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

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.