1.1 The Importance Of Risk Management:

            What will be the US dollar currency at the end of 2004 in Turkey? And what will be the Euro-Dollar parity? These are the common questions many Turkish company officials ask themselves. Turkish Central Bank (CB) started to implement floating exchange rates in February 2001. It became very difficult to forecast the exchange rates in Turkey since then. Exchange rates are important not only for financial firms but also for non-financial firms, especially if they are import or export based. Floating exchange rates increased the uncertainty for these firms. Uncertainty is by no means a synonym of risk for them because it is a major source of risk affecting their survival. What about the other sources of risk? What are their effects to the firms? And finally what is the total risk the firms are exposed to?

            Firms are operating in an ever-changing environment today. It is nothing but the change that affects every process in these firms. These changes show themselves as “globalization, disintermediation, innovation, and changes in regulatory environment, technological advancement and change in competitive structure of financial sector.” (Carlton, 1999) These changes have joint impact on firms’ risk exposure. These sources lead strategic, financial, operational, commercial, and technical risks for the firms. (Pricewaterhouse Coopers, 1997) These risk components’ joint impact on firms’ cash flow is regarded as the total risk of the firms. As a consequence, risk should be managed in firms for their survival.    

            1.2 Capital Management, Risk And Shareholder Value:

            The academicians have thought risk as a variance of the expected returns. They suggest investors to minimize their portfolios’ variances in order to decrease their risk exposures. Is it the same for non-financial firms? How does risk management add value to shareholders in non-financial firms?

Firms having tradable, financial and mostly liquid assets such as banks, insurance companies, pension funds, securities firms and investment companies are regarded as financial firms. Whereas, production or service based firms having mostly illiquid assets are regarded as non-financial firms.

Risk management is indispensable component of a firm’s capital structure and strategic planning decisions. The right combination of risk management, capital structure and strategic planning is needed to optimize shareholder value. (Guth, 1996) The important problem is how to find this combination?

Risk management does not demand variance minimization in the non-financial firms’ cash flow. On the contrary, it demands just eliminating the downside risk of firms’ cash flow. Non-financial firms try to reduce the expected cost of financial trouble while preserving firms’ ability to utilize any comparative advantage in risk bearing. (Stulz, 1996) Non-financial firms direct their risk management towards shortfalls of the cash flow but not towards cash flow volatility as traditionally expected. Risk management in non-financial firms can constitute shareholder value if they focus on eliminating lower tail situations.

Modigliani and Miller (1958) proposed that the financial strategies do not add value under certain assumptions. They supported their propositions under a circumstance that there are no taxes, no costs of bankruptcy while operating cash flows are given and management acts to increase shareholder value. The risk management can add value from three perspectives if these assumptions are relaxed. These perspectives are:

        Risk management can reduce bankruptcy cost

        It can reduce payments to stakeholders and required returns to owners of closely held firms

        Taxation

            Risk management can reduce bankruptcy cost just by decreasing the probability of financial distress. It is decreasing the direct and also the indirect costs. It is in fact decreasing the variability in the companies’ cash flows. When there is a risk for default, firms need more external funds than before. It is very apparent that financially weak firms face difficulties when raising funds. And these funds cost more to problematic firms if the funds are reachable. Reaching outside funds become so costly that these firms might lose to exploit profitable investments. Risk management can reduce the likelihood of such under-investment problems. (Froot et al. 1993)

Both private or closely held firms’ owners and stakeholders in public firms are anxious about the inability to diversify probable large financial exposures. These people heavily rely on the firms. That is, their considerable amount of investment is the shares they have in these firms. For that reason, risk management can add value by limiting uncontrolled financial exposures. Moreover, stakeholders from customers and suppliers to employees are always dubious about their self-interest. Customers expect the firms to fulfill their obligations. Suppliers, on the other hand, are reluctant to establish long-term relations with the problematic firms. As for the employees, they want to feel secure about the future of themselves. Risk management can ease potential tensions of the stakeholders.

Risk management is important because it can decrease the variability of the firms’ reported income. As in the U.S, it is very common that firms’ tax rates are proportional to their pre-tax income. Risk management seeks to minimize the tax and utilizes the tax-loss carry forwards of the firms’.  The aim of these efforts is to keep firms’ tax rate in an optimal range. That is why risk management plays a critical role in taxation.

1.3 Definition Of The Problem:

There are various risk components for non-financial firms, which jointly affect the firms’ cash flow stream. The firms’ total risk exposure must be managed in order to minimize this effect. Minimization of risk effects is important for the survival of these firms. And they are working hard to eliminate these effects they faced. They allocate remarkable resources on risk management by using information, technology, time and wisdom. As a result, they are still developing some basic tools. These tools are:

                   Identification/Assessment tools, such as risk matrixes, which help firms’ management to identify and assess the risks exposing the firms.

                   Categorization tools, which help management to group and prioritize, risk components. These tools are helpful because of using holistic view towards all risk factors.

                    Financial quantification tools, such as cash flow-at-risk (C-FaR) model, which help firms to assess overall impact of risk factors in numbers. (KPMG, 2001)

C-FaR model is analogous to value at risk (VaR) model. One should know VaR model in order to be familiar with C-FaR. VaR is used commonly by financial firms to explore the effects of operating risks exposed by the firms. It also explores the potential effects of these risks on firms’ earnings. C-FaR can be interpreted as a form of VaR for measuring total risk against non-financial firms’ cash flow. This analytic model helps non-financial firms to determine the probability of severe shocks to their cash flows and find their capital adequacy. (Wengroff, 2001)

In fact, C-FaR model helps non-financial firms to simulate the future to some extent. Non-financial firms can use this model to shape their strategic processes. The model is used explicitly to forecast the probable deviations in the earnings of the firms. It is assumed that firms’ total risk exposure, referred as a shock, directly affects their operating cash flows. The model helps the management of the firms to make their strategic decisions through the forecast. Moreover, quantification of cash flow volatility helps firms to comprehend downside and worst-case scenarios together with developing strategies to increase shareholder value under alternative business environments. Defense companies are among the probable non-financial firms having this idea in mind. They make significant investments, develop products, and take reasonable risks with respect to providing products and services to the security mission. These companies are in a rapidly changing technological environment and stiff competence. They must allocate considerable resources to R&D projects to survive but there is no guarantee to pay back their investments. That is why defense industry is seen one of the risky industries. C-FaR application in defense industry is expected to constitute good example for this respect.

Aselsan, Otokar and Netas¸ are three publicly traded defense firms in Turkey. The thesis intends to investigate the application of C-FaR model in these firms, in Turkish Army, and its participations, and in Turkey. This application is expected to guide other applications in non-financial firms as well. It will be easier to apply the model in all publicly traded non-financial firms by the principles given in the thesis. C-FaR application in other non-financial firms, which are not publicly traded, will be also possible by making some changes in the model. C-FaR model is applied to three defense firms because they are concerned with managing the risks inherent in their operating cash flows like any other non-financial firms. The analytic model will help these firms to forecast their expected earnings and probable deviations in these earnings for the next quarter. These firms will also benefit from finding the effects of volatility in interest and exchange rates on firms’ cash flows. Following questions will be asked and expectantly answered in that sense:

 How much can defense companies and other non-financial firms’ operating cash flows be expected to decline in the last quarter of 2003?

Is the proposed model powerful enough to explain the answers of the following questions?

What are advantages and disadvantages of the model?

What are the test results of the model?

Information about sample firms is complementary tool for practitioners. That is why following sentences give basic information about the sample firms. The Turkish Armed Forces Foundation founded Aselsan in 20 November 1975. Objective of the firm is to produce tactical military radios and defense electronic systems for the Turkish Army. It is the leading multi-product electronics company of Turkey that designs, develops and manufactures modern electronic systems for military and professional customers. Nortel Networks Netas¸ is representative of Nortel Networks in Turkey. It provides networking and communication services and infrastructure to service providers, enterprises and Turkish Armed Forces in Turkey. Otokar, another defense firm, was founded to produce intercity buses in 1963 but it concentrated on armor technology since mid-1980. It started to manufacture 4x4 tactical vehicles under license from Land Rover-UK in 1987. Today it manufactures armored Tactical Vehicles for military purposes in addition to its minibuses production. A sample application of C-FaR model in these defense firms is expected to be useful to understand the basics of the model and its application.

1.4 Scope Of The Thesis:

In the beginning, the importance of the risk was explained. The relation between risk, shareholder value and capital management fostered the necessity of its management. Risk perception in non-financial firms was also pointed. C-FaR, an analytical model was proposed to assist these firms to quantify their risk and make decisions for the future. Finally, the necessity to investigate C-FaR model was explained.

In the second chapter including literature review, detailed information will be given to understand the basics of risk concept. Why operating cash flow was selected to measure risk will be proved. In order to understand C-FaR model, both VaR and C-FaR concepts will be compared. Finally, the differences and similarities of two models will be discussed.

In chapter three, the data collection and EBIT/Total Assets notion will be interpreted. How the collected data was processed and model-building phases will be covered. The tests, which were done to check the power of the model, are presented before the findings. As a consequence of the study, the findings will be discussed at the end of the chapter.

In the final chapter, summary and concluding remarks are presented. Avenues for future research are also discussed.