Hedging, Financing, and Investment Decisions: A Simultaneous Equations Framework

Working Paper 2005-5 March 2005 Abstract: The purpose of this paper is to empirically investigate the interaction between hedging, financing, and investment decisions. This work is relevant in that theoretical predictions are not necessarily identical to those in the case where only two decisions are being made. We argue that the way in which hedging affects the firms' financing and investing decisions differs for firms with different growth opportunities. We empirically find that high-growth firms increase their investment, but not their leverage, by hedging. However, we also find that firms with few investment opportunities use derivatives to increase their leverage. JEL classification: G31, G32 Key words: investment, financing, hedging I. Introduction According to the theory of Modigliani and Miller (1958, 1963), in a perfect capital market neither hedging nor financing decisions add value to shareholders since companies can always obtain external funds at the same costs as internal funds to finance their investment opportunities. Thus, in order for investors to care about these decisions by corporations, some market imperfections must exist. Most existing theories discuss either investment and financing, investment and hedging or financing and hedging. They show that various imperfections affect hedging and financing, hedging and investment, or investment and financing decisions. Underinvestment theories raised by Bessembinder (1991) and Froot, Scharfstein, and Stein (1993) argue that firms with greater growth opportunities should hedge more because of capital market imperfections. Tax shields associated with debt financing lead Stulz (1996), Ross (1996), and Leland (1998) to posit that hedging causes an increase in firm value by enabling firms to increase leverage. The debt capacity argument thus predicts a positive relationship between hedging and leverage. When looking at financing and investment, Myers (1977) demonstrates that firms with good investment opportunities should carry less debt since a high level of debt induces managers to forgo positive NPV projects. However, the theoretical relationship between hedging, financing, and investment decisions can be different than when we consider just two of three decisions in isolation. For example, by considering the relation among hedging, leverage, and investment, Ross (1996) argues that hedging to increase leverage may not mitigate the underinvestment problem, since if firms increase debt capacity after hedging then this higher leverage increases the agency cost of debt that in turn leads to the incentive for underinvestment. Ross' argument implies that firms with high growth opportunities are more likely to hedge to mitigate the underinvestment problem and are less likely to increase debt capacity. For firms with few growth opportunities, Stulz (1996) suggests that a manager with interests that are aligned with those of shareholders would be more likely to hedge to increase leverage in order to maximize shareholder wealth. Given these often conflicting theories, the purpose of this paper is to empirically investigate the interaction between hedging, financing, and investment decisions for firms with different growth opportunities. We argue that a three equation system is more consistent with the idea that all three decisions are made at the same time. Therefore, we investigate these decisions within a simultaneous framework in order to avoid the standard problem of endogeneity. In particular, we use derivative usage to measure the extent of risk management. While we recognize that derivatives can be used for speculation purposes, due to the data constraints we assume that derivatives are used as hedging instruments. By conducting cross-sectional regressions as well as tests for new users of derivatives, we find empirical evidence to support Ross' hypothesis (1996) that firms with high investment opportunities are more likely to mitigate the underinvestment problem by hedging. …