IBF ch 8 and 9 - L7: (Ch8) The Rationale for Hedging...

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L7: (Ch8) The Rationale for Hedging Currency Risk When Hedging Adds Value Too add value, hedging must either increase the firm’s future expected cash flows or reduce the risk of those cash flows. That is, if hedging is to add value to the firm, then it must affect either expected future cash flows or the cost of capital. Perfect Model for an Imperfect World Modigliani and Miller (MM) contribution was in indentifying conditions under which financial policy does not matter. Perfect Financial Market Assumptions 1. Frictionless markets 2. Equal access to market prices 3. Rational investors 4. Equal access to costless information MM Irrelevance Proposition If financial markets are perfect, then corporate financial policy is irrelevant. If financial policy is to increase firm value; it must either increase future expected cash flows or decrease the discount rate in a way that cannot be replicated by investors . Example If investors can replicate any financial action the firm can take, there is no value in the firm’s f inancial policy. A good example of this is homemade leverage by borrowing and investing the proceeds in common stock. The implication is that a firm s financial policy becomes irrelevant in a perfect market .
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Three market imperfections have been found to be relevant for firms’ hedging and risk management policies: 1. Taxes differential taxes on different levels of taxable income 2. Cost of financial distress direct and indirect 3. Agency costs between the managers and other stakeholders of the firm. Convexity in the Tax Schedule Taxes are said to be convex when the effective tax rate is greater at high levels that at low levels of income. MNCs can reduce their expected tax payment by reducing the variability of investment outcomes. Factors responsible for creating tax schedule convexity include: Forgone present value of tax preference items Progressive taxation Tax Preference Items Items such as investment tax credits and tax-loss carryforwards that are used to shield taxable income from taxes. Deductions should be taken as early as possibly to maximize the present value of the tax schedule. Progressive Taxation A system in which larger taxable incomes pay a higher income tax rate. Graham and Smith estimate that the biggest incentive to hedge currency comes from tax-loss carryforwards.
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Costs of Financial Distress Direct costs of financial distress directly observed during bankruptcy, such as attorney and court fees. Indirect costs are tougher to observe and incur prior to bankruptcy. I.e. the cost of lost credibility in the marketplace. Equity as a Call Option on Firm Value Suppose debt is given a claim on the assets of a firm. In an option context, the promised payment to bondholders is the exercise price of the option and the due date on the bonds is the expiration date of the option. Equity
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IBF ch 8 and 9 - L7: (Ch8) The Rationale for Hedging...

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