Corporate Finance Class Question Please Help!!?
Derivatives were originally designed to reduce uncertainty. That is, they were a risk management tool. However, in recent years they have, more and more, become a tool for generating income, often speculative income, at significant risk. In fact, in some companies the finance department is considered a profit center. Comment on whether you think this is appropriate or not and why you think as you do.
Since the main goal of a company is to maximize shareholder wealth, it is appropriate for a finance department to be a profit center IF the risk is acceptable to the shareholders. A serious problem at Enron was those in charge of the raptor projects didn’t properly disclose the risks involved to the board of directors. They should also be properly disclosed in the financial statements so that shareholders and other stakeholders (lenders, etc.) can make informed decisions.
Derivatives are instruments to hedge risk – price risk, currency risk, coupon risk etc. So it should only be used for the same. Un-necessary and heavy use of derivatives can make you for exposed to risk rather than covering you. Derivatives are highly sophisticated instruments so it should be used with extreme care. Lastly as a corporations main objective should be earn revenue through operation and wealt generation and not merely by speculation so use of derivatives should be restricted only for risk coverage.
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Since the main goal of a company is to maximize shareholder wealth, it is appropriate for a finance department to be a profit center IF the risk is acceptable to the shareholders. A serious problem at Enron was those in charge of the raptor projects didn’t properly disclose the risks involved to the board of directors. They should also be properly disclosed in the financial statements so that shareholders and other stakeholders (lenders, etc.) can make informed decisions.
References :