Why is an internally generated cash flow of such importance to Merck? Can't Merck use the financial markets as a source of funds?
What will be an ideal response?
Merck realized that it was operating in an environment of asymmetric information. They needed to be assured of generating sufficiently large internal cash flows such that they could finance their research and development projects over the course of many years. An alternative would be to potentially suffer losses in foreign exchange markets and try to fund its investment projects in the external capital markets. They key question to address is the following: Can the firm successfully raise the funds that it needs at reasonable costs of capital in those states of the world? The answer appears to be no, because the firm will be going to the financial markets when it is unprofitable. As a result, participants in the financial markets must assess why the firm is unprofitable. They will attribute some of the losses to adverse fluctuations in exchange rates, but they might also assign some of the blame to poor managerial decisions. In such a case, the firm's managers will find it difficult to pursue the projects they believe will keep the firm competitive. Hedging would prevent this from happening.
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