Question

You want to maximize the value of the firm.

Apple, for example is domiciled in a country where interest payments are not tax deductible. Bankruptcy proceedings in this country are primitive, and bankruptcy would be a costly event for Apple.

Otherwise, there are no other significant departures from the assumptions of the Modigliani-Miller theorem (perfect information, no financial frictions, etc.).

Given these assumptions: (mark all that are true)

A. Apple should not hedge any of its foreign exchange risk.

B. Apple should hedge 100% of its foreign exchange risk.

C. apple hedge ratio should lie between 0% and 100%.

D. Apple choice of hedging policy will not affect the value of the firm.

Answer 1

Answer-

The correct Option is B. Apple should hedge 100% of its foreign exchange risk.

As the country of operation has no tax deductions on interest payments and moreover if bankruptcy takes place it will be a costly event which will inur huge losses to the Apple in this country.

Hedging helps in  reducing the cost of debt for Apple as it has higher bankruptcy or financial distress risk. As financial distress is a costly event Apple should will gain from hedging because it will decrease the likelihood of bankruptcy or financial distress. Hedging will help in maximizing the valueof firm.

The Other options are inorrect.

Option A if followed by not hedging will cause losses in case of bankruptcy.
Option C is incorrect as range of 0 % t0 100 % is that the lower limit of 0 % is not applicable.
Option D is incorrect as the hedging policy affects the value of firm as the bankruptcy will adversely affect the financial position of the company which can be eliminated by hedging.