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CHAPTER II LITERATURE REVIEW
A. Theory Development
1. Introduction
The review will start with the understanding of company risks, risk management, environmental risk management, and the cost of capital. In the next step this literature
intends to elaborate a critical evaluation of the relationship between the environmental risk management and the cost of capital.
2. Company Risks
According Taswan 2006, business is sharing the risk, not only sharing profit. The more a company discloses its risk, the more the ability to avoid such risks. Amran et al
2009 mentions some risks in a company as follows: a. Financial risk are risks associated with financial instruments like market risk, credit,
liquidity and interest rate. b. Operational risk are risks associated with customer satisfaction, product
development, sourcing, product failure, and the environment. c. Technology and information processing risk are risks associated with access,
availability, and technology and information infrastructure of the company. d. Integrity risk are risks associated with the fraud in the management or byemployees,
illegal acts, and reputation.
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e. Risk strategy are risks associated with environmental monitoring, industrial, business portfolio, competitors, regulatory, and political power.
Muslich 2007 stated that companies which are aware of the risks and conduct risk management are capable to survive because they could handle the current risk and ready to
face future incoming risks. 3. Definition of Risk Management
The word risk has two distinct meanings. It can mean in one context a hazard or a danger, that is, an exposure to mischance or peril. In the other context, risk is interpreted
more narrowly to mean the probability or chance of suffering an adverse consequence, or of encountering some loss. Because the word risk can be used in these different ways the term
has led to some confusion. Vaughan 1978 raised several definitions of risk as follows:
Risk is the chance of loss
Chance of loss is associated with an exposure to the possibility of losses. In the case of 100 chance of loss, the loss is a certainty so that there is no risk.
Risk is the possibility of loss
The term possibility means that the probability of an event is somewhere between zero and one.
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Risk is uncertainty
Uncertainty is an individual assessment of the risk situation based on knowledge and attitude of the individual concerned.
Risk is the dispersion of actual from expected results Statisticians defines risk as the degree of deviation of a value around a central position or
around the point on average. Risk is the probability of any outcome different from the one expected
Risk is not the probability of a single event, but the probability of several outcomes which might be different from the one expected.
One of the most general definitions of risk was defined by the International Organization for Standardization in the ISO 31000 standard. According to this standard, risk is defined as
the effect of uncertainty on objectives ISO, 2009. According to Smith 1990 risk management is defined as the identification,
measurement, and control of financial risks that threaten an asset and the income of a company or project that may cause damage or loss to the company.
Amran et al 2009 expresses that risk management is very beneficial for the company in managing the risk-owned. Risk management is conducted by company to manage the risks
and opportunities that relate to the achievement of corporate goals. The purpose of risk management is to ensure that measures are taken to protect people,
the environment and assets from harmful consequences. Risk management includes measures to avoid hazards and reduce potential harms. Risk management is one of the goals
in an organization. It is acknowledged that risk cannot be eliminated but must be managed Aven and Vinnem, 2007
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a. Environmental Risk Management
Environmental management is a mixture of science, policy, and socio economic applications. It focuses on the solution of the practical problems that humans encounter in
cohabitation with nature, exploitation of resources, and production of waste McGraw-Hill, P.831.
Investors and companies have become more and more conscious of the many ways that environmental issues affect their businesses, presenting not only challenges but also
opportunities. Environmental issues generate business risks that have to be carefully handled. Regulations related to businesses and the environment constantly improve and
almost often create uncertainties for companies bringing significant implications for their financial performance. Consumer‘s reactions and other environmentally motivated actions
create serious non-regulatory r isks that may reduce a company‘s markets or affects its
financial strengthFall, 2001. Case 1999 stated that many business leaders realized that environment factors can
lead to economic growth around the world and agrees that environmental management can improve the bottom line performance of the company. Cost savings have been identified
through: Reduce the usage of raw materials through more efficient production techniques
Reuse or recycle wastes Reducing the amount of energy used, such as gas and electricity
Cutting water consumptions Lowering air emissions
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b. Difference Between Risk Management and Risk Assessment
According to the Environmental Protection Agency, a risk assessment is ―the evaluation of scientific information on the hazardous properties of environmental agents, the dose-
response relationship, and the extent of human exposure to those agents‖ EPA Glossary of IRIS Terms.
Once risk has been assessed and characterized, ―political, social, economic and engineering implications together with risk-
related information‖ are gathered ―in order to develop, analyze and compare management options and select the appropriate managerial
response to a potential chronic health hazard‖ EPA Glossary of IRIS Terms. This process is called risk management. Together these steps comprise the scientific approach to risk
Stern, 2007. According to Pritchard 2012, risk assessment is defined as risk estimation and risk
evaluation or can be said as risk analysis, while risk management is the process of implementing decisions on managing risks. Risk management involves identifying,
analyzing, and taking steps to reduce or eliminate the loss faced by an organization or individual.
4. Definition of Cost of Capital
Cost of capital has two meanings, depending on the investor and company point of view. From the point of view of investors, the cost of capital is the opportunity cost of the
funds invested in a company keown,1999. While from the standpoint of company, the cost of capital the cost incurred by the company to obtain the necessary funding Iramani, 2005.
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Cost of capital is the expected rate of return that the market participants require in order to attract funds to a particular investment. In economic terms, the cost of capital for a
particular investment is an opportunity cost —the cost of forgoing the next best alternative
investment. In this sense, it relates to the economic principle of substitution —that is, an
investor will not invest in a particular asset if there is a more attractive substitute Pratt and Grabowski 2010.
The cost of capital usually is expressed in percentage terms, that is, the annual amount of dollars that the investor requires or expects to realize, expressed as a percentage of the
dollar amount invested Pratt and Grabowski 2010. According to Sharfman and Fernando 2007, cost of capital is the rate that investors
use to discount a firm‘s future cash flow. The higher the cost of capital, the lower the present value of the firm‘s future cash flow. Firms lower cost of capital will be more highly valued
than firms with higher cost of capital and therefore more attractive to investors. Ogier, Rugman, and Spicer 2004 stated that cost of capital is a financial resource
given to an enterprise or a project which is paid back in a period of time. The cost of capital increases with risk. The riskier an investment, the higher the reward needed to attract
investors. According to Lee 1990 and Brigham 1994, the cost of capital is important because:
In the capital budgeting decision, requires the estimation of cost of capital Business decisions such as issuing bonds, choose of leasing or purchase of
assets also requires the estimation of cost of capital.
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Financial managers aim to maximize firm value by minimizing costs including cost of capital.
According to Iramani and Hidalgo 2005, the practice of financing or funding of the company is acquired from various sources. Thus the real cost borne by the companys is the
overall cost of all financing sources are used. According to Damodaran 2001 calculating the firm‘s overall cost of capital is by the weighted average cost of capital WACC. The
firm‘s after-tax weighted average cost of capital Modigliani and Miller 1958
�
��
= +
� + +
�
Where E = market value of firm‘s equity;
D = market value of firm‘s debt; r
E
= the firm‘s cost of equity capital; r
D
= the firm‘s cost of debt capital.
a. Definition of Cost of equity capital
Damodaran 2001 defines equity as a financial instrument that has a residual claim on the firm, does not provide tax advantages from the firm‘s cash outflow, has an infinitive age,
and providing management control to its owner. According to Siregar and Ali 1995 cost of equity is the rate that should be achieved by
the company in order to fulfill the expected return which is required by the shareholders for the funds that have been invested in the company. This definition from Siregar and Ali is in
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line with the definition by Damodaran 2001 which defines the cost of equity as the expected return of investors that includes the risk premium of equity or the required rate of
return by the investor on the investment in the equity. Cost of equity capital is the cost which is taken out to fund the source of financing
Modigliani and Miller 1958. Mardiyah 2002 stated that cost of equity capital can be identified as the minimum level of return which is required by investors.
According to Riyanto 1996, the cost of equity capital is the part that should be issued by the company to give satisfaction to the investors on a particular level of risk. Stated that
companies have the duty to reveal reports regarding the company which have an impact on the costs incurred. Therefore, the cost of equity is the cost incurred by the company to
provide information to the public shareholders, investors, and the society in general. According to Chancera 2011, the cost of equity capital measurements are influenced
by valuation models used by company. One of the valuation models is Capital Asset Pricing Model CAPM Sharpe 1964; Littner 1965
� = � + � �
�
− � Where
r
F
= the risk free rate; r
M
= the return on the market portfolio; β = the firm‘s systematic risk.
b. Definition of cost of debt
Debt is defined by Damodaran 2001 as a financial tool that possess a contractual claim on the cash flows and assets of the company, resulting a tax deductable payment, has
a maturity, and has a priority claim on cash flow during the period of operation as well as
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bankruptcy. The company has the option to conduct debt financing in the form of bank loans, bonds, and leasing.
Young and O‘byrne 2001 confess that cost of debt is the interest rate that must be paid by the company if they obtain funds or capital by way of loans from the lenders or creditors.
By borrowing from outside the company, then it will raise a debt interest which became costs for the company.
Fabozzi 2007 define the cost of debt as the desired rate of return by the lender at time when they provide funding to the company. Pittman and Fortin 2004 measures the cost of
debt as interest expense paid by the company during the year divided by the average number of long-term and short-term loans during the year.
According to Brigham 1994 and Lee 1990 the relevant cost of debt is the cost of issuing new debt after taxes or interest paid by the company to new bondholders. Cost of
debt can be calculated as follow:
After-Tax cost of debt = R
d
1-t
c
Where R
d =
Interest rate of debt t
c
= corporate tax rate
5. Relationship between Environmental Risk Management and Cost of Capital
As firms make strategic investments that reduce emissions and pollution, it ease risk either from governmental regulators or from non-governmental stakeholders. This reduces
both immediate risks from known hazards and future risks from unknown hazard and both
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hazards bring uncertain level of financial impact. By reducing potential hazards the firm reduces number of potential claimants through fines, settlements or other compliance and
therefore firms‘ economic resources can be directed to dividends to stockholders, debt payments, internal investments or acquisitions. This strategy improved risk perception of the
company by the market King and Shaver 2001. Sharfman and Fernando 2007 stated that doing environmental risk management
activities by improving environmental performance can reduce the possibility that firms will face extreme environmental events
Union Carbide‘s Bhopal disaster or the Exxon Valdez oil spill that can require heavy cash outflows arise from compensation and clean-up costs,
and thereby brings firm closer to bankruptcy. Environmental risk management investments are usually long term and cannot be easily
reversed. Perhaps such stability makes more credible from the view of the firm‘s future debt holders Chidambaran, Fernando, and Spindt 2001.
In summary the literature shows that the environment is directly affecting the bottom line, often with very different consequences for companies even within the same sector. In
many industries, environmental issues have implications that can significantly affect companies‘ financial results.
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B. Previous Research
This literature review tries to find out the research already conducted in this field and to what this thesis could contribute. The following researches have already been conducted in
this field:
1. Environmental Risk Management and the Cost of Capital Study on publicly-
held US firms Sharfman and Fernando, 2007 :
This research is about a study of 267 U.S. firms shows that improved environmental risk management is associated with a lower cost of capital. These findings provide an
alternative perspective on the environmental – economic performance relationship, which
has been dominated by the view that improvements in economic performance stem from better resource utilization. Firms also benefit from improved environmental risk
management through a reduction in their cost of equity capital, a shift from equity to debt financing, and higher tax benefits associated with the ability to add debt. These findings
help build better theory regarding the outcomes of strategic improvements in environmental risk management.
2. Environmental Externalities and Cost of Capital Chava, 2010
This research analyze the impact of a firm‘s environmental profile on its cost of
equity and debt capital. Using i mplied cost of capital derived from analysts‘ earnings
estimates, this research find that investors demand significantly higher expected returns on stocks excluded by environmental screens such as hazardous chemical, substantial
emissions and climate change concerns compared to firms without such environmental concerns. Lenders also charge a significantly higher interest rate on the bank loans issued
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