The underinvestment problem and corporate derivatives use

Financial Management (Financial Management Association), Winter, 1998 by Gerald D. Gay, Jouahn Nam

In a perfect world such as that of Modigliani and Miller (1958), there would almost be no justification for corporations to engage in hedging, including those strategies that use derivatives. However, financial economics offers several hypotheses to explain why corporate hedging can be rational or value-enhancing, each of which relies on some form of market imperfection. One hypothesis, based on the shareholder-value-maximization paradigm, suggests that hedging can increase firm value by reducing expected taxes, lowering the expected costs of financial distress, or alleviating the underinvestment problem associated with costly external financing. A second hypothesis is based on agency theory, and it focuses on the private motives of managers who attempt to maximize their personal wealth through risk management.

The primary focus of this paper is on one of the less well-explored hypotheses, alleviating the underinvestment problem through hedging. As described in Froot, Scharfstein, and Stein (1993), costly external financing is a market imperfection that makes hedging a value-enhancing strategy. That is, an underinvestment problem results when firms find that external financing is sufficiently expensive that they must reduce investment spending during times when internally generated cash flows are not sufficient to finance growth opportunities.(1) Hedging or risk management in this situation adds value because it helps ensure that the corporation has sufficient funds available to take advantage of attractive investment opportunities.

Our paper investigates these issues. Our analysis builds on existing empirical studies by using improved methods for capturing investment opportunities, and by examining interaction effects among a firm's investment opportunities, cash stocks, and internally generated funds. We are thus able to more clearly distinguish the role of the underinvestment hypothesis in the determination of corporate hedging policy.

Following standard convention, we assume for analytical purposes that firms conduct their hedging through the use of derivatives. We recognize that in addition to using derivatives, firms can and do use other techniques to manage risk.

The paper is organized as follows. Section I reviews the extant literature that deals with the role of risk management in mitigating the underinvestment problem. Section II presents three testable hypotheses examining the importance of internally generated cash flow, cash stocks, and investment opportunities on a firm's hedging position. The empirical results are presented in Section III. Section IV concludes.

I. Prior Research: Underinvestment and the Use of Derivatives

Froot, Scharfstein, and Stein (1993) develop a general framework for analyzing corporate risk management in the presence of costly external financing. Their risk-management paradigm rests on three premises: first, firm value is created through investment in positive net-present-value (NPV) projects. Second, an important key for supporting good investments is internal generation of sufficient cash to fund those investments. When firms do not generate sufficient cash flow, they tend to cut investments below the optimal level because of costly external financing. Third, internally generated cash flow, which is critical to the investment process, can be disrupted by external factors such as movements in exchange rates, interest rates, or commodity prices. Under this framework, Froot et al. show that a firm's hedging activity can increase value to the extent that it ensures that a firm has sufficient cash flow available to make value-enhancing investments. Other studies, including Smith and Stulz (1985) and Smith, Smithson, and Wilford (1990), develop rationales for hedging similar to Froot et al. However, Tufano (1998) discusses the potential value-decreasing effects of cash flow hedging associated with heightened agency conflicts between managers and shareholders.

Empirical studies provide mixed support for the underinvestment hypothesis. Nance, Smith, and Smithson (1993), Geczy, Minton, and Schrand (1995), and Dolde (1995) find that firms with high levels of research and development (R&D) expenses are more likely to use some form of derivatives instrument. However, using a market-to-book-value ratio to proxy for a firm's future investment opportunities, Mian (1996) finds a negative relation between a firm's investment opportunities and its derivatives use, which does not support the underinvestment hypothesis. Mian states that one explanation for not finding a positive association between hedging and the market-to-book ratio could be due to constraints imposed by mandated reporting requirements on hedging of anticipated exposures. However, these reporting requirements do not predict a negative association. For a sample of New Zealand firms, Berkman and Bradbury (1996) find little or no support for the underinvestment hypothesis when using either an earnings-price ratio or asset growth/cash flow variable to capture a firm's investment opportunity set.