International Financial Management P G Apte

1. CHAPTER - 2 Objectives of the Firm and the Impact of Risk International Financial Management P G Apte P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

2. 2.1 Objectives of The Firm • In modern theory of finance the objective of the management of a firm is to maximize the current value of shareholders' wealth. Are we sure that: • Current value maximization objective does not ignore the multi-period character of financial (and other) decisions • It incorporates uncertainty in some way P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

3. 2.1 Objectives of The Firm (contd.) • The current value of shareholders' wealth is • S0 =  Dt/(1+ks)t • S0 is the current value of the shareholders' wealth, Dt is the dividend paid at the end of period t and ks is the rate of discount used by the shareholders Capital gains are taken care of in the above formula P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

4. 2.1 Objectives of The Firm (contd.) • The concept of wealth maximization incorporates a multi-period horizon with any combination of dividends and capital gains • Equity shares are risky assets • The modern theory of finance as represented by the famous Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) rests on the following three propositions P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

5. 2.1 Objectives of The Firm (contd.) • Investors are "risk-averse" • A risky asset has two types of risks associated with it viz. the unsystematic, firm- specific risk and thesystematic risk • Risk-averse investors will not worry about firm-specific, unsystematic risks since these risks are diversifiable Hence according to CAPM mitigating unsystematic risk would not add shareholder value. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

6. 2.2 Risk Management and Wealth Maximization • What should be the attitude of the firm's management regarding firm-specific risks? • Risks arising out of fluctuations in exchange rates, interest rates and commodity prices are pervasive, however they affect different firms in different ways and are therefore firm-specific or idiosyncratic P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

7. 2.2 Risk Management and Wealth Maximization (contd.) • The theory underlying the CAPM tells us that hedging such risks is irrelevant i.e. adds no shareholder value • Modigliani-Miller analysis of a firm's optimal capital structure offers another argument against hedging • If capital markets are perfect, individual investors, in particular a firm's shareholders can replicate any financial strategy adopted by the firm P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

8. 2.2 Risk Management and Wealth Maximization (contd.) • Still another argument against hedging is that with efficient markets it would not matter in the long run whether a firm follows an active hedging policy, a purely passive strategy of hedging all risks at all times or a policy of no hedging at all • Also, can a firm pass on the risk to someone else without compensating the other party? P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

9. 2.2 Risk Management and Wealth Maximization (contd.) • If active risk management by a firm adds shareholder value it must be • Because it alters the firm's cash flows in a way which is beneficial to the shareholders even after meeting the cost of hedging • The firm can achieve this at a lower cost than what the shareholders would have to incur if they did it on their own P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

10. 2.2 Risk Management and Wealth Maximization (contd.) • Why selective or discretionary hedging rather than 100 percent hedging might be an optimal policy under certain conditions • The firm's ability to take advantage of all the available good investment opportunities depends crucially on the availability of internally generated cash • Careful hedging can minimize the probability of the firm finding itself short of internal cash at a time when the environment presents good investment opportunities P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

11. 2.2 Risk Management and Wealth Maximization (contd.) • The investment-financing inter-linkage predicts that firms with more growth opportunities are more likely to be hedgers than those with more stable businesses • Unsystematic risks like exchange rate risks, if left unmanaged, increase the probability of the firm getting into financial distress • This can have adverse long term consequences P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

12. 2.2Risk Management and Wealth Maximization (contd.) • Adverse reactions by bankers, suppliers, customers etc. can increase costs, and reduce market share • Perception of financial distress may induce key employees to leave • May induce managers to cut corners, compromise on quality etc. • All this may threaten long-run survival of the firm P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

13. 2.2 Risk Management and Wealth Maximization (contd.) • Another argument in favor of hedging has to do with the nature of tax schedules faced by the firm. • Convex tax schedules mean greater tax payment on increase in profits than tax savings on equal reduction in profits • Still another reason might be divisional performance appraisal P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

14. 2.2 Risk Management and Wealth Maximization (contd.) • Agency-theoretic explanations for hedging focus on the conflict between stockholders and bondholders. Cost of debt can decrease if bondholders perceive prudence on the part of management. • To undertake hedging themselves, shareholders would need to gather lot of information. This is a costly activity. The firm can do it cheaper. P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT

15. 2.2 Risk Management and Wealth Maximization (contd.) • In the case of a multinational firm whose shareholders are scattered around the world, it is not clear exactly how hedging serves shareholder interests. • Different shareholders have different currency habitats. A US multinational protecting its income measured in US dollars may actually hurt its German stockholders P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT