List and explain some reasons companies might employ risk management techniques.

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List and explain some reasons companies might employ risk management techniques.


List and explain some reasons companies might employ risk management techniques.

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Debt capacity: By employing risk management activities in the business, the company can reduce the volatility of cash flows and profits, and thus decreasing the overall operating risk of the company. A company with low operating risk can raise more debt.
Maintaining the optimal capital budget over time: Many companies shy away from using external equity due to the high flotation costs. To fund the business, these companies rely on internal cash flows in the form of retained earnings and depreciation. In difficult times, a firm may not be able to generate enough internal cash flow and so has to rely on external high cost financing for maintaining the optimal budget. Applying risk management techniques will reduce the extent of external financing required.
Financial Distress: it is caused when cash flows fall below a certain level. Risk management helps in stabilizing the cash flows and thus reducing the chances of financial distress
Comparative advantage in hedging: Most of the investors are not able to effectively hedge their exposure. Companies on the hand can do so because they have low transaction costs, management has more knowledge about the company, and the companies can employ people with specialised knowledge and expertise in hedging.
Borrowing Costs: Companies can effectively reduce  their cost of debt by using derivatives like swaps and futures contracts and also hedge against rising interest rates using the same.
Tax effects: Companies with volatile earnings are at a disadvantage when it comes to paying taxes. These companies pay more taxes than the ones with stable earnings because of the tax credit treatment, and the corporate loss carry forward rules. Also, in times of bankruptcy, the tax loss carry-forward is mostly lost. Risk management reduces the volatility in earnings.
Compensation systems: Most of the companies have compensation systems that encourage stable earnings. In such companies, the management uses risk management to stabilize the earnings and  get rewarded in return.

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