The Arguments for Corporate Hedging and Hedging Reduces the Probability of Financial Distress

If risk management is to be logically justified in financial terms, there has to be a positive answer to the question. Will exposure management increase the value of the firm? The fact that the firm is confronted with interest rates, exchange rates and / or commodity price risk is only a necessary condition for the firm to manage that risk. The sufficient conditions is that exposure management increases the value of the firm.

Value of the firm (V) = E (NCFt) / (1+k) t

Where E (NCFt) = Expected Net Cash flows

K = Cost of capital (discounted at the firms ‘K)

Hedging can reduce the cost of financial distress by:-

Reducing the probability of financial distress.

Reducing the Costs imposed by financial problems

Hedging Reduces the Probability of Financial Distress

Where VFD is the value of the firm above which financial distress is encountered, it can be seen that hedging reduces the probability of financial distress from point ‘p’ to point ‘q’.

Hedging and the tax system interrelate to impact upon the level of net cash flows of the firm. How does this work? If company is facing an effective tax schedule which is convex, than a reduction in the volatility of profit through hedging can reduce corporate tax payable. What is meant by a convex tax schedule? If the firm follows average effective tax rate raises the profit. (If the tax schedule is convex, hedging can lead to a reduction in the firm’s expected taxes. The more convex the tax schedule and the more volatile the firm’s pre-tax profits, the greater are the tax benefits that accrue to the company. Corporate tax schedule in Britain and the USA currently give the firm only minimal)