sing Economic Capital to Make Decis

sing Economic Capital to Make Decisions
As we saw earlier, if companies could simply stockpile equity capital at no cost, there would be no deadweight costs asso- ciated with adverse outcomes. Management could use its liquid assets to finance the losses, and the bad outcome would have no effect on the firm’s investment policy. But in the real world, there are significant costs associated with carrying too much equity. If the market perceives that a company has more equity than it needs to support the risk of the business, it will reduce the firm’s value to reflect management’s failure to earn the cost of capital on that excess capital.
When a company undertakes a new risky activity, the probability that it will experience financial distress increases, thus raising the expected costs of financial distress. One way to avoid these additional costs is by raising enough additional capital so that taking on the new risky activity has no effect on the probability of financial distress. Conse- quently, the most straightforward way to estimate the cost of the impact of a new risky activity on the firm’s total risk is to evaluate how much incremental capital would be neces- sary to ensure that the new risky activity has no impact on the firm’s probability of financial distress.
To illustrate, suppose that before the company takes on the new activity, the VaR estimate used to set the firm’s
capital is $5 billion. Now, with the new activity, this VaR estimate increases to $5.1 billion. Thus, for the firm to have the same probability of financial distress as it had before it undertook the new risky activity, it would need to raise capital of $100 million. Moreover, this capital would have to be invested in such a way that the investment does not increase the risk of the firm, since otherwise the VaR of the firm would further increase. If the risky new activ- ity is expected to last one year, and the cost to the firm of having this additional $100 million available for one year is estimated to be $8 million, then the economic value added of the new activity should be reduced by $8 million. If the firm ignores this cost, it effectively subsidizes the new risky activity. To the extent that riskier activities have higher expected payoffs before taking into account their contribu- tion to the firm’s probability of financial distress, a firm that ignores the impact of project risks on firm-wide risk ends up favoring riskier projects over less risky ones.
Though the example just discussed is straightforward, the implementation of this idea in practice faces several difficulties. A company is a collection of risky projects. At any time, a project’s contribution to the firm’s total risk depends on the risk of the other projects and their correla- tions. When business units are asked to make decisions that take into account the contribution of a project to firm-wide risk, they must have enough information when making the decision to know how to evaluate that contribution. They cannot be told that the contribution will depend on every- thing else that is going to happen within the firm over the next year, and then have a risk charge assigned to their unit after the fact.