Question 1: The two sentences before (i): The first sentence states M & M’s proposition 1. The second sentence apparently follows on from the first sentence, i.e. the first sentence implies the second sentence. I think my first uncertainty here is the definition of “financial risk”. Page 1 of SA5’s chp 9 does not define financial risk but categorises market and credit risk as the two main sources of financial risk. I have searched through several books and on the internet for the definition of financial risk. As I understand it financial risk can refer to the risk that arises from financial gearing. By increasing borrowing (particularly fixed debt) the volatility of shareholders’ returns increases. The risk of financial distress can increase and possibly even bankruptcy (with high levels of debt) can result. However, financial risk can also refer to the risk arising because of factors that cause volatility of profits. This would include gearing but include other factors as well – I presume market and credit risks, for example. This would seem to be true if one looks at q (iii) where “three of the largest financial risks” are asked for. Having read the first sentence I immediately associated “financial risk” in the second sentence with the risk arising out of “gearing” because M&M's first proposition handles capital structure and therefore gearing. But the question in (i) and answer does not seem to refer to gearing risk, but would seem rather to refer to reducing risk in general. I do not actually see how the first sentence implies the second sentence and hence could not completely relate the question in (i) to these two sentences. The second sentence seems to be saying that shareholders are able to reduce the various risks faced by a firm (possibly) better than the firm itself. Is this really what M&M’s proposition is saying? M&M argued that, in a perfect market, the firm’s value is determined by the asset side of the balance sheet. It does not matter in what proportions debt and equity are on the capital side of the balance sheet. Shareholders are able to borrow at the same rate as firms and hence firms add no value by gearing up – this was what was argued by M&M using a no-arbitrage argument. I don’t see how this fits in with that second sentence. Did anyone else struggle to understand this question? Or else if you do understand it - please shed some light…. Thanks.
