Hedging vs Firm Value

[rahul.goyl]

Hi David,
Found another gud one, wud say the answer for this one in debatable.
Cud you plz shed some light on this one.

Which of the following statements is not correct?

a. In order to maximize the value, a firm must hedge its financial exposure irrespective of its capital structure.

b. Decisions to hedge financial exposures should be made jointly with the company’s capital structure decisions.

c. The use of risk management to reduce financial exposures effectively increases a firm’s debt capacity.

d. The more the firm hedges its financial exposures, the less equity it requires to support its business.

The correct answer is In order to maximize the value, a firm must hedge its financial exposure irrespective of its capital structure.


Regards,
Rahul

 

[hsuwang]

Hi Rahul,

I think for some reason I've seen this question before and I think the answer is different, can you please give me the source to this question? Thank you.

 

[rahul.goyl]

Hi Jack,

Apologies for responding late, I have these Q banks from some FRM Classes & these Questions are collated in a word doc.
So honestly myself is not aware from where they have collected these Q banks.
Though for FRM preparation these are really gud practice questions.

Regards
Rahul

 

[David Harper CFA FRM]

Rahul,

I agree with you it may be generally debatable, but the relevant FRM assignments are Stulz.
His chapter 2 (following classic M&M) holds that risk management is irrelevant to issues like capital structure; so it's a very "traditional academic" perspective from M&M that, under a set of restrictive assumptions, cap structure doesn't impact firm value.

But Stulz chapter 3 concerns real life frictions, in particular cost of financial distress. Due to cost of financial distress (and debt overhang), frictions (tax is another friction that "distorts") imply that risk management does have potential to add value and, therefore, does interact with cap structure.

That's my summary of Stulz 2 & 3: Stulz 2 says risk can't add value under classic assumptions; Stulz 3 says the classic assumptions are violated and therefore, risk can add value.

David