatisticsDepartment at the Herriot-Watt University of Edinburgh Between 2006 and 2008

he successfully finished the Management Trainee Program (SGP) of the Siemens

AG, Sector Energy His main research areas are commodity risk management,energy prices and derivatives

Dr Arno Gerken is a Director in McKinsey & Company’s Frankfurt Office, and isleading McKinsey’s Global Risk Management Practice out of Europe Dr ArnoGerken has vaste experience in risk management for financial institutions as well asfor corporates Dr Arno Gerken holds a diploma in national economics, withmajors in game theory, micro theory, and statistics and received his PhD from theUniversity of Bonn, Germany, on credit portfolio modeling

Dr Sven Heiligtag is a Principal in McKinsey & Company´s Hamburg Office and

a member of both the Transportation & Logistics as well as the Risk ManagementPractice He has significant experience in advising clients on corporate finance,strategy, organizational and marketing/sales topics Dr Sven Heiligtag has a

Masters degree in Chemistry from the University of Hamburg, a Ph.D in istry from the University of Hamburg and the Cancer Research Center of Hawaii.Prof Ulrich Hommel PhD is a Full Professor of Finance and heads the EndowedChair of Corporate Finance & Capital Markets at European Business School (EBS).Ulrich Hommel holds a Ph.D in Economics from the University of Michigan, AnnArbor, and has completed his habilitation in Business Administration at the WHU,Germany He was an Assistant Professor of Finance at the WHU from 1994 to 1999and has subsequently joined the faculty of the EBS He is the Director of theStrategic Finance Institute at the EBS In the past, Ulrich Hommel has held visitingappointments at the Stephen M Ross School of Business (University of Michigan),the Krannert School of Management (Purdue University) and the Bordeaux Busi-ness School His main research interests are corporate risk management, venturecapital & private equity, family business finance and corporate restructuring UlrichHommel has been Academic Dean of the Faculty at the EBS from 2000 to 2002 andhas subsequently held the position of Rector and Managing Director from 2003 to

Biochem-2006 Since 2007, he is also an Associate Director of Quality Services at theEuropean Foundation for Management Development (EFMD) in Brussels and, asone of the Directors, is responsible for the EFMD Programme Accreditation System(EPAS)

Prof Dr Arnd Huchzermeier chairs the Production Management Department andthe Center for Collaborative Commerce (CCC) of WHU – Otto Beisheim School ofManagement in Vallendar In 1986, he received a masters degree in businessadministration as well as computer science and operations research from theKarlsruhe Institute of Technology (KIT) In 1991, he received a Ph.D degree inOperations Management from the Wharton School of the University of Pennsylvania,

Manufacturing & Service Operations Management, Marketing Science and tions Research Since 2007, he is Member of the Board of ECR Europe’s Interna-tional Commerce Institute; Belgium, and Executive Editor of the InternationalCommerce Review: ECR Journal In 2000, he was awarded the Mercurius Award

Opera-by Fedis, the European Federation of Distribution Societies, Belgium In 2002, he

Research and Management Science/INFORMS, U.S.A In 2003, he won both theISMS Practice Prize from the Marketing Science Institute, U.S.A and the Manage-ment Science Strategic Innovation Prize from the European Associations of Opera-

Case Award from the European Case Clearing House, U.K., in the category

‘Production and Operations Management’ Since 1995, he acts as Academic tor of the German industry competition ‘Best Factory/Industrial Excellence Award’(jointly with the business journal Wirtschaftswoche and INSEAD, France) In

Direc-2009, he co-founded the car sharing company Mobility Now

Ha˚kan Jankensga˚rd is a PhD candidate at School of Economics and Management,Lund University His dissertation consists of a collection of essays about corporaterisk management Previously he has worked for Norsk Hydro ASA, Oslo, Norway,implementing their strategic risk management programme Currently he is manag-ing partner in HedgeCorp AS, Copenhagen, Denmark, specializing in developingstandardized products for financial planning and risk-adjusted forecasts to supportcorporate decision-making.

Dr Wilhelm K Kross is an internationally recognized expert in the fields

of applied risk and project management, and the immediate Past President ofthe PMI Frankfurt Chapter A post-graduate engineer with an Exec MBA and

a doctorate degree in finance, and co-author of more than four dozen publicationsand two books on risk management, Wilhelm gained hands-on experience whileworking on initiatives in more than 40 countries across the globe Formerly a SeniorVice President of Marsh GmbH, responsible for the functions of CFO and COO ofthe risk consulting subsidiary in Germany and Austria; previously the Head ofManagement Consulting of Value & Risk AG; and with more than 10 years ofearlier working experience in various managerial functions in Africa and Canada;Wilhelm’s main engagements since starting his own business have consisted ofdesigning and implementing risk management systems, mega-project (re-) struc-turing and financing, and interim management in major turn-around and crisismanagement situations

Dr Matthias Kru¨hler is a Project Leader and member of the Corporate ment practice area at the Boston consulting group in Hamburg His project work andresearch is focused on corporate strategy, portfolio management, the role of the centerand post merger integration Matthias Kru¨hler has studied business administration

Develop-at Albert-Ludurigs-University Develop-at Freiberg and Westfa¨lische Wilhelms-University Develop-atMu¨nster, and moreover holds a PhD in business administration from the TechnicalUniversity of Freiberg His dissertation focuses on parenting advantage and valuecreation in corporate conglomerates and private equity firms

Prof Petri Ma¨ntysaari PhD is Professor of Commercial Law at Hanken School ofEconomics in Finland He is a graduate of the University of Helsinki (M.Jur., 1988),the University of Bristol (LLM, 1989), and Hanken (PhD, 1998) Prior to coming toHanken in 1996, he practised law in Helsinki and was a visitor at Max-Planck-Institut fu¨r ausla¨ndisches und internationales Privatrecht in Hamburg (1992–1994).Professor Ma¨ntysaari’s main research interests are in corporate finance law, the law

of corporate governance, commercial contract law, and electricity law

Dr Johnathan Mun is Chairman and CEO of Real Options Valuation, Inc.(a software, training and consulting firm in Silicon Valley, focusing on advancedrisk analytics, risk simulation, stochastic forecasting, portfolio optimization, strate-gic real options analysis, and general business modeling analytics) He has authored

12 books used by multinationals and universities around the world, and created 12

software applications in risk analysis, risk simulation, strategic real options, ness statistics, and general decsion analytic tools (www.realoptionsvaluation.com).

busi-He holds a PhD in finance and economics (Lehigh University), an MBA in businessadministration, an MS in management science, and a BS in biophysics, and holdsother financial charters and certifications in risk and financial analysis (CRM, FRM,CFC, MIFC)

Prof Lars Oxelheim holds a Chair in International Business and Finance at theLund Institute of Economic Research, Lund University and is affiliated with theResearch Institute of Industrial Economics (IFN), Stockholm, and with the FudanUniversity, Shanghai Dr Lars Oxelheim is chairman of the Swedish Network forEuropean Studies in Economics and Business (SNEE) He has authored or editedsome 35 research monographs and authored or co-authored a number of researcharticles published in international business, finance, and economic journals Hisrecent research monographs include Corporate decision-making with macroeco-nomic uncertainty (Oxford University Press), Markets and Compensation forExecutives in Europe (Emerald Group Publishing), National Tax Policy in Europe– To Be or Not to Be (Springer Verlag), Corporate and Institutional Transparencyfor Economic Growth in Europe (Elsevier), How unified is the European Union?(Springer Verlag), European Union and the Race for Inward FDI in Europe (Else-vier) and Money Markets and Politics – A Study of European Financial Integrationand Monetary Policy Options (Edgar Elgar) Lars Oxelheim is a frequently invitedkey-note speaker and adviser to corporations and government agencies

Dr Ulrich Pidun is an Associate Director Corporate Development at The BostonConsulting Group in Frankfurt His project work and research is focused oncorporate strategy development, corporate portfolio management, value-basedmanagement, and strategic risk management Ulrich Pidun has studied chemistryand mathematics in Marburg and London and holds a PhD in Theoretical Chemistryand an MBA from INSEAD, Fontainebleau He is also a visiting professor forstrategic management at the Technical University of Freiberg

Jan-Carl Plagge After graduating in business administration from the University

of Muenster with a M.Sc degree in 2006, Jan-Carl Plagge joined the Issuer Data &Analytics team at Deutsche Boerse His work is focused on the development ofinternational- and strategy index concepts serving as underlying for structuredproducts In 2010 Jan-Carl Plagge joined the index provider STOXX Ltd.Since

2009, he is an External Doctoral Candidate at the European Business School (EBS)International University in Oestrich-Winkel/Wiesbaden (Germany)

Dr Frank Plaschke is a Partner and Managing Director in the Munich office ofThe Boston Consulting Group (BCG) He joined BCG in 1997 and worked for BCGHong Kong in 1999/2000 He is a member of BCG’s worldwide leadership team

in the Corporate Development practice area Dr Plaschke is the global topic leader

for “Office of the CFO”, which comprises topics around finance excellence andorganization, value management and incentive systems, monitoring and reporting,planning and capital allocation, risk management, as well as capital marketsand investor strategy He also co-authors BCG’s annual Value Creators Report.

Dr Plaschke was awarded his master degree in business administration from theUniversity of Bayreuth, and his PhD in business administration from the University

of Dresden and the Schmalenbach award in 2002

Dr Michael Rees is currently an independent consultant with over 20 yearsexperience in strategy formulation, business analysis, financial analysis and riskmodelling He has previously worked as a Partner at Mercer Management Consult-ing, as a Vice-President at J.P Morgan, and – as a retained consultant – as Director

of Training and Consulting at Palisade Corporation.Michael has a Doctorate inMathematical Modelling and Numerical Algorithms from Oxford University, anMBA from INSEAD, and has studied for the Certificate of Quantitative Finance,graduating top of the course and also receiving the highest final exam mark He isalso the author of Financial Modelling in Practice (John Wiley & Sons, 2008).Hiscurrent professional focus is on providing model-building, training and associatedproject management services to support the decision- and communication-needs ofsenior executives; more information about Michael and his services is available atwww.michaelrees.co.uk

Dr Konrad Richter is a Senior Expert in McKinsey & Company’s Vienna office,and is dedicated member of the Risk Practice Dr Konrad Richters work focusespredominantly on risk management topics for European financial institutions aswell as for leading utility and telecommunication firms Dr Konrad Richter holds adiploma in Physics from the Vienna University and a PhD in economics from theUniversity of Kiel

Dr Marc Rodt is a Principal in the Munich office of The Boston Consulting Group(BCG) He is a core member of the Corporate Development practice area and theCorporate Finance Task Force His work focuses on corporate finance topicsranging from M&A and IPO support to finance organization and corporate processes.Previously, Dr Rodt studied business administration at Ludwigs-Maximilians-Universita¨t Munich and earned a doctorate in business administration in financefrom Ludwigs-Maximilians-Universita¨t Munich

Dr Thomas Ru¨schen completed his business studies in Mannheim and Frankfurtbefore joining Deutsche Bank in 1990 in the field of European financial markets AsSenior Relationship Manager in London he was responsible for corporate accounts

in continental Europe and then became Country Manager for Italy From 2003 tillFebruary 2011 he headed the department Asset Finance & Leasing, a product groupwithin Deutsche Bank’s Corporate and Investment Bank Division, responsible forthe financing of long-term economic commodities worldwide, e.g in the area ofrenewable energies He is currently globally responsible for Key Account

Management within DWS Investment GmbH, the mutual fund subsidiary ofDeutsche Bank Group In addition, he is responsible for Distribution in Europe aswell as for DWS Access, DWS’ closed-end fund business for illiquid assets He is amember of the executive committee of DWS and is also responsible for coordinat-ing DWS’ overall strategy around sustainable and climate change related invest-ments In this capacity he is also a member of the ESC Environmental SteeringCommittee of Deutsche Bank Group Furthermore, he is Member of the Group ofFounders of Dii GmbH, the Industrial Initiative of DESERTEC.

Ervin Schellenberg is co-Founder and Managing Partner of EquityGate AdvisorsGmbH in Wiesbaden (Germany), with over 20 years of professional experienceinvestment banking and private equity Ervin leads EquityGate’s equity advisoryteam and co-heads corporate finance He has previously been Member of the Boardand Head of DACH at Duke Street Capital, an alternative investment firm inLondon He joined from Salomon Smith Barney (Citigroup), London, where hewas Director in the European industrial investmentbanking group and the leader ofthe automotive investmentbanking team in Europe Before, Ervin worked forDresdner Kleinwort Benson, Frankfurt, in the structured finance and M&A depart-ment As a graduate from Goethe University in Frankfurt, Ervin regularly publishes

on recent topics in corporate finance and capital markets, lectures at EuropeanBusiness School (EBS) and Hochschule RheinMain, holds seminars, and is regu-larly invited to speak at finance conferences

Dr Marcus Schulmerich is a Vice President with State Street Global AdvisorsGmbH (SSgA), Munich, and as a Senior Product Engineer responsible for Europe,Middle East and Africa He heads a team of product specialists covering all quantitativeequity strategies in the Enhanced and Active space as well as Hedge Fund and AbsoluteReturn strategies Before joining SSgA he was a product specialist with PIMCO inLondon and Munich for many years, responsible for actively managed fixed incomeand commodity portfolios Dr Schulmerich started his career with ADIG Investment as

a Financial Engineer and Risk Manager He has worked with SSgA since 2006 and haseleven years of work experience Dr Schulmerich holds a Masters degree in Mathe-matics and an MBA (M.I.T Sloan School of Management) Since 2005 he is a guestlecturer in Finance at the European Business School (EBS) in Wiesbaden / Germanyand at the University of Applied Sciences in Munich where he regularly gives lectures

in Financial Engineering, Derivatives as well as Portfolio and Risk Management.Besides his professional and academic work Dr Schulmerich publishes on equityportfolio management, interest rate modelling and real options valuation

Dr Uwe Stegemann is a Director in McKinsey & Company’s Cologne Office He

is leading McKinsey’s German Risk Management Practice Dr Uwe Stegeman haslong lasting experience in risk management for financial institutions and corporates

Dr Uwe Stegemann studied business administration and economics at the sity of Cologne, and received his PhD from the European Business School (EBS)

Marcus Thorsheim holds a M.Sc degree in business and economics with aspecialization in corporate and financial management from Lund University School

of Economics and Management He is currently a researcher at the Institute ofEconomic Research at Lund University and coordinator of the Swedish Network forEuropean Studies in Economics and Business His research interest are risk man-agement, capital structure and financial reporting standards

Dr Holger Wohlenberg became Managing Director of Deutsche Boerse in July

2004 He is responsible for the exchanges Market Data & Analytics business.Holger joined from Deutsche Bank where he headed Technology InvestmentBanking.He began his career at McKinsey & Company, where he was focused onadvising technology, network and media clients He was elected Partner in 1997.Holger received a PhD degree in Business Administration, major in Informationand Communication Economics, from the University of Munich.Holger Wohlen-berg is chairman of Stoxx Ltd., Market News International Inc., Infobolsa S.A andholds a board seat in Indexium AG

Katinka Wo¨lfer is a Doctoral Candidate at the Strategic Finance Institute (SFI) atEuropean Business School (EBS) International University in Oestrich-Winkel/Wiesbaden (Germany) She received a diploma in business from the Justus LiebigUniversity in Giessen and the University of Kentucky, and graduated with an MBAfrom the University of Wisconsin-Milwaukee In recognition of high scholasticachievements, Katinka was selected for membership in Beta Gamma Sigma, theinternational honor society for collegiate schools of business Her main researchinterests include corporate capital structure management and mid-cap financing.Katinka is also a Junior Analyst at EquityGate Advisors GmbH in Wiesbaden(Germany)

Prof Clas Wihlborg holds the Fletcher Jones Chair of International Business atChapman University, California Dr Wihlborg is author, co-authors, and editor ofsome 20 books and numerous articles in the areas of risk management, internationalfinance and financial institutions He serves on the editorial board of several journalsand he is a member of the European shadow Financial Regulatory Committee

.

The Strategic CFO: New Responsibilities

and Increasing Job Complexity

Michael Fabich, Lutz Firnkorn, Ulrich Hommel, and Ervin Schellenberg

The role of Chief Financial Officers (CFOs) has evolved significantly in recentyears They are no longer restricting themselves to managing funding availability,capital structure and financial market risk CFOs are increasingly involving them-selves in all areas of company management including strategy selection and opera-tion While industrial companies have traditionally shown great reluctance toappoint CFOs as CEOs, this appears to have become a more regular occurrence

in recent years These developments are certainly reflective of increased capitalmarket pressures to deliver satisfactory performance to shareholders and the factthat competition increasingly involves the liability side of the balance sheet as well

As CFOs see their roles evolve to what we refer to as “Strategic CFOs”, linkingfinancial policies to strategy and operations in the context of managing thecompany’s risk position assumes a central role in their task portfolio This volume

is based on the fundamental premise that managing company risk properly isthe very essence of good management Risk needs to be managed at the source,i.e the company’s investment decisions In this context, we define risk as acombination of threat and opportunity as any spread around expected outcomestend to have a “bad” as well as a “good” side

CFOs everywhere are currently facing a variety of challenges, which requiresthem to tackle their job differently going forward First, financial markets continue

to evolve and the financing toolkit keeps on changing despite (or because) of thefinancial crisis Many companies are still operating in “natural habitats” on the

M Fabich ( * ) • E Schellenberg

EquityGate Advisors GmbH, Wiesbaden, Germany

e-mail: fabich@equitygate.de ; schellenberg@equitygate.de

L Firnkorn • U Hommel

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

e-mail: lutz.firnkorn@googlemail.com ; ulrich.hommel@ebs.edu

U Hommel et al (eds.), The Strategic CFO,

DOI 10.1007/978-3-642-04349-9_1, # Springer-Verlag Berlin Heidelberg 2012 1

financing side and are not fully exploiting the benefits of ongoing financialinnovation In fact, they frequently interact with a limited set of financial inter-mediaries and are therefore guided to certain product groups by their financialadvisors Second, the financial crisis has put the management of liquidity high up

on the CFOs agenda While financial market rationing has historically been viewed

as a purely academic issue, it has achieved very practical relevance in recent yearsand companies still lack a good understanding how much liquidity should beaccumulated to prepare for turbulent times Third, shaping overall performancevolatility is an essential part of managing enterprise-wide liquidity as well as theexpectations of financial analysts and investors Volatility can be reduced as part ofrisk mitigation or can be used as a performance enhancer in the presence ofoperative flexibility (real options) The full utilization of this potential requiresCFOs to involve themselves in non-finance matters and to assume control of anexplicit process of coordinating a company’s investment and financial policies.Hence, CFOs increasingly become enablers for the strategy selection process It istherefore more than appropriate to refer to the “modern CFO” as the “StrategicCFO”

This book represents an inquiry of how the CFOs role has been evolving inrecent years and what further changes can be expected in the future It will shedlight on the CFOs novel challenges and how to cope with them from an academic

as well as a practical perspective The remainder of this volume is divided intothree parts:

• Part I focuses on the linkage between strategy and financing as well asrisk management activities The reader will be provided with state-of-the-artmethodological underpinnings for the measurement of risk and will be givenexamples and general insights how capital budgeting and (real) investmentportfolio management can be improved with a risk-enhanced view

• Part II deals with changes in the CFOs more traditional task portfolio and placesspecial emphasis on how they can put their companies in a position to benefitfrom financial market dynamics

• Part III focuses more explicitly on the interdependencies between changes in thefirm’s competitive environment and the evolution of financial markets As thescope of competition is expanding to involve the liability side of the balancesheet, CFOs need to coordinate a company’s response to financial and productmarket dynamics

and Corporate Financing

Financing and risk management, on the one hand, and corporate strategy, on theother hand, are two sides of the same coin Investment opportunities can only berealized if sufficient funding is available and, thus, a firm’s financial policy must act

as an enabler for value creation on the business side In addition, financial slack is

nowadays increasingly considered an important competitive weapon, for instance inthe context of takeover contests While risk management is still treated by many as a

‘back office’ function, its reach must include strategy selection and investment as

linkages on a conceptual level in their chapter “Linking Strategy to Finance andRisk-Based Capital Budgeting” They outline the logical steps of designing a value-based risk management regime and explain why the Cash-Flow-at-Risk (CFaR)approach is the logical methodological choice In the subsequent chapter on

“Linking Strategy, Operations and Finance with Simulation-Based Planning cesses”, Michael Rees provides a detailed treatment of risk analysis using Monte-Carlo simulations, which also serve as the conceptual underpinning of CFaR Hediscusses how a simulation approach can help firms to better understand, evaluateand manage risks and how it can be integrated into an explicit “risk-based planningprocess” Rees identifies the CFO as the natural owner of this process, whichunderlines the general argument of this volume that the “modern CFO” is a

Pro-“Strategic CFO”

The management of business uncertainty using simulation techniques is furtherdiscussed in the following two chapters.Ulrich Pidun and Matthias Kr€uhler elabo-rate in their chapter “Risk-Return Management of the Corporate Portfolio” how thesimulation approach can enable companies to make better-informed portfoliodecisions on the real investment side They propose logical steps required for theoptimization of the corporate portfolio from a risk-return perspective JohnathanMun shows in his chapter “Capturing the Strategic Flexibility of InvestmentDecisions Through Real Options Analysis” that interpreting investment opportunities

as real options is a natural extension of risk-based capital budgeting The authorprovides an overview of the different forms of optionality and illustrates theirrelevance for firm decision-making based on a large variety of industry applications.Lastly,Niclas Andre´n, Ha˚kan Jankensga˚rd, and Lars Oxelheim illustrate in theirchapter “Exposure-Based Cash-Flow-at-Risk for Value-Creating Risk ManagementUnder Macroeconomic Uncertainty” how firms can manage the impact of adversemacroeconomic developments Unlike the simulation-based approaches discussedearlier, the authors propose a regression-based approach to quantify the firm’sexposure to macroeconomic and financial market risk They explain the methodol-ogy in general terms and then illustrate its application using the case of NorskHydro

more in-depth understanding of the firm’s core business and need to keep abreast offinancial market innovation as well as regulation They increasingly see themselves

in the role of lobbyists to guide political bodies through the process of crisis-proofingfinancial markets without imposing an undue burden on non-financial firms.Holger Wohlenberg and Jan-Carl Plagge provide an overview of recent capitalmarket developments from the perspective of non-financial firms in their chapter

“Capital Markets 2.0 – New Requirements for the Financial Manager?” Theydiscuss the opportunities arising from financial market globalization, liberalizationand innovation and describe the challenges associated with financial market fragmen-tation, lacking transparency as well as regulatory changes In the next chapter on the

“Evolving Capital Markets and the Changing Role of the CFO”, Hady Farag, FrankPlaschke and Marc Rodt build on the discussion so far and provide an in-depthtreatment how the CFO’s role has changed in recent years and how thesedevelopments have impacted the CFO’s required skillset

The following three chapters of Part II provide insights on how CFOs need

to approach specific aspects of managing the firm’s finance function MichaelFabich, Ervin Schellenberg and Katinka W€olfer discuss in their chapter “IntegratedCapital Structure Management – Value Improvement by Overcoming the SiloApproach of Financial Institutions” the principles of capital structure managementfrom a theoretical as well as a practical perspective They stress the importance ofaligning corporate financing with the firm’s business activities, as both determinethe enterprise-wide risk profile jointly Based on a thorough discussion of thelimitations of the scientific capital structure literature, the authors suggest practicalapproaches of how the CFO can design a firm’s capital structure, manage itsequity value and enlarge its debt capacity.Petri M€antysaari focuses in his chapter

“Managing Cash Flow and Control Risks of Financial Contracting” on the generaldrivers of corporate financing and places particular emphasis on how governanceand contracting structure are shaping the availability of funds Lastly, LarsOxelheim, Clas Whilborg and Marcus Thorsheim explain in “The CFO’s Informa-tion Challenge in Managing Macroeconomic Risk” the importance of conditioningfinancing decisions on the macroeconomic environment as a core driver of volatil-ity facing the firm The authors propose an integrated approach linking financial,operational and strategic considerations and outline how risk management canshield the firm from detrimental changes in the macroeconomic environment

Markets

The third part of the book is dedicated to the question how the CFO can actuallyassist the firm in conducting its overall strategy in a highly volatile environment.The availability of funds plays a central role for shaping the firm’s (real) investmentand product market behavior, which in turn is influenced by market dynamics andcompetitors’ actions Given the CFO’s knowledge of the enterprise’s financing

opportunities and risk exposures, she is ideally positioned to enforce an integratedand coordinated approach to corporate financing and investment This part of thevolume will take a closer look at this issue.

Benoi^t Chevalier-Roignant and Arnd Huchzermeier show in their chapter

“Capacity-Adjustment Decisions and Hysteresis” how firms can adjust theircapacity planning in the presence of risk and operational flexibility They arguethat the real-option approach is particularly relevant when determining short-termcapacity requirements in the light of the firm’s uncertain long-term prospects Theauthors illustrate additionally how to adjust the valuation framework to account forunrecoverable initial outlays (‘hysteresis effect’) In the chapter “Linking Strategy

to the Real World: Working Toward Risk-Based Supply Chain Optimization”,Wilhelm Kross examines how supply-chain-specific risks can be managed and, inthis context, emphasizes the need to align the risk management approach with otherbusiness processes and organizational choices

Lutz Firnkorn, Arno Gerken, Sven Heiligtag, Konrad Richter and UweStegemann focus on “Dealing with Recent Challenges in Cash Flow Management:Commodity Volatility and Competitive Pressure.” They provide an overview ofhow firms can manage the short-term impact of market volatility as well as theirlonger-term dependency on competitors’ behavior in the context of strategy selec-tion and liquidity management The authors argue that short-term aspects can behandled as part of the firm’s regular hedging program or by optimizing contractswith business partners and financial stakeholders While short-term issues lendthemselves to a quantitative approach, the longer-term consequences of marketdynamics need to be addressed with a qualitative analysis of competitors’ financialviability and their ability to react to environmental changes

The remainder of Part III is devoted to a number of special topics with

“How Climate Change Impacts the Role of the CFO” They explain that climatechange, particularly CO2 emissions, can exert significant influence on a firm’soperations, reputation and, ultimately, economic performance The authors discussin-depth how the various risks associated with climate change can be identified,quantified and mitigated Furthermore, the authors explain why the CFO plays acentral role in any effort to deal with these issues pro-actively.Diem Ho argues thatservice-driven firms are special and, hence, that CFOs of those companies face avariety of unique challenges In his chapter “Capturing the Impact of MarketDynamics on Firm Value for Service-Driven Enterprises”, Ho develops a three-step approach of financing and planning and places particular emphasis on theinformation and process infrastructure needed for achieving managerial excellence

with the Exposure to Financial Innovations: The Case of Interests Rates” howinterest rate volatility impacts real option values The chapter serves as an illustra-tion that real investment decisions can be affected by financial market risk (even as

‘remote’ as interest rate risk) Schulmerich demonstrates how interest rate risk can

be incorporated into real options valuation models and uses several illustrations toexplain the practical relevance of his approach

The Strategic CFO: New Responsibilities and Increasing Job Complexity 5

Part I

Strategy-Linked Approaches to Risk Management and Corporate Financing

Linking Strategy to Finance and Risk-Based Capital Budgeting

Ulrich Hommel and Mathias Gerner

Contents

1 Introduction 10

2 Strategy-Based Risk Management and Risk-Based Capital Budgeting – Two Sides

of the Same Coin 11

3 Strategy-Based Risk Management – A Process View 13 3.1 Overview 14 3.2 Linking Investment Performance and Risk Management Objectives 18 3.3 A Comment on the Time Horizon for Corporate Risk Management 19 3.4 The Corporate Risk Map – Distinguishing Between Compensated and

Uncompensated Risks 21 3.5 Hedging Strategy Selection and Enterprise-Wide Risk Management 21

4 The Cash Flow at Risk Approach (CFaR) 22 4.1 The Relevance of Cash Flow at Risk 22 4.2 Relevant Risks, Distributional Properties and Their Aggregation 23 4.3 Managing the Internal Financing Gap 25

5 Summary 26 References 27

Abstract Today’s strategic business decisions require a thorough picture of boththe firm’s risk environment and the linkage to financial performance Thus, seniormanagement cannot pursue a silo approach and consider the company’s capitalbudgeting and risk management decision as separate and distinct activities.The purpose of this chapter is to highlight that all risk management activitiesneed to be an integral part of the overall business strategy and must be ultimatelyaligned 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

U Hommel ( * ) • M Gerner

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

e-mail: Ulrich.Hommel@ebs.edu ; Mathias.Gerner@ebs.edu

U Hommel et al (eds.), The Strategic CFO,

DOI 10.1007/978-3-642-04349-9_2, # Springer-Verlag Berlin Heidelberg 2012 9

comprehensively integrate strategic, financial and risk considerations in uniformdecision framework.

The role of risk management within non-financial firms has significantly changedover the course of the past 20 years In the late 1980s and throughout the 1990s, thejob of a firm’s risk manager was still defined as a mid-level position withinthe corporate treasury dealing predominately with insurance contracts, whereasthe treasury department itself was dealing with the firm’s interest rate and foreignexchange rate risk exposures The vast majority of practitioners interpreted riskmanagement as a form of crisis management and established the function out offear of financial losses and not because a well-defined risk management process

been implemented without actually paying attention to the suitability of these risktools for mapping the firm’s specific business environment.1While VaR may bebeneficial for financial trading departments in the context of pricing exoticderivatives and monitoring the daily trading risk, it provides only a limited benefitfor non-financial firms managing their corporate risk exposures in illiquid marketsand over long time horizons (Culp2002a)

The risk managers of the early 1990s – oftentimes having an academic ground in mathematics or physics rather than in business or economics – merelyconcentrated on the technical nature of risk management by defining probabilitydistributions or estimating time-varying correlation matrices.2However, only littleeffort has been spend on the question of how to harmonize the firm’s risk manage-ment practices with the corporate objectives such as value maximization or thestabilization of the firm’s cash flows

back-Over the past decade though, the scope of risk management has been widelyextended – beyond the sole concentration on insurance contracts and the hedging offinancial risks Nowadays, a firm’s risk management approach covers a broadselection of the potential risks a corporation faces, for instance including opera-tional risk, regulatory risk, political risk, and most recently strategic and liquidityrisk At the same time, the risk manager’s position has significantly gained in terms

of prominence Within most firms, the risk management function is nowadaysexecuted by a senior manager with the titleChief Risk Officer (CRO) and is directly

responsibilities cover the definition of risk limits and the monitoring of the various

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

risk measures with the objective to manage the overall risk position in line with thecompany’s fundamental business objectives.

This chapter will emphasize that a corporate risk management departmentshould never be considered as a stand-alone insurance function In fact, we want

to highlight that each risk management activity needs to be an integral part of thebusiness strategy and must be aligned with the firm’s financing decisions CashFlow at Risk (CFaR) is presented as a management tool enabling the firm’s topexecutives to integrate the various strategic, financial and risk aspects This meth-odology allows non-financial firms to quantitatively assess the various threats andopportunities facing a corporation occasionally, periodically or even continuously

In addition, CFaR summarizes all relevant information into a single performancemeasure, which can then be used as a basis for strategic business decisions.The structure of the chapter is as follows: Section2provides the background ofthe recent academic discussion on the integrative treatment of strategic risk man-agement activities and the firm’s financing decisions The subsequent sectionconcentrates on the design of the risk management process and its role within a

the reader to the principles of employing the CFaR technique in a risk managementcontext While our focus is on CFaR’s role as a coordination mechanism betweenrisk management and financing activities, this chapter will provide a more detailedtreatment of the quantitative techniques needed to compute the CFaR measure.Finally, Section5concludes

Budgeting – Two Sides of the Same Coin

Capital management and corporate risk management are effectively two sides of thesame coin Nevertheless, finance theory and practice have treated these two topicslargely separately in the past (Shimpi2002) The CFO was assigned the role ofmanaging the firm’s capital requirements by minimizing the cost of capital (mainlyvia the creation of an optimal mix of debt and equity funding), whereas the treasurydepartment was dealing with the firm’s risk position ex post using insurancecontracts and financial hedging instruments (mainly focusing on foreign exchange,interest rate and commodity price exposures)

However, managing risk exposures and capital availability separately comes at asignificant cost as it ignores the causal impact of risk exposures on cash flows andcost of capital (Froot et al.1994) In order to overcome the isolated treatment ofthese two issues, companies need to adopt a comprehensive decision-makingframework, which integrates the risk view into the strategy selection process andthe management of real investments It requires the application of a tool set for riskmodeling, which complements and extends standard capital budgeting techniques.Business schools commonly teach the gospel of “perfect capital markets” as part

of their basic finance curriculum, where shareholders are able to fully diversify their

Linking Strategy to Finance and Risk-Based Capital Budgeting 11

portfolio and where corporate value only depends on systematic (non-diversifiable)rather than total risk It implies that management should solely focus on market-related risks, while it can safely ignore diversifiable (idiosyncratic) risk (e.g.technical risk associated with R&D projects) The real-life business environment

is however significantly more complex with shareholders only having an plete picture of a company’s true economic prospects Company crises may giverise to financial distress and are ultimately triggered by total (rather than system-atic) risk (O’Brien2006) They also tend to generate significant deadweight costsresulting either from contracting inefficiencies between the company and itsstakeholders or from deficiencies in insolvency regulations While it may be arguedthat currency exposures largely belong to the class of diversifiable risks, theynevertheless tend to have a significant impact on the financial situation of multina-tional companies, which often goes well beyond the direct influence on cash flowsand earnings (Nocco and Stulz2007)

incom-When financing their investments, companies face the problem of whatinstruments to use to cover the necessary capital expenditures Myers and Majluf(1984) addressed this issue by developing the so-calledPecking Order Theory Ifthe firm has accumulated sufficient earnings in the past, management will initiallydeplete its cash reserves to fund new investments (e.g modernization of plant andequipment) If the cost of the investment however exceeds the firm’s existinginternal cash reserves, then the firm has to choose between different forms ofexternal financing It can turn towards debt markets and cover the capital expendi-ture gap with an intermediated bank loan or the issuance of fixed-incomeinstruments (e.g corporate bond) If the company fails to obtain the requiredfunding on the debt side, it can alternatively tap into equity markets and issuenew stock (or other forms of equity claims) Corporations most commonly preferthe first option.3However, Myers and Majluf (1984) argue that the sources of debtfinance are limited The firm’s level of credit borrowing today has a time-delayedinfluence on the availability of debt in the future Credit lenders could simplyconclude that a company with a large debt burden will rather pay off its existingoutstanding debt position than investing it in value creating projects Secondly, veryhigh debt levels are able to trigger financial distress, and can ultimately lead tobankruptcy Hence, the authors conclude that internal funds are used first, and oncethey are depleted, debt is issued, and when the firm’s debt capacity is exhausted,new equity is being raised.4

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” Lo´pez-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 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.

Thus, for the vast majority of firms the main objective of managing corporaterisks – without distinguishing between diversifiable and non-diversifiable – consists

of the reduction of potential cuts in earnings or cash flows ultimately leading to asignificant underinvestment problem An integrative management of the firm’s riskexposures and their financial implications potentially limits the probability of heavycash shortfalls

In other words, a viable corporate risk management strategy should include acomprehensive treatment of the firm’s risk environment and its implications onfinancial resources, thereby increasing the firm’s ability to achieve its strategicobjectives (Nocco and Stulz2007) Corporate strategy and corporate risk manage-ment are therefore indeed two sides of the same coin A company’s corporate riskposition needs to be analyzed in the context of a valuation framework and can bequantified using the CFaR approach Strategy selection represents the ultimatesource of corporate risk exposures and, hence, strategic decision-making must notonly take into account the expected value creation, but also its implications on thevariability of performance

The previous decade has seen the development of first-best risk managementpractices and the significant refinement of risk measurement tools – especiallywhen considering non-financial firms (Culp2002a; Shimpi2002) Applying thesemore advanced methods however requires them being embedded in a well-designedrisk management process, especially when looking at the problem from a gover-nance perspective Hence, this section explains the key generic steps of such aprocess In line with the argument developed in the previous section, the reach ofthe risk management function must explicitly cover the full range of corporatedecision-making from strategy selection to the narrow management of actual riskexposures

Traditional designs of the corporate risk management function focus oncontracted exposures and emphasize a factor-based silo approach to risk manage-ment – thereby largely ignoring the statistical interdependence between differentrisk factors In contrast, modern strategic risk management concepts adopt a moreholistic view of the firm’s essential risks, its corresponding exposures and theresulting enterprise-wide risk profile As a consequence, the firm’s executives areencouraged to utilize all available information relevant for understanding perfor-mance variability ranging from the “easily quantifiable” to the “fuzzy and vague”sources of risk

Anderson (2005) presents a strategic risk management framework for tionally active non-financial firms, which is based on the principle that seniormanagement should conduct an extensive risk review for all business units on anongoing basis Corporate executives need to concentrate on the conditions thatpermeate the firm’s external environment as well as the internal organizational

interna-Linking Strategy to Finance and Risk-Based Capital Budgeting 13

traits including productive assets, operational infrastructure, processes and humanresources By specifying all relevant risks, a firm’s internal risk awareness is beingdeveloped to observe changes in company’s business environment which maypossibly have an impact on the achievement of strategic objectives and the firm’scash-flow performance Moreover, an ongoing monitoring of the various riskfactors ensures the creation of feasible response actions before adverse events areaffecting operations Immediate action will not always be required, but constantmonitoring will develop a strategy-based risk management framework as thebackbone of corporate decision-making.

Current literature offers an overwhelming variety of ways how to structure acorporate risk management process Following Culp (2002c), four steps are essen-tial and are always included in one form or another (e.g Chapman2006) for a moredetailed exposition:

(a) Identify risk factors and determine overall risk tolerances

(b) Measure risk exposures

(c) Implement risk mitigation measures

(d) Monitor and report risk

The first critical step is the identification of all risk factors with potentialrelevance for the firm’s operations and ultimately its long-term strategic develop-ment In addition, management has to develop an explicit view on the overall risktolerances (which needs to be derived on the basis of the company’s risk manage-ment objectives) Secondly, the company needs to determine its risk exposures,which requires management to develop a view on the statistical properties of eachrisk factor and the correlation structure covering the interactions between individualexposures

Thirdly, the company must implement a risk management program consisting of

a potentially large variety of financial and operative risk mitigation actions Finally,management must evaluate the effectiveness of risk management policies coupledwith appropriate feedback loops to calibrate its overall approach By definition, riskmanagement is an ongoing process and involves continuous reflection on thepotential impact of business and market dynamics (compare Fig.1)

Following the specification of the relevant risk management motives (and thecorresponding performance metric), the starting point of any risk managementprocess must be the identification of significant risk factors that might causebusiness disruption, threaten the value of the firm’s assets and liabilities, or create

new business opportunities Typically, the essential risk factors influencing a financial firm can mainly be separated into three categories: business risks, eventrisks, and financial risks (see Fig.2) The first category contains the compensatedrisks from a shareholder value perspective These are typically associated with thecompany’s underlying business (therefore called business risks) such as

non-Fig 1 A formalized risk

management process (based

- Foreign Exchange Risk

- Interest Rate Risk

Target of Risk Mitigation (e.g Insurance)

Source of Shareholder Value (Compensated Risks)

Fig 2 Risk environment of non-financial institutions

Linking Strategy to Finance and Risk-Based Capital Budgeting 15

competition risk, demand risk, market risk, product risk, and human resource risk.The second category is related to adverse events These risks are typically managedusing insurance-type contracts such as regulatory risk, political risk, legal risk, orreputation risk Finally, the last category represents financial market risks such asforeign exchange risk, interest rate risk, commodity risk, and credit risk Theytypically represent non-compensated risks from the perspective of non-financialfirms Every investment can be interpreted as a portfolio of compensated and non-compensated risk exposures While the firm would clearly prefer to eliminate allnon-compensated exposures, many of those are in practice non-hedgeable or non-insurable, thereby, complicating the task of managing corporate risk exposuresconsiderably Risk management must further take into account to what extent riskexposures are endogenous rather than exogenous in nature.

Once the relevant risk factors are identified, the firm needs to set acceptabletolerance levels There are basically two alternatives for expressing risk tolerances,either in absolute or in relative terms The absolute value approach allows theevaluation of all corporate-wide defined exposures in terms of a maximum loss andthe frequencies of their occurrence (Culp2002c) Value-at-Risk (VaR) represents awell-known technique in this context, primarily applied in the financial industry.The non-financial counterpart measures are Earnings-at-Risk (EaR) or Cash-

non-financial companies feel uncomfortable or are not able to quantify and gate all of their risk exposures They tend to set tolerance levels in relative terms byfor instance grouping risks into high/medium/low categories according to probabil-ity of occurrence and likely impact While the absolute approach explicitly fosters

aggre-an enterprise-wide approach, using the relative approach resembles already bydesign the far less appropriate silo approach

The techniques and possibilities of measuring risks are manifold Nominal sure measures only consider a static view and simply indicate how much capital is

expo-at risk considering a specific risk factor More sophisticexpo-ated methods such assensitivity or scenario analysis are able illustrate the development of certain riskexposures in several pre-defined business environments Probabilistic techniquesbased on Monte Carlo simulations represent the most advanced approach as thistool incorporates a dynamic view on the effect of a specific risk exposure over time(the concepts of VaR and CFaR fall into this category)

By evaluating risk exposures with the performance metric chosen by the firm, aperformance shortfall can be determined, which must be addressed with riskmitigation measures While the effectiveness of risk management needs to be

evaluated using a top-down view with aggregate exposures in focus, risk mitigationmust deal with specific risk exposures The firm can typically choose from aconsiderable range of instruments Currency exposures can for instance be managedwith financial derivatives, financing choices, business contracting, target marketselection, sourcing decisions, geographical plant allocations and other operativemeasures Some of these instruments offer short-term benefits in the context ofmanaging transaction exposures, while others are better suited to manage longer-term operative exposures Some buffer away exposures temporarily, while otherseliminate exposures completely Some may reduce exposures outright; others are

develop a natural habitat approach by focusing on a limited set of instruments –

an approach potentially leading to sub-optimal outcomes

Risk monitoring and reporting are ongoing activities to track the effectiveness

of risk management policies and to re-calibrate the overall system in response

to the arrival of new information The length of the monitoring intervals willvary depending on the specific nature of the firm’s business activities and thetypes of risks being tracked While financial risks should probably be managed

on a daily or even intra-days basis, operative activities based on long-term deliverycontracts or on large (discrete) orders lend themselves to a more lax approach (Culp

2002c) Hence, one key challenge facing senior management is to synchronizedifferent monitoring cycles within the company

A strategy-based risk management (SRM) approach then concatenates the step risk process presented with the firm’s strategic and financing activities Thisprocedure allows the incorporation of the numerous interactions among alldecisions involved In other words, the SRM framework aligns the on-goinganalytical risk management process to the strategic management process with theobjective to ensure the firm’s future financial stability leading to a superior strategicposition of the company (compare Fig.3)

Evaluate Risks EvaluateRisks MonitorRisks

Strategic Analysis

(SWOT)

Business Planning (Strategic Plan)

Strategic Control (Balanced Scorecard)

Strategic Management Process Risk Management Process

Fig 3 A strategy-based risk management process (based on Andersen 2005 )

Linking Strategy to Finance and Risk-Based Capital Budgeting 17

On the one hand, the analysis of the corporate risk environment enables seniormanagement to prepare the company for unexpected events, and allows the decisionmakers to generate an internal awareness for the identified risk exposures On theother hand, the strategic management process provides a broad selection of man-agement tools – such as the SWOT analysis or the balanced scorecard – tacklingstrategic and financing decisions (Simons2000) Consequently, the implementation

of the SRM framework fosters the development and initiation of activities shieldingthe company against potential threats.5

Objectives

The bulk of theoretical and empirical studies in the area of corporate risk ment have focused on the questions “Why does a firm hedge?” and “Does riskmanagement increases firm value?” The literature has identified a significant range

manage-of plausible explanations that risk management is indeed able to increase firm valueeven after considering the costs associated with the establishment of the riskmanagement function

arguments of how risk management can actually assist firms to stabilize or evenincrease their expected cash flows or earnings (Culp2002a; Hommel2005,2009):(a) Smooth corporate earnings over time leading to a reduction of the firm’s taxexpenses when facing a concave tax curve

(b) Mitigate financial distress cost caused by a sudden breakdown of cash-flows orearnings, or by an abrupt shortfall in the value of assets below the firm liabilities(c) Decrease agency costs resulting from potential conflicts between the manage-ment, shareholders and corporate creditors

(d) Optimize the level of managerial risk aversion – usually leading to conservativeproject decisions protecting the firm’s income with the objective to secure theexisting job position – via incentives

(e) Reduce the corporate underinvestment problem commonly arising from ticipated depletions of the cash reserves when the firm is confronted withexternal financing costs that are high enough to outweigh the benefits of newinvestment projects

unan-In a nutshell, a well-developed corporate risk management program goes beyondsoftening the firm’s fluctuations of reported earnings or minimizing the variance ofthe corporate cash flows As for instance pointed out by Froot et al (1993), the main

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).

contribution of corporate risk management consists in enabling firms to carry outkey investments even in times of adverse market movements.

Hence, risk management grants decision-makers important degrees of freedom

on the “asset” side of the balance sheet by building in financial slack on the

“liability” side This view is consistent with the observation that competitivestrength is nowadays just as much defined by the availability of funds as it is byputting the right assets in place Maintaining a minimum level of cash flow willenable firms to maintain their operations with effectively less equity – hence, riskmanagement may serve as cost-effective substitute By implication, even wellcapitalized companies will benefit from risk management as they may just as easilysuffer from rationing by financial markets As will be discussed subsequently, theCash-Flow-at-Risk approach represents the natural choice of technique to ensurethat companies will generate a sufficient number of funds through their operationswith a certain level of statistical significance

Management

So far we have just concentrated on the procedural view of risk management and itslinkage to corporate financing decisions We now attempt to shed some light on therelationship between risk exposures and time As companies start to deal withexposures of longer maturities, they face the problem of rising spreads

In this context, senior management needs to carefully evaluate the potentialimpact of the various risk factors on future cash flows with respect to different timehorizons Typically, any risks arising from price fluctuations in the financial marketare being analyzed with a short-term focus assessing their potential effects on thefirm’s transaction exposures The handling of these short-term financial risks istypically straightforward, e.g by employing financial derivatives

Figure4illustrates the effect of an increasing hedging horizon on risk spreadsusing the example of a EUR/USD exchange rate simulation over the time span of

12 months The upper and lower boundaries combined indicate the widening rangesfor a 90% two-sided confidence interval This phenomenon is commonly referred to

as the “cone of uncertainty” It explains why companies have a tendency of adopting

a short-term focus when managing financial risks They can be more easily mapped

to performance-related exposures and can also be managed with more precision andlower costs In this context, it is therefore not very surprising that many firms limittheir (explicit) risk management activities to a 1-year horizon (Stulz2008)

As the hedging horizon is extended, companies need to switch to operativehedging instruments (which, by definition, are more resource intensive) In practicecompanies show typically great reluctance to commit today’s resources to manage alonger-term risk issue given that changes in the underlying market conditions may

Linking Strategy to Finance and Risk-Based Capital Budgeting 19

put into question whether the exposures will ever materialize.6 They may alsosimply struggle with the fact that derivative-based hedges (as for instance in thecontext of managing EUR/USD swings) are ultimately expiring while the level-changes in financial prices may still persist.

More precisely, the use of financial instruments to hedge and manage price andmarket exposures is most suitable for specific settings in the near future They areless effective as a universal hedging tool for all time horizons.7Andersen (2005) forinstance argues that it is not sensible to trade short-term interest rate futuresand medium-term interest rate swaps in an effort to modify the duration gap ofthe firm’s equity position, which reflects the value effects on long-term assets andliabilities It is actually more appropriate to alter the maturity structure of balancesheet positions directly Mid-and long-term risk exposures are usually far morechallenging issues for risk management, as the magnitude of these exposures isgenerally difficult to quantify with adequate precision In order to devote sufficientattention to these exposures, the firm needs to establish effective responsive actionsreflective of its corporate resources and the operational business environment itoperates in (Andersen2005)

Nov 00 Dez 00 Jan 01 Feb 01 Mrz 01 Apr 01 Mai 01 Jun 01 Jul 01 Aug 01 Sep 01 Okt 01

Two-side confidence interval (90%)

5 out of 10,000 simulated paths

of currency exchange rates

in the planning horizon

Fig 4 Two sided confidence interval Five out of 10,000 simulated paths are visualized to show the change of the currency exchange rate for a 12-months hedging horizon from Nov 2000–Nov.

2001 (Wiedemann and Hager 2003 )

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 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.

3.4 The Corporate Risk Map – Distinguishing Between

Compensated and Uncompensated Risks

The corporate risk map consists of risks, which are the source of corporate value(compensated risks), and risks, which threaten to destroy value (uncompensatedrisks) It is the task of risk management to focus, above all, on the latter category.Given that the firm’s risk capacity is limited overall, applying risk mitigation torisks outside of the firm’s sphere of core competencies will create scope of addingcompensated risks to the investment portfolio (Hommel2005; Nance et al.1993;Schrand and Unal1998; Tufano1998) Applying this principle implies that the firmshould engage in selective risk management by hedging away only certain types ofexposures (e.g financial market risks for non-financial firms)

Management

The shortcomings of managing risk exposures separately on the basis of a so-called

“silo” approach have received increasing attention during the last decade Theadvantages of a more holistic risk management based on an explicit effort to capture

a company’s aggregate risk profile are obvious Consequently, concepts such asIntegrated Risk Management (IRM) or Enterprise-Wide Risk Management (ERM)have garnered increasing support in the literature (Doherty2000; Harrington et al

represents a prerequisite for aligning the company’s financing decisions with theshareholder value maximization objective Laux (2005) provides an overview overthe four main aspects and advantages of ERM from the firm’s perspective:(a) The integration of various risk management factors and responsibilities within afirm leads to a shift from an isolated view on each individual risk towards anevaluation of the company’s collective net risk exposure

(b) The holistic treatment of risk management, financing and operating decision iscrucial for estimating the relevant net exposure and for developing alternativeways to pursue a potential multitude of (competing or at least related) riskmanagement objectives

(c) The integration of various risk management techniques provides the opportunityfor designing a more efficient way to transfer the risks to third parties

(d) The simultaneous handling of risk management and managerial incentiveproblems potentially reduces agency costs (e.g incentive problems betweenheadquarters and division managers or between equity holders and the seniormanagement)

As will be discussed in the subsequent section, CFaR/EaR represent logicalmethodological choices for company-wide risk management They generate a

Linking Strategy to Finance and Risk-Based Capital Budgeting 21

single risk measure, which can be employed for embedding ERM into a

Capturing the statistical interdependence between different risk factors is ously essential for managing corporate risk on an enterprise-wide basis Most risksare imperfectly correlated and therefore yield collectively a diversification effect.Accounting for such natural hedges reduces hedging needs, while ignoring themimplies a waste of corporate resources Estimating correlation structures howeverrepresents a daunting task in a corporate setting with managers being faced with thethreat of applying ad-hoc reasoning and producing “garbage-in – garbage-out”outcomes (Hager2004; Meulbroek2002)

The well-known Value at Risk (VaR) method – initially developed by JP Morgan in

1993 – still has an ongoing impact on today’s risk measurement practice within thefinancial industry The majority of the banks and insurance companies nowadaysmanage their risk exposure applying this technique (Deloitte 2007) In addition,VaR is used by regulators to set capital adequacy requirements for financial servicefirms The triumphal development of this method can mainly be attributed to thefact that it offers the possibility of aggregating the various risk exposures into asingle measure, thereby raising the efficiency and effectiveness of risk monitoringand communication activities (Andre´n et al.2005) Section4provides an overview

of the VaR equivalent – Cash-Flow-at-Risk – for non-financial firms with a focus onits relevance, its advantages and the procedural execution (Hommel2009)

The success of the VaR methodology in the financial sector created an increasinginterest within the non-financial industry to develop an “at Risk” technique adapted

to the corporate environment Alternative principles have been engineered replacing

“value” with financial figures such as cash flows or earnings – Cash-Flow-at-Risk(CFaR) and Earnings-at-Risk (EaR) We will focus in the remainder of this chapter

on CFaR, but the arguments can be equivalently applied to corporate earnings as therelevant performance metric.8

CFaR provides – similar to VaR – an integrated view on all relevant risk factorsfacing non-financial firms and yield a single measure of the enterprise-wide (aggre-gate) risk exposures To a certain degree, the analogy between a bank’s portfolio of

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

financial assets and a non-financial firm’s portfolio of real investment projects holds

up well (Jankensga˚rd2008) While financial as well as real assets generate cashflows, real investments are however more long-term, involve more sunk costs andare far less liquid than financial assets As a consequence, the time horizon forestimating CFaR compared to VaR is remarkably different While the VaR value istypically calculated in days or weeks, the CFaR approach commonly looks at ahorizon of a quarter or a financial year While financial service firms can base theirVaR calculations on daily or even intra-day prices, non-financial firms may need torely on monthly or even quarterly data and may struggle with the fact that historicaltime series may not at all be representative of the future outlook Companies willnevertheless benefit from using CFaR in decision-making (Stein et al.2001):(a) Capital Structure Policy

The CFaR approach supports a more precise quantitative evaluation of the equity financing choice In addition, it enables corporate executives to reflect oncapital structure policy in more detail (for example the appropriate level of cashreserves or the correct magnitude of credit lines)

debt-(b) Risk Management Policy

CFaR analysis enables companies to coordinate their investment and financialstrategies and to determine the proper amount of internally generated cashflows for financing (Froot et al.1993); (Stulz1996)

(c) Managing Investors’ Expectations with respect to Earnings Volatility

In general, capital market participants such as investors or analysts are usuallyvery concerned about fluctuations in quarterly reported cash flows and earnings.Disappointing the financial markets is likely to put tremendous pressure on thefirm and its management Managing investor relations and analyst expectations

by communicating on the basis of CFaR/EaR may reinvigorate trust whenunder-delivering on market expectations

In sum, CFaR can represent a very powerful technique in a strategy-basedrisk management process Moreover, the application of this method allows non-financial firms to link risk measures with more traditional indicators of operatingand financial performance (McVay and Turner1995)

4.2 Relevant Risks, Distributional Properties and Their

Aggregation

CFaR or EaR can be calculated by either using a bottom-up or a top-down approach.The bottom-up approach (initially developed by RiskMetrics) focuses on the simu-lation of certain cash flow components and their exposure to market risks, which arethen subsequently aggregated to derive the firms overall cash flow distribution TheCFaR measure can be inferred directly from the firm-wide cash flow distribution Itrequires the analyst to include all relevant risk factors facing the firm and to alsoexplicitly account for any causal and statistical linkages between different risk

Linking Strategy to Finance and Risk-Based Capital Budgeting 23

factors and cash flow streams (see Fig.5).9Kim et al (1999) for instance concentrate

on production volumes and their exposure to exchange rates as the two main pillarsfor computing a CFaR distribution They simulate production prices and exchangerates on the basis of a variance-covariance matrix consistent with historical data inorder to calculate the conditional values of the firm’s cash flows

Bottom-up CFaR measures are typically calculated using Monte-Carlo simulations(Condamin et al.2006; Damodaran2008; Mun2004,2006a; Rees2008; Vose2008).Each risk factor is characterized by a probability distribution based on historical data.While it is comparatively straightforward to derive probability distributions forfinancial market risks, modeling business risks is generally a much more challeng-ing task due to the lack of historical data Properly defining the variance-covariancematrix often tends to be exceedingly difficult and, hence, practitioners often choose

to ignore statistical interdependencies (which is however equivalent to assuming acorrelation of zero!) Capturing non-linearities often proves to be equally challeng-ing and quickly moves practitioners beyond spreadsheet-based modeling (Hoitschand Winter2004)

A widely accepted approach in literature represents the so calledBusiness RiskModel, where the identified risk factors are being connected to the firm’s financialobjectives – commonly operationalized by corporate cash flows, earnings or the

Fig 5 An example for a bottom-up CFaR approach (Bansal and Jacobs 2009 )

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.

annual net income (McVay and Turner1995) Nevertheless, Andre´n et al (2005)argue that even this bottom-up type methodology contains a number of shortcomings.

In particular, the last two decades of academic research have shown that thefirm’s exposure to macroeconomic and market risks is so complex and multifacetedthat it is basically impossible to capture the cross-dependencies within an analyticalmodel

The top-down methodology has been developed to avoid the aforementionedshortcomings Instead of using the firm’s own historical data, cash flow data for alarge number of comparable companies is collected in order to estimate apooledcash flow distribution Clearly, the net benefit of switching to a top-down approachhinges on the quality of the peer group selection process Stein et al (2001) employthe top-down method and identify mainly four elements which have a high explan-atory power for unexpected fluctuations in cash flows (measured by EBITDA): firmsize, riskiness of industry cash flow, share price volatility, and profitability There-fore, they suggest relying on these four characteristics when selecting the set ofcomparable companies

Andre´n et al (2005) propose theexposure-based CFaR as an alternative approach,which actually represents a mixture of the top-down and bottom-up approach Theysimulate a firm-wide CFaR measure (based on the top-down approach), which is thenrelated to macroeconomic risk factors (quantified using the bottom-up approach).This method addresses the need of management to understand the underlying riskdrivers and their impact on corporate cash flows The application of a multivariateregression framework (Oxelheim and Wihlborg1997) allows the estimation of a set

of exposure coefficients offering information on how market and macroeconomic riskfactors actually influence corporate performance Consequently, the exposure-basedCFaR framework combines the favorable characteristics of both the bottom-up andthe top-down methodology providing a more comprehensive picture of the firm’soverall cash flow variability.10

Once quantified, companies can adopt various strategies for managing the internalfinancing gap with financial operative means The most obvious approach is toreconfigure real investments so that earnings or cash flow targets are actually reached.CFOs can adopt a variety of complementary financial strategies to support theseefforts A few examples of recently invented products are:

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 Jankensga˚rd ( 2008 ) uses the bottom-up approach

to derive a CFaR measure for Norsk Hydro ASA, an integrated aluminum company headquartered

in Oslo, Norway.

Linking Strategy to Finance and Risk-Based Capital Budgeting 25

• Total Return Swaps (TRS) allow firms to move the risk together with the return

of a certain asset in exchange for a predefined fixed commission calculated onthe basis of expected revenues from that asset Thus, a TRS can be seen as afinancing transaction equivalent to the disposal of an asset (Culp2002b)

• Equitized derivative products allow firms to contract conditional equity bysecuring an equity infusion in specific market environments, while avoidingthe typical transaction costs of a new equity issue.11

• Integrated Risk Management (IRM) products represent multi-line risk transfersolutions supporting corporations to manage their enterprise-wide risk manage-ment strategy They offer the opportunity to cover a certain bundle of risks withthe same aggregate limits and deductibles Due to the fact that losses due tosingle risk factors are commonly not perfectly correlated to each other (i.e.production, exchange rate and fire risks), the total costs of acquiring such abundled risk management solution should in principle be less than the sum ofinsurance fees when purchasing individual coverage for different risks(Meulbroek2002)

corporation to concatenate strategic risk management and financing decisions.They exhibit similar features asKnock-in Put Options on equity or debt, wherethe firm as the owner is able to exercise the option in cases where a specific lossdue to a predefined risk exposure has materialized As a consequence, contingentcapital enables a corporation to raise additional capital during difficult times.12

The quality of the firm’s risk management policy critically depends on whether thesenior executives in charge – primarily CRO or CFO – are able to foster a riskmanagement culture deeply ingrained in the corporate organization Its scope mustextend to all core management functions and must reach from headquarters to near-market operational units Strategy-based risk management should ultimately act as

an enabler for the availability of funds to invest in value-increasing projects (inparticular those critical for the firm’s competitive positioning and those potentiallyrepresenting game-changing investment opportunities)

In this context, the CFaR methodology provides a quantitative framework todetect potential financing gaps and to assess the effectiveness of risk mitigationactions CFaR fosters an enterprise-wide approach to risk management and, hence,

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 Culp ( 2002a ) provides an illustrative example of a Contingent Capital contract offered by Swiss

Re to the French tire manufacturer Michelin.