sols_10 - FM212 Solutions to Class Exercises Lent Term...

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FM212 Solutions to Class Exercises Lent Term 2009/10 Solutions to Class Exercise 10 1. Hedging & MM Modigliani and Miller would say that both financing and risk management are irrelevant in perfect capital markets because any changes in capital structure and firm risk that can be created by the firm’s management can also be created in the capital markets by individual investors. In perfect capital markets, management can not increase firm value by adjusting capital structure and firm risk because individual investors can accomplish these adjustments on their own. The assumptions for MM capital structure irrelevance would also apply to risk management irrelevance, and are 1. No transactions costs 2. No Taxes 3. No Bankruptcy costs 4. Investment is held constant 5. Efficient capital markets (no asymmetric information) 6. Managers maximize shareholders' wealth If market imperfections exist, it may be beneficial to the firm and its stockholders if the firm hedges the firm’s risks. A large firm can hedge many of its risks with much greater cost effectiveness than could an individual shareholder. For example, hedges in the commodity futures markets and in foreign currency futures can be accomplished at much lower cost by the firm than by individual shareholders.
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