Financial Risk Management: Is it a value adding activity?

This article analyzes whether financial risk management is value adding or not. Having been a controversial issue, risk management is very much desired by the companies. A firm’s total risk equals market risk and specific risk of which the latter can be handled by maintaining a diversified portfolio but the former cannot be eliminated. Further, the paper says that risk management activities will not increase the market price of the firm’s share because though total risk is reduced but the market risk remains unaltered. On the contrary risk management may actually be value reducing, since it creates expenses in terms of time and resources.

Further it is argued that the total risk does matter, through its effects on the cash flows. Risk management aimed at reducing total risk, may increase expected cash flows because risk reduction may attract higher cash flows and thus increase the firm’s value. Also, it is argues that firm’s managers consider two discount rates, one private and one social because management would have a lower private valuation of the firm than the market. And risk management is a way for management to increase their private valuation towards the market valuation.

Shimko (2001) then proposes an adjustment to the NPV method and introduced RPV (risk-adjusted present value) which attacks the problem by adjusting the discount rate. RPV is equal to project’s NPV value minus a risk charge that is proportional to the difference between the expected value and the worst case value.

Notably the value of the asset is affected by total risk and particularly the value-at-risk. Thus this approach emphasizes that, when there are limitations to portfolio diversification, investors become concerned with total risk. Drawback of this approach is that the valuation is not standardized and thus RPV method could lead to incorrect project acceptance/rejection decisions.

Shapiro and Titman (1998) provided another approach to investment appraisal whose goal is to identify and accept value-increasing projects. Assumptions made are that the CAPM formulation is robust, and that investors are only rewarded for holding market risk and the idea of value-at-risk is retained. It says that it is better to adjust the cash-flows rather than the discount rate. But the major drawback of this valuation is that self-interested management may reject a value-increasing project. Thus this valuation is not further explored in the paper. Instead managers are assumed to be acting in the interests of shareholders.

After analyzing the effect of risk management on the value of the firm, it is concluded that risk management activities are worthwhile if the elimination of the present value of financial distress costs exceeds the expenditure required on risk management activities. Following this 3 decision rules regarding project acceptance and risk management are formulated and the paper is concluded after few worked out examples.