VOLUME 20 | NUMBER 4 | FALL 2008 Journal of APPLIED CORPORATE FINANCE A MORGAN STANLEY PUBLICATION In This Issue: Honoring Stewart Myers The Contributions of Stewart Myers to the Theory 8 Franklin Allen, University of Pennsylvania, Sudipto and Practice of Corporate Finance Bhattacharya, London School of Economics, Raghuram Rajan, University of Chicago, and Antoinette Schoar, MIT MIT Roundtable on Corporate Risk Management 20 Panelists: Judy Lewent, Merck; Donald Lessard and Andrew Lo, MIT; and Lakshmi Shyam-Sunder, International Finance Corporation. Moderated by Robert Merton, Harvard Business School. Risk Management Failures: What Are They and When Do They Happen? 39 René Stulz, Ohio State University Brealey, Myers, and Allen on Valuation, Capital Structure, and Agency Issues 49 Richard A. Brealey, London Business School, Stewart C. Myers, MIT, and Franklin Allen, University of Pennsylvania Brealey, Myers, and Allen on Real Options 58 Richard A. Brealey, London Business School, Stewart C. Myers, MIT, and Franklin Allen, University of Pennsylvania Equity Issues and the Disappearing Rights Offer Phenomenon 72 B. Espen Eckbo, Dartmouth College Can Companies Use Hedging Programs to Profit from the Market? 86 Tim R. Adam, Humboldt University, and Chitru S. Fernando, Evidence from Gold Producers University of Oklahoma Corporate Leverage and Specialized Investments by Customers and Suppliers 98 Jayant R. Kale, Georgia State University, and Husayn Shahrur, Bentley College Estimating Risk-Adjusted Costs of Financial Distress 105 Heitor Almeida, University of Illinois at Urbana-Champaign, and Thomas Philippon, New York University MIT Roundtable on Corporate Risk Management Endicott House | Dedham, Massachusetts | September 6, 2008 Photographs by Yvonne Gunner 20 Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Fall 2008 ROUNDTABLE Robert Merton: Good morning, I’m Bob private equity, or any of our derivatives is not only that uncertainty and risk have Merton, and I want to welcome you all markets. important effects on value, but that cor- to this discussion. Our topic is corporate Now, there are some interesting porate risk management can be used to risk management, with perhaps a look at parallels between today’s financial envi- increase the values of industrial companies the implications for the current financial ronment and the early 1970s, when Stew as well as financial institutions. How do crisis. And I’d like to start by saying a few and I and some of our colleagues were they do that? At the risk of front-running things that might help set the stage for our looking at the effects of risk on security our panelists, let me just throw out the four panelists, who are all very interesting values. And, with hindsight, it now seems idea that, by offering firms and institu- and accomplished people. clear why the innovations in derivatives tions protection against risks they have When we think about risk and risk and risk management started in the no comparative advantage in taking, risk management, everybody says it’s very 1970s—and not, say, in the 1960s or the management helps them expand their important. When a firm or an institution 1950s. It was the need, or demand, for risk-taking in those areas where they do goes down, a lot of people lose their jobs, these new instruments that gave rise to have a competitive advantage. Used in this assets change hands, and a lot of franchise them. The demand I’m talking about way, risk management becomes a critical value can be destroyed in the process. So came from the fact that, in the 1970s, part of corporate strategy. risk management is important in the sense we saw double-digit inflation and interest Now, let me take a moment to intro- of protecting on the downside. But there’s rates in the U.S. for the first time. We also duce each of our panelists—though I don’t also a common perception that risk man- had a huge oil price shock—and we had think any of them really needs an intro- agement has very little to do with creating the breakdown of Bretton Woods, which duction, certainly not to this audience. growth and value—that you’ll never get to meant that all the currencies started to Lakshmi Shyam-Sunder is Direc- the Fortune 100 just by having good risk float. The result of all this was unprec- tor, Corporate Risk at the International management. And I think that’s a serious edented volatility in virtually all financial Finance Corporation, which is viewed misunderstanding of what risk manage- markets. And the effect of such volatility as the “private sector arm” of the World ment is really all about. and uncertainty on corporate values was Bank Group. Lakshmi is leading IFC’s Since this discussion is part of a confer- pretty dramatic: During the 18 months new Client Risk Advisory function whose ence on finance honoring Stew Myers, I from the beginning of 1973 until August mission is to anticipate and cushion the think it’s important to keep in mind that of ’74, the U.S. stock market lost roughly effects of the current crisis on projects in if uncertainty and risk were not a major half its value in inflation-adjusted terms. emerging markets. She also serves as IFC part of this branch of economics, you That’s probably the largest decline for representative on the boards of some client could teach the entire finance course in an that short a period that we’ve ever expe- institutions. After joining IFC in 1994, afternoon. Valuation would come down rienced, even if you go back to the Great Lakshmi worked in a variety of positions to nothing more than the time value of Depression. in treasury and portfolio before becom- money. You wouldn’t need any valuation The good news, though, is that this ing Director of Risk Management and models or financial instruments, and you period of turmoil in our markets provided Financial Policy. Before joining IFC she wouldn’t have to worry about incentives or the stimulus for important advances in was on the finance faculties of the MIT information costs or any of the other main the theory and practice of financial risk Sloan School and Dartmouth’s Tuck concerns that now inform our theory of management. And there were equally School—and, during that time, consulted corporate finance. But, as I think most of important developments in the field of on valuation and risk management for us understand—and if you didn’t see this corporate finance, including Stew Myers’s U.S. financial institutions and corpora- before, recent events have made it pain- work on the cost of capital, capital struc- tions, as well as institutions in emerging fully clear—risk is a major driver of value ture, and the valuation of what Stew called markets. Lakshmi holds a PhD. in finance in any financial market, whether it be the “real options.” And one of the main les- from the Sloan School, where she was a stock market, credit markets, real estate, sons underlying all this pioneering work student of Stew’s. Journal of Applied Corporate Finance • Volume 20 Number 4 A Morgan Stanley Publication • Winter 2007 21 ROUNDTABLE Judy Lewent recently retired as Execu- NASD’s Economic Advisory Board, and and ends with one listed as forthcoming tive Vice President and Chief Financial the founder of the AlphaSimplex Group, in 2008, while including papers in almost Officer of Merck. Judy became the com- a quantitative investment management every year during this 44-year period. Even pany’s CFO, as well as a member of its company. more remarkable is the number of these Executive Committee, as far back as 1990. So, we have four people here who have papers that have turned out to provide new In 2005, after also running Merck’s Asian done a lot of thinking about and have a lot “paradigms,” new ways of thinking about operations, she assumed responsibility for of experience in managing corporate risks. and advancing our knowledge of capital corporate strategy and development as Each of them will be showing us different structure and corporate finance generally. well as worldwide finance. Judy continues aspects and dimensions of risk manage- Whether it is real options or contingent to serve on the boards of Dell, Motorola, ment, particularly the interface with claims analysis, asymmetric information, and Thermo Fisher Scientific—and is also corporate finance. And let’s get started agency costs and corporate governance, or, a trustee of the Rockefeller Family Trust, with Lakshmi Shyam-Sunder, who, as I more recently, risk capital allocation, Stew a life member of the MIT Corporation, mentioned, is director of finance and risk has shown an uncanny knack for think- and a member of the American Academy management at the IFC. ing about the implications of these new of Arts and Sciences. approaches, and how they both explain Don Lessard is the Epoch Foundation Capital Structure as Risk Management and can be used to improve the practice Professor of International Management at Strategy: The Case of IFC of corporate finance. And each time Stew the Sloan School. Risk has been a central Lakshmi Shyam-Sunder: Thanks, Bob. I’d spells out his thoughts in a paper, it seems theme in Don’s research, starting with his like to begin by thanking the organizers of to spawn a whole new field of inquiry that, work on risk management for emerging this event for the job they’ve done, and for in addition to other benefits, provides economies in the early 1970s and alter- giving me this opportunity to participate. careers for many academics. natives to conventional general obligation Having been a student of Stew’s, I’ve long Take Stew’s Presidential address to debt financing for developing countries expected this kind of event to take place, the American Finance Association in in the early 1980s.