Foundations of Financial Actuarial Science — Part 3: Creating Value with Financial Actuarial Science
The goal of financial actuarial science is not to minimize or eliminate risk, but to increase the value of the firm.
1. Introduction
The goal of financial actuarial science is not to minimize or eliminate risk, but to increase the value of the firm. In the previous topic, we examined risk reduction in the context of perfect/frictionless markets.
In this topic, we will look at the benefits of risk reduction when taxes and transactions costs exist and when economic agents do not always have identical information about the firm’s prospects.
2. Reducing the Potential Costs of Financial Distress and Bankruptcy
When bankruptcy and financial distress are costly, reducing risk can increase the value of the firm by reducing the present value of expected future costs of financial distress in an amount greater than the cost of the hedging strategy employed.
3. Reducing the Volatility of Taxable Income
Because of the nature of the corporate tax code, reducing the volatility of taxable income can reduce a firm’s tax liability and increase firm value.
4. Reducing the Weighted Average Cost of Capital (WACC)
The optimal amount of debt in the firm’s target capital structure can be increased by risk-reduction strategies, leading to lower funding costs and increased firm value. In the weighted average cost of capital (WACC) calculation, the contribution of debt is after-tax, hence the tax benefits of adding debt to a firm’s capital structure.
5. Reducing Diversifiable Risk
A large shareholder may be valuable to the firm so that risk-reduction strategies, which reduce the risk and required return of a large shareholder, can increase firm value.
6. Improving Management Incentives
Financial actuarial science can clarify the relation between managerial decisions/actions and firm value, leading to more efficient management incentive compensation schemes.
7. Reducing the Probability of Debt Overhang
By reducing the probability that a firm will become over-leveraged, financial actuarial science can increase firm value by reducing the potential for conflicts between the interests of debtholders and the interests of equity holders and managers.
9. Reducing Information Asymmetries
Financial actuarial science strategies can increase firm value by reducing the problem of asymmetric information, thereby reducing the firm’s cost of capital.
About the Author
Roi Polanitzer, CFV, QFV, FEM, F.IL.A.V.F.A., FRM, CRM, PDS, is a well-known authority in Israel the field of business valuation and has written hundreds of papers that articulate many of the concepts used in modern business valuation around the world. Mr. Polanitzer is the Owner and Chief Appraiser of Intrinsic Value — Independent Business Appraisers, a business valuation firm headquartered in Rishon LeZion, Israel. He is also the Owner and Chief Data Scientist of Prediction Consultants, a consulting firm that specializes in advanced analysis and model development.
Over more than 17 years, he has performed financial actuarial science consulting engagements in the areas of: identifying, quantifying, valuing, hedging, mitigating, and diversifying risk types, implementing measurement and management tools, creating value with risk management, applying Modern Portfolio Theory (MPT), modeling standard and non-standard forms of the Capital Asset Pricing Model (CAPM), building Index models, analyzing risk-adjusted performance measurement, and lecturing on Enterprise Risk Management and financial disasters and risk management failures.
Mr. Polanitzer holds an undergraduate degree in economics and a graduate degree in business administration, majoring in finance, both from the Ben-Gurion University of the Negev. He is a Full Actuary (Fellow), a Corporate Finance Valuator (CFV), a Quantitative Finance Valuator (QFV) and a Financial and Economic Modeler (FEM) from the Israel Association of Valuators and Financial Actuaries (IAVFA). Mr. Polanitzer is the Founder of the IAVFA and currently serves as its chairman.
Mr. Polanitzer’s professional recognitions include being designated a Financial Risk Manager (FRM) by the Global Association of Risk Professionals (GARP), a Certified Risk Manager (CRM) by the Israel Association of Risk Managers (IARM), as well as being designated a Python Data Analyst (PDA), a Machine Learning Specialist (MLS), an Accredited in Deep Learning (ADL) and a Professional Data Scientist (PDS) by the Professional Data Scientists’ Israel Association (PDSIA). Mr. Polanitzer is the Founder of the PDSIA and currently serves as its CEO.
He is the editor of IAVFA’s weekly newsletter since its inception (primarily for the professional appraisal community in Israel).
Mr. Polanitzer develops and teaches business valuation professional trainings and courses for the Israel Association of Valuators and Financial Actuaries, and frequently speaks on business valuation at professional meetings and conferences in Israel. He also developed IAVFA’s certification programs in the field of valuation and he is responsible for writing the IAVFA’s statement of financial valuation standards.