Explain why finance theory, combined with well-diversified investors and “homemade hedging,”

Explain why finance theory, combined with well-diversified investors and “homemade hedging,”

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June 8, 2021
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Explain why finance theory, combined with well-diversified investors and “homemade hedging,” might suggest that risk management should not add much value to a company.

Answer and ExplanationSolution by a verified expert

Explanation

The financial theory suggests that the value of a firm is directly proportional to its future earnings and inversely proportional to its WACC.
 
Upcoming cash flows from new contracts are already accounted in the share price. Using risk management to stabilize the cash flows will not reduce the cost of equity. This is because a well diversified investor will hold companies that have negative correlation with other companies in the portfolio, and so when the share price of one company falls due to a certain factor, the share price of another company will increase due to the same factor; resulting in the same expected portfolio return for the investor. This kind of diversification by an investor is also called "home-made hedging". Sophisticated investors on the other hand can enter into derivative contracts such as futures and forwards. The cost of these contracts to the investor will be the same as the cost to the company that uses risk management techniques. Therefore, the investors are less likely to reduce the required return on equity, thus limiting any value addition to the company if it uses risk management.

Sample Response

The value of a firm increases only when the WACC is reduced or the expected future earnings are increased. Using risk management techniques in a company neither increases the expected future earnings nor decreases the WACC. The value of a company essentially remains the same with or without risk management. Also, investors with a well diversified portfolio will have the same expected return on their portfolio.

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