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Financial risk management: is it a value‐adding activity?

Financial risk management: is it a value‐adding activity? Considers whether financial risk management is value‐adding. Although risk management can reduce total risk, this may not affect the cost of capital or firm value. Well‐diversified investors have already eliminated all of the specific risk, and risk‐management may be seen as a zero NPV activity at best, and at worst, a value‐reducing activity. However, there is a role for risk management. Reduction of total risk may reduce the expected costs of financial distress, hence increasing expected cashflows. This increases firm value. Presents a method of investment appraisal that takes account of total risk through expected financial distress costs. Such a method can result in three possible decisions relating to a new project; reject the project invest in the project; and risk‐manage; or invest in the project but do not risk‐manage. Finally, presents worked examples. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Balance Sheet Emerald Publishing

Financial risk management: is it a value‐adding activity?

Richard Fairchild
Balance Sheet , Volume 10 (4): 4 – Dec 1, 2002
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Publisher
Emerald Publishing
Copyright
Copyright © 2002 MCB UP Ltd. All rights reserved.
ISSN
0965-7967
DOI
10.1108/09657960210450754
Publisher site
See Article on Publisher Site

Abstract

Considers whether financial risk management is value‐adding. Although risk management can reduce total risk, this may not affect the cost of capital or firm value. Well‐diversified investors have already eliminated all of the specific risk, and risk‐management may be seen as a zero NPV activity at best, and at worst, a value‐reducing activity. However, there is a role for risk management. Reduction of total risk may reduce the expected costs of financial distress, hence increasing expected cashflows. This increases firm value. Presents a method of investment appraisal that takes account of total risk through expected financial distress costs. Such a method can result in three possible decisions relating to a new project; reject the project invest in the project; and risk‐manage; or invest in the project but do not risk‐manage. Finally, presents worked examples.

Journal

Balance Sheet – Emerald Publishing

Published: Dec 1, 2002

Keywords: Risk management; Financial investment

References

  • The Revolution in Corporate Finance
  • NPV No More: RPV for Risk‐based Valuation
  • The Revolution in Corporate Finance