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A 2007 questions

Discussion in 'SA5' started by Edwin, Mar 9, 2015.

  1. Edwin

    Edwin Member

    Q 1 i) I seriously have no clue what part i of this question is asking for, nor what the statement is saying. I understand the part of Modigliani & Miller that says a certain market value of a firm is unaffected by how that firm is financed.

    Also see this thread;- http://www.acted.co.uk/forums/showthread.php?t=983&highlight=april

    However when it comes to the second sentence that says "In other words it does not pay a firm to eliminate financial risk if shareholders can achieve the same result for the same or lower cost." I have no idea what this means and how it follows from M&M? Is this statement saying that M&M implies that implies that shareholders can run the firm themselves?

    Also the solution seems to have no connection to M&M except the following quote i got from Wikipedia
    Which justifies the tax, asymmetric information and bankruptcy costs in the ER.

    In my solution I tried to provide a link by discussing tax in the aspect of gearing, as well as to provide some general points like;- hedging financial risk reduces volatility of ROE, hedging financial risk helps the company to minimise losses on assets and hence can meet cashflows related liabilities as they occur etc The point is there are so many reasons why a firm may decide to hedge financial risk including get a good credit rating. Most of the questions (& solutions) in this paper were disappointing....Any help will be appreciated as always.

    (P.S Hello Colin, I see you prefer to answer questions when posted in different threads since my A2010 post has not been answered so I thought I will not post all my questions from this paper here as I normally do but will instead use different threads?)
     
    Last edited by a moderator: Mar 9, 2015
    Edwin, Mar 9, 2015
    #1
  2. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    Hi, Keep posting the qustions in the appropriate threads rather than always in a new thread. If I havent answered a thread its probably because I don't know the answer and have left it for others to contribute to, or I havent seen it pop up. Best to avoid a million separate threads.

    With respect to this one, I don't see your issues with it. M&M says that in a perfect world firms should not mess around with their financial structures because it doesnt add anything that the investor cant do themselves. This means that the firm should not add gearing, reduce gearing, or increase/decrease financial risk through any other means. But the theory is based on a perfect world, and the things mentioned in the ER for part (i) are the problems with the assumptions involved. Namely that shareholders fear bankruptcy (so it may pay a firm to reduce financial risk), managers have increased information if the firm approaching hard times (so it may pay to decrease financial risk), there may be tax benefits that the company can have when it reduces financial risk where investors would not be able to benefit from these, and finally the well-being of staff, customers, ... These all seem like perfetly good answers to me. Anyone else have a view?
     
    Colin McKee, Mar 10, 2015
    #2
  3. Edwin

    Edwin Member

    Thanks for the reply Colin, (comment about posts noted)

    The part I don't understand is;-
    ...In other words, what can investors do that can bring the same effect as optimising gearing by the firm?

    because this now tastes like spikes some agency problem, where shareholders say "we can manage the firm ourselves"?
     
    Edwin, Mar 10, 2015
    #3
  4. didster

    didster Member

    Think idea is that investors can borrow money themselves to buy shares to increase gearing (without any change in firm) etc.
     
    didster, Mar 11, 2015
    #4
  5. Edwin

    Edwin Member

    Beautiful!
     
    Edwin, Mar 12, 2015
    #5

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