JQ/Practice Question-Risk Mgnt and Value Equation

For our practice exam, Professor Grace asked us to answer what risk management would do the value of a firm equation. I then noticed that it was also a JQ. So I'm taking it that this is really important. Therefore, I'll break down each component and tell how risk management will affect the equation.

First, let's assume that the appropriate risk management technique has been implemented, and it was performed correctly. So with better risk management, the following will occur:
1. The probability of a firm going bankrupt will decrease. Therefore, the bankruptcy costs will also decrease.
2. As the probability of bankruptcy decreases for a firm, their credibility and reputation begin to look better to lenders. (As Professor Grace said, when you need money the most, that's when people do not want to lend it to you. This is especially true when a company has a higher risk of going bankrupt and losing the money that was lent to them. I believe this is called default risk). Thus, a smaller bankruptcy probability and lower bankruptcy costs will lead to a better interest rates from lenders. This interest rate will be smaller, making the denominator (1+r)^t smaller

The combination of these two factors (low bankruptcy cost and lower interest rate, therefore lower denominator) makes the overall equation and value of the firm increase. One might notice that we didn't mention NCF (Net Cash Flows). This is equal to (Revenues-Costs). With the implementation of risk management techniques, costs will increase. (Paying for insurance, hedging, etc). However, if done correctly and with good financial forecasting, Revenues might also increase, thereby balancing out the numerator of the equation.

Hope this helps.