Risk Management and Value Creation in ... - Arabictrader.com

78 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
increase the firm’s (expected) cash flows 118 by decreasing the frictional costs
(as mentioned previously) to increase the value of a widely held firm. 119
This can only happen under circumstances 120 that basically turn M&M’s
Proposition I 121 “upside down”, 122 that is, when financial decisions (including
risk management) have an impact on taxes, transaction costs, or the
investment decisions of a firm. 123 Besides these three reasons (as shown in
the gray shaded areas in Figure 3.2 below) stemming immediately from the
relaxation of the M&M assumptions, 124 there are other circumstances under
which it can make economic sense to manage risks at the firm level.
They are the result of the relaxation of other neoclassical assumptions and
are, for example, due to managerial risk aversion 125 or other effects of having
not-well-diversified investors. 126 Similarly, other market inefficiencies (as discussed
in detail below) show that it is not sufficient to just turn the M&M
proposition upside down in order to get a comprehensive picture of the
economic rationales for risk management in the neoinstitutional world; a
more differentiated view is necessary.
Clearly, because we now permit agency and transaction costs, there are
not only benefits but also costs associated with risk-management actions. 127
Only as long as the benefits outweigh the costs can risk management be
sensible from an economic point of view. In the subsequent sections we will
118 Smithson (1998), pp. 6–13, labels this view the “Real Cash Flow” rationale for
risk management.
119 See Smith (1995), p. 20.
120 As first identified and discussed by Smith and Stulz (1985).
121 M&M Proposition I postulates that, in a world without taxes and transaction
costs, and given a fixed investment program, financial decisions cannot affect the
value of a firm.
122 See Smithson et al. (1990), pp. 357 and 363, Smithson (1998), p. 7.
123 See Smith and Stulz (1985), p. 392, and Smith (1993), p. 17.
124 These three points of turning the M&M Proposition I upside down are labeled by
Tufano (1996), p. 1106, as the Shareholder Value Maximization Hypothesis of risk
management.
125 This is labeled the Managerial Utility Maximization Hypothesis by Tufano (1996),
p. 1109. Fenn et al. (1997), pp. 13+, also identify this fourth rationale in addition
to the three stemming from the relaxation of the M&M assumptions. Likewise, see
Froot et al. (1993), pp. 1631+. Smithson (1998), pp. 13–14, calls this view the “Agency
Relations with the Firm’s Managers” rationale for risk management.
126 Damodaran (1997), pp. 785+, also distinguishes between risk-management rationales
that apply to companies with well-diversified investors and undiversified
investors.
127 Both benefits and costs are difficult to quantify in this context.