Cost of capital and probability of default in value-based risk management

Abstract

Purpose This paper aims to present the combination of enterprise risk management (ERM) and value-based management as especially suitable methods for companies with a shareholder value imperative. Among its major benefits, these methods make the contribution of risk management for business decisions more effective. Design/methodology/approach Any possible inconsistencies between ERM, generating value because of imperfect capital markets and the CAPM to calculate cost of capital, which assumes perfect markets, must be avoided. Therefore, it is imperative that valuation methods used are based on risk analysis, and thus do not require perfect capital markets. Findings Value-based risk management requires the impact of changes in risk on enterprise value to be calculated and the aggregation of opportunities and risks related to planning to calculate total risk (using Monte Carlo simulation) and valuation techniques that reflect the effects changes in risk, on probability of default, cost of capital and enterprise value (and do not assume perfect capital markets). It is recommended that all relevant risks should be quantified and described using adequate probability distributions derived from the best information. Practical implications This approach can help to improve the use of risk analysis in decision-making by improving existing risk-management systems. Originality/value This extension of ERM is outlined to provide risk-adequate evaluation methods for business decisions, using Monte Carlo simulation and recently developed methods for risk–fair valuation with incomplete replication in combination with the probability of default. It is shown that quantification of all risk using available information should be accepted for the linking of risk analysis and business decisions.

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Guest editorial

“…After standard peer-review procedures over several rounds, four papers were selected for publication in this special issue. Two of these offer a holistic view of framing risk governance (Gotteiner et al, 2019;Stein et al, 2019), while the other two tackle specific issues in designing risk governance (Gleißner, 2019;Handschumacher et al, 2019). The four papers are, however, united in underpinning the relevance of risk governance choices and carry important implications for both research and practice.…”

“…The second conceptual paper included in this special is Gleißner's (2019) approach to integrating enterprise risk management (ERM) with ideas from value-based management. The paper is motivated by the paradox that existing attempts to link ERM and value-based management are based on the assumption of perfect capital markets, which, however, is thwarted by numerous empirical findings in the literature indicating that the application of ERM is value-enhancing (Grace et al, 2015;McShane et al, 2011;Pagach and Warr, 2011)a finding indicating imperfect capital markets.…”