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Applied Risk Management Strategies in the field of M&A

Term Paper (Advanced seminar) 2006 40 Pages

Business economics - Investment and Finance

Excerpt

Table of Contents

List of Figures

List of Abbreviations

List of Symbols

Risk Management and M&A - a brief introduction

1 Risk Management
1.1 Portfolio Theory
1.2 Financial Risk Measures
1.2.1 Variance
1.2.2 Standard Deviation
1.2.3 Covariance
1.2.4 Correlation Coefficient
1.2.5 Beta factor
1.3 Summary

2 M&A
2.1 Mergers and Acquisitions in the economic context
2.2 Basic information on Mergers and Acquisitions
2.2.1 Definitions
2.2.2 History, Strategy and Motives
2.3 M&A as a means of risk diversification
2.3.1 Diversification strategies
2.3.2 Reduction of a company’s total risk by international diversification.
2.4 Criticism

3 M&A and Risk diversification by the example of ThyssenKrupp
3.1 Company description
3.2 Portfolio optimization and M&A strategies
3.3 Expansion of products and international presence
3.4 Applied risk management strategies of ThyssenKrupp

4 Conclusion

Bibliography - Print Media

Bibliography - Internet Files

List of Figures

Figure 1: Variance

Figure 2: Standard deviation

Figure 3: Covariance

Figure 4: Correlation coefficient

Figure 5: Beta factor

Figure 6: Growth initiatives of a company

Figure 7: Porter’s Value Chain Model

Figure 8: Product-Life-Cycle

Figure 9: Principal-Agent Theory

Figure 10: ThyssenKrupp Group - Overview

Figure 11: ThyssenKrupp - Global presence

Figure 12: Active portfolio management of ThyssenKrupp

Figure 13: ThyssenKrupp - Portfolio management growth drivers

List of Abbreviations

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List of Symbols

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Risk Management and M&A - a brief introduction

Risk minimization and return maximization is what managers, shareholders and even private investors aspire. However, risk and return are highly correlated so that investors have to manage this trade-off. Risk management is thus essential both for investment managers and company executives. Within portfolio management and corporate practice risk can be reduced by diversification.

In the “Risk Management” part Portfolio Theory - particularly Markowitz’ Portfolio Selection - is to be introduced and the most common measures of risk i.e. volatility, covariance, correlation and the beta factor are to be presented. The next section refers to Mergers and Acquisitions and starts with a general introduction of the topic. Afterwards, M&A is to be related to diversification as a means of risk minimization. Finally, by the example of ThyssenKrupp, the theoretical assumptions of the first two parts are to be applied.

1 Risk Management

1.1 Portfolio Theory

Portfolio Theory deals with the problem of how to create an optimal portfolio which corresponds to investor needs. The needs of an investor are determined by the risk and the return whereas empirical results prove that risk and return are highly corre- lated. A higher risk is therefore accompanied by a higher return - this is described as the so called risk-return trade-off. In economic theory and corporate finance lit- erature, risk is defined as the deviation of an uncertain result from its expected value whereas the deviation can be positive or negative. In a second definition of risk which is used in corporate practice, risk is the danger of a loss resulting from managerial decisions.1 In the section “Risk Management” I refer to the first defini- tion of risk.

Within the process of creating a portfolio it is not only relevant to choose individual assets with a desirable risk-return character but the relationship among the full spectrum of securities has to be considered since the different returns are all corre- lated. The definition of the best asset mix in order to obtain the highest return at the lowest risk is called asset allocation. Diversification is a chief activity within this process2. The basic concepts of modern Portfolio Theory are developed by Harry Markowitz who described the topic in his 1952 Journal of Finance article “Portfolio Selection” and in his subsequent book in 1959.3 Markowitz derived the expected rate of return for a portfolio of assets as well as an expected risk measure, the standard deviation. His model describes concepts for the creation of an efficient portfolio which provides the highest return at a given level of risk.4 Hereby Marko- witz assumes that investors are basically risk-averse. This means that investors will only hold risky assets if the expected return is high enough to compensate the risk. Consequently the investors’ goal is to maximize utility and not primarily the return since utility considers both risk and return5. In his analysis Markowitz demonstrates how to diversify effectively in order to reduce the risk and to create a good portfolio which is “…a balanced whole, providing the investor with protections and opportuni- ties...6 ”.

Diversification across individual assets is the underlying concept in the process of constructing a portfolio. This is due to the fact that the impact of adverse results from assets can be minimized since the specific risk of an individual security can be diversified away. Markowitz proved that a risk reduction can be obtained by the combination of single securities to portfolios, if the yields of the individual shares are not correlated completely positively.7

Risk measures for the identification of the best asset allocation in the process of creating an efficient portfolio are to be discussed in the next chapter.

1.2 Financial Risk Measures

For the purpose of defining the best asset mix it is necessary to compute the risk of the individual assets and furthermore to measure the correlation between all securi- ties. Volatility is a useful risk measure if the random variable i.e. the portfolio is dis- tributed normally - if not, the results of the computation will be wrong.8 The most common measures for the volatility of an individual asset are variance and standard deviation. Both compute the dispersion of returns around the expected value whereby a larger variance or standard deviation means a greater dispersion and a higher risk since future returns are more uncertain. Measures for the interrelation between two securities are covariance and correlation whereas the standardization of the covariance yields the correlation coefficient. If the assets are positively corre- lated in a portfolio they tend to move in the same direction whereupon a negative relationship means that the returns move in the opposite direction leading to a de- crease of the variance of the entire portfolio.9

1.2.1 Variance

The Variance measures the variation of possible rates of return,R , from the ex- i pected rate of return E R and is defined as:

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Figure 1: Variance

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1.2.2 Standard Deviation

The standard deviation is the square root of the variance and can be viewed as a measure of the risk associated with individual stocks. It is defined as:

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Figure 2: Standard deviation

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1.2.3 Covariance

Covariance is a statistical measure that presents the relationship between two vari- ables. That is, it is a measure of the degree to which two variables move together over time. If the covariance is positive it indicates that the securities’ returns are positively correlated. Thus a better-than-expected return for one asset is likely to also occur for the other securities’ return. A negative value for covariance implies that the returns of the securities offset each other - for example, if the expected return of one asset is better than expected, the return of the other asset is likely to be worse than expected. If two securities are unrelated, the covariance will be zero.10

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Figure 3: Covariance

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1.2.4 Correlation Coefficient

The correlation coefficient is a relative measure for a given relationship and is val- ued between 1 and (-1). A correlation coefficient of 1 means that the returns are perfectly correlated i.e. they always move together in the same direction. The lower the correlation coefficient between the returns of the stocks in a portfolio the greater are the diversification benefits. If the returns of two assets are perfectly positively correlated i.e. r = 1, no real benefit will be gained from the portfolio since their re- turns move together. If the correlation coefficient would be r = (-1), the portfolio would be risk-free as the returns would show no variability. Combinations of assets which are perfectly negatively correlated completely eliminate risk and thus provide the maximum benefits of diversification. The correlation coefficient is the critical factor in the process of creating a portfolio since at a given level of return the risk can be downscaled by combining assets with a low positive or negative correlation coefficient.11

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Figure 4: Correlation coefficient

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1.2.5 Beta factor

In a market portfolio the unique risk of assets i.e. the risk that affects an individual or a small group of assets can be diversified away if the assets are not perfectly correlated12. This diversifiable risk that may be eliminated is called unsystematic risk. The remaining risk in a portfolio that affects a large number of assets is called systematic risk and may change over time13. Systematic risk is also referred to as market risk such as equity, interest rate and credit risk.14 Beta is a standardized measure of systematic risk since it computes how the returns on the stock move in reaction to changes in the overall market i.e. it shows the relation between covari- ance and the variance of the market portfolio. If the beta of a market portfolio is above 1.0, the asset’s return is higher than the market’s return or in other words the asset has a higher normalized systematic risk than the market and is thus more volatile. The impact of systematic risk on a stock’s return can be derived from the magnitude of the beta. Thus a beta of +5 indicates that the stock’s return increases by 5-percent for every 1-percent increase of the systematic risk. In contrast, a beta of (-1) indicates that the stock moves in the opposite direction as the systematic factor and would fall by 1-percent if the market risk increased by 1-percent.15

Beta is defined as:

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Figure 5: Beta factor

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1.3 Summary

The first chapter should give a brief introduction into the topic “Portfolio Theory” and present the most common risk measures of portfolio management. Referring to portfolio theory it was described that the risk-return trade-off may be influenced positively by diversification. Thus, combining different assets may re- duce the specific risk of individual securities. In the section “Financial Risk Meas- ures”, the most common measures have been introduced. It was demonstrated that these instruments help to identify the risk of individual assets as well as to reveal the correlation between all securities. Furthermore, through the beta factor, the re- lation between systematic/market risk and the stock’s returns can be derived. In the next chapter, M&A shall be implicated with Risk Management as a means to downscale a company’s risk through diversification.

2 M&A

2.1 Mergers and Acquisitions in the economic context

Long-term profit maximization is defined as the principal aim in business economizing teaching16. However, the environment of a company is dynamic and thus, continuous adjustment processes are inevitable for the increasing of the enterprise value. These processes are described as “growth”17 both, on a quantitative and qualitative level.18 If a company decides to grow, the businesses and the strategies which are pursued have to be defined.

Ansoff presents the four main growth strategies in his product/market matrix:

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Following: Ansoff (1965) p. 109.

Figure 6: Growth initiatives of a company

Distributing products in existing markets is defined as market penetration whereas market development means that existing products are sold in new markets. In con- trast, product development implies that the existing markets are supplied with new products. Ansoff describes extensions to the current portfolio on the product and market dimension as diversification whereas this strategy usually requires a com- pany to acquire.19 Diversification occurs either at the business unit level or at the corporate level20. At the business unit level it implies adjacency moves into new segments of an industry in which the company is already acting. At the corporate level, diversification is a means to enter into new businesses outside the existing scope of the firm.21 Once a company has decided in which fields and in which ways growth should be achieved, management has to choose between organic and external growth; this is the so called make-or-buy decision22. Organic growth implies that a company’s growth strategy is affected by its own power whereas external growth is realized by acquisitions.

2.2 Basic information on Mergers and Acquisitions

Mergers and acquisitions (M&A) belongs to the field of corporate finance and char- acterises the transactions of companies for the restructuring of an enterprises’ port- folio23. The traditional subject of M&A includes takeovers and related issues of cor- porate restructuring, corporate control, and most constitutive, changes in the own- ership structure of firms24,25. In addition, M&A can be regarded as a means of cor- porate expansion and growth whereas it is important that acquisition-based growth and organic growth are closely connected within a company's strategy to develop its business. Another approach to the optimization of an enterprises’ portfolio is di- vestment. Divestment strategies can be relevant for companies needing to concen- trate their resources on core activities since the aspect of selling business units takes effect26.

2.2.1 Definitions

Merger:

A merger is defined as the combination of two corporations and can be explained by the disappearance of one firm into another firm. Hence, the legal independence of one company gets lost.

[...]


1 Cf. Frenkel, Hommel, Rudolf (2000) p. 264 f.

2 Cf. Rudin, Morgan (2006) p. 81.

3 Cf. Farrel (1997) p. 3.

4 Cf. Markowitz (1952) p. 77 f.

5 Cf. Farrel (1997) p. 18.

6 Markowitz (1970) p. 3.

7 Cf. Kleeberg (1995) p. 11.

8 Cf. Ross, Westerfield, Jaffe (1999) p. 222 ff.

9 Cf. Reilly, Brown (2000) p. 260.

10 Cf. Gordon, Sharpe (1989) p. 125.

11 Cf. Reilly, Brown (2000) p. 103-105.

12 Cf. Conrad, Stahl (2000) p. 185.

13 Cf. Reilly, Brown (2000) p. 292.

14 Cf. Clarke, Da Silva, Murdock (2005) p. 4.

15 Cf. Ross, Westerfield, Jaffe (1999) p. 257-277.

16 Cf. Wöhe (1996) p. 603.

17 Cf. Aghte (1972) p. 167-169.

18 Cf. Hahn (1970) p. 609.

19 Cf. Kreikebaum (1997) p. 59.

20 Cf. Edward, Keny, Sanderson, Luffmann (1996) p. 113.

21 Cf. http://en.wikipedia.org/wiki/Diversification_%28strategy%29, as of 08.11.2006.

22 Cf. Ansoff (1965) p. 196-200.

23 Cf. Vogel (2002) p. 3.

24 Cf. Copeland, Weston (1988) p. 676.

25 Cf. Meckl, Lucks (2002) p. 23.

26 Cf. Graham, Coyle (2000) p. 12.

Details

Pages
40
Year
2006
ISBN (eBook)
9783638629133
ISBN (Book)
9783638674706
File size
632 KB
Language
English
Catalog Number
v70833
Institution / College
University of Applied Sciences Essen
Grade
1,3
Tags
Applied Risk Management Strategies International Finance

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Title: Applied Risk Management Strategies in the field of M&A