IMPLEMENTING ECONOMIC CAPITAL IN AN INDUSTRIAL COMPANY: THE CASE OF MICHELIN

Jacques Tierny and Charles Smithson

Journal of Applied Corporate Finance, 2003, vol. 15, issue 4, 81-94

Abstract: Economic capital (also referred to as “risk capital” or “risk‐based capital”) is the amount of capital, generally in the form of equity or equity equivalents, that is necessary to provide an adequate cushion against lower‐than‐expected operating results. Over the last two decades, the concept has taken root among banks, particularly in determining the amount of capital needed to protect against financial distress in the event of unexpectedly large credit losses. Michelin is in the vanguard of industrial companies that are beginning to apply economic capital concepts. The company uses an option‐pricing approach that effectively allows the market to identify the level of economic capital that is expected to maximize corporate value. Michelin has also begun the process of attributing economic capital to individual business units and activities. By so doing, the company is able to use a single, company‐wide hurdle rate for all projects and business units. Thus, instead of raising the discount rate when evaluating riskier projects and businesses, management assigns them larger amounts of economic capital (and, hence, a higher charge for use of that capital). The use of economic capital to evaluate ongoing activities and contemplated investments makes it more likely that decisions will translate into increased shareholder value. A case in point is outsourcing. As illustrated in an example analyzing the company's decision to sell but continue sourcing from a textile factory, outsourcing decisions typically reduce a firm's required amount of economic capital—and thus an analysis based on the use of economic capital provides a more realistic picture of the expected value added from such transactions.

Date: 2003
References: Add references at CitEc
Citations:

Downloads: (external link)
https://doi.org/10.1111/j.1745-6622.2003.tb00529.x

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bla:jacrfn:v:15:y:2003:i:4:p:81-94

Ordering information: This journal article can be ordered from
http://www.blackwell ... bs.asp?ref=1078-1196

Access Statistics for this article

Journal of Applied Corporate Finance is currently edited by Donald H. Chew Jr.

More articles in Journal of Applied Corporate Finance from Morgan Stanley
Bibliographic data for series maintained by Wiley Content Delivery ().