A Typology of risk
There are a variety of pressures acting upon organisations in terms of risk to which they are subject, and these can be viewed as representing different dimensions of risk. In order to consider the way in which the various aspects of risk affect an organisation and its behaviour in relation to sustainability it is possible to construct a typology of these different types of risk:
As the world has become more integrated - a facet of the globalisation which we considered in the last chapter - the risk from global competition has naturally increased. Consequently both the nature of the risks and the scale of the risk have increased.
An organisation affects its environment and this includes not just the physical environment, in geophysical terms, but also the local environment through such things as pollution, noise or traffic congestion.
A firm is of course part of society and reacts with that society, both positively and negatively. Risk naturally arises from this interaction.
Much has been written17 about the relationship between a firm and its employees, which is often negative in nature. This relationship is a source of risk which is particularly significant when the relationship breaks down and litigation or industrial action ensues.
All corporate activity has financial implications. Indeed the nature of a corporation requires the undertaking of financial risk and the acceptance of the consequences. Ideally these will result in financial rewards which are commensurate with the level of risk18 undertaken but sometimes small rewards lead to a high level of exposure to risk19 . Here we will mention that good governance is one way to prevent, or at least minimise the possible consequences of this kind of risk.
Long term/short term risk
Often consequences of corporate activity become manifest in the long term and all decisions are subject to both long as well as short term risks. This is of particular significance as some of the long term risks might not be apparent20when decisions are taken and action is commenced. Some risk therefore might exist which cannot even be recognised.
The power and influence of various stakeholder groups is increasing - something to which we will return - and this might increase the level of risk brought about by conflicts of interest between shareholders and other stakeholders, or between different groups of stakeholders.
Developments take place for all corporations and these include product or service development and mechanisms for delivery. We will return to this later as this is very significant for our consideration of sustainability, at this point however we must recognise that developments have associated risks.
Once risk has been identified then it is possible to develop appropriate strategies to manage it. Risk management is an important topic for a business in its own right. In fact it is a topic which is of increasing importance in the current economic climate. But it is a topic which is too specialist for this book. Here we will focus upon the relationship between risk and governance. Consequently we are considering primarily financial risk.
Risk analysis: the cost of capital
Components of the cost of capital
The level of risk for a company - or rather the level of risk that it is perceived to be exposed to - determines the cost of capital. And the lower the level of risk then the lower the cost of capital, and so the cost of borrowing is lowered. This is obviously beneficial for the company.
Understanding how to calculate the cost of capital is important for understanding its impact upon risk. It is also important for the measurement of performance of the company as many techniques measure performance against the cost of capital. There are primarily two sources - share capital and debt. The cost of capital for a firm is therefore made up of these two elements:
o the cost of share capital
o the cost of debt
The weighted average of these gives the cost of capital for a company, known as the weighted average cost of capital - the WACC.
Of course the actual calculation of the cost of capital is considerably more complex than this and the managers of many companies spend considerable periods of time in trying to arrive at an accurate calculation of the cost of capital of the company. This is because so many strategic decisions for the company depend upon the NPV21 calculations, and these in turn depend upon a cost of capital being applied. Different costs of capital will result in different NPV calculations, and therefore different decisions being made. Thus the calculation of the cost of capital is a crucial part of decision making.
This calculation is of particular difficulty for shares, which have no fixed rate of return but rather a fluctuating return based upon results. Nevertheless this fluctuating return is based upon share price, which is determined by market expectations. In general terms the financial return on the use of capital can be expected to increase as risk increases. We have however to define the precise relationship between risk and return.
The Capital Asset Pricing Model (CAPM) is used to describe an explicit relationship between the degree of uncertainty in income flow for a financial investment and the level of return, and therefore helps to explain how discount rates are established and how shares can be valued.
The CAPM divides a shares' risk into two parts: systematic and unsystematic. Systematic risk refers to the extent to which share returns vary when the returns on the market as a whole change; it is measured by beta. A share with a beta of 1 tends to rise by 10% for a 10% rise in the market index; a share with a beta of 2 tends to rise by 20% when the returns to the market rise by 10 %. In other words shares of companies with higher betas are more volatile.
The systematic risk element for a firm is determined by risk factors common to all firms to a greater or less extent - for example such things as changes in GDP or in exchange rates. No firm is entirely unaffected by changes in these variables and as a result the prices of nearly all shares tend to move together - they are generally positively correlated.
Unsystematic risk is that portion of total risk which is unique to a firm (or possibly an industry); examples include the quality of management, equipment failure, or new inventions. Because this type of risk is specific to the firm it is possible to reduce the variability of an investors' returns by choosing not to place all funds in one company. That is, the investor diversifies with the expectation that if one or two shares in the portfolio are doing badly this is compensated for by the good performance of others. In a fully diversified22 portfolio unsystematic risks cancel each other out.
This can be illustrated in figure 7.3 where the amount of unsystematic risk reduces as the number of individual types of share in the portfolio increases:
Figure 7.3 Risk and Diversification
A major implication of the CAPM is that investors will not be rewarded for bearing unsystematic risk, since they are able to diversify this risk away. Imagine that you are an investor who is undiversified and you require a return of between 30% and 40% p.a. on shares before you invest to compensate for the variability of returns caused by unsystematic and systematic risk.
You will not find such a share because there are plenty of fully diversified investors willing to buy shares which yield significantly less than 30-40% and so the share prices would never be low enough for you to invest and obtain your target rate of return. Investors continue to bid up the price of shares until only systematic risk is rewarded.
Once unsystematic risk is eliminated the risk of an individual share is measured not as the standard deviation of return of that share but as the volatility of the share relative to the market as a whole i.e. its beta. Using this definition of risk all securities plot along a security market line relating return and systematic risk.
Figure 7.4 The risk premium calculation