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

94 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
ibility needed to take advantage of new investment opportunities, 211 increasing
the agency costs of debt. Additionally, because the shareholder incentive
increases as the firm is closer to distress, firms may find it difficult in general
to raise external funds to finance valuable investment projects.
Risk management can help to reduce these agency costs from risk shifting
by balancing conflicting interests. It can:
■
■
■
■
■
■
Decrease the agency costs from the asset substitution problem by
lowering the cash flow volatility of the firm.
Increase the debt capacity of the firm without increasing default
probability. Risk shifting will therefore be less of an issue. 212
Reduce the probability of default. Potential debt holders are therefore
willing to pay more for the bond or to require lower coupon
payments, which will increase the firm value.
Be more beneficial, the more likely is the breaching of covenants and
other restrictive measures. Firms that are more likely to be exposed
to this risk will conduct more risk management to avoid additional
agency costs.
Decrease agency costs from risk shifting, which are likely to be greater
in firms whose cash flows cannot be easily observed and monitored. 213
Be beneficial when credible commitments to manage observable risks
can reduce the incentive to substitute assets and the associated agency
costs of debt. 214
The Underinvestment Problem As defined in Equation (2.1), (operating) cash
flows are the sum of debt holders’ and stockholders’ claims on the company.
Having to split these cash flows between the two groups can create problems
(so-called shareholder-bondholder conflicts) that might result in a reduction
of the value of the firm due to the agency costs associated with
them. This problem is especially relevant in the underinvestment problem,
which has two facets:
■
The firm does not generate enough internal cash flows that are then
available for valuable investment projects. This leads to less investment
than what would otherwise be possible (underinvestment). We
211 See Stulz (1999), p. 5.
212 See Smithson (1998), p. 8. Also, a higher debt ratio increases the benefits from the
tax shield of debt.
213 See Damodaran (1997), pp. 453+.
214 See Raposo (1999), p. 47.