2.

0 Literature Review

This section presents the theories regarding capital structure and corporate hedging. The
definition of hedging is first clarified as hedging can come in many forms. This is followed
by the mainstream theories of capital structure such as trade off theory, pecking order theory,
free cash flow, agency issues and information asymmetry. The capital structure theories are
ended with how hedging can help mitigate certain issues. The final section will argue the idea
of simultaneity between the determinants of hedging policy and capital structure policy.

MM Irrelevance Theorem

Modigliani-Miller’s (1958) irrelevance theorem (or MM theorem for short) forms the basis
for modern thinking on capital structure. The model implies that in the absence of taxes,
bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm
is unaffected by how that firm is financed. In effect, MM theorem refocuses on gauging firm
value on the right side of the balance sheet of value creation in the absence of a perfect
market condition rather then the financing decision. Although MM theorem’s intention was
to provide an intuitive view on the irrelevance of financing, it did lead to the opposite. MM’s
proposition prompted the research community to focus on how to achieve the optimal capital
structure as assumed by MM and its determinants rather then what it was intended. In the
practical world, many of the assumptions by MM theorem are violated. This is where hedging
comes into play. By hedging, firms can minimize the covariance of some of the imperfection
(determinants of optimal capital structure) in relation with firm’s value thus immunizes the
firm to certain adverse condition that occurs in the market.

Definition & Research on Hedging

Hedging can come in many different forms. Entering into a bank loan and repaying it later,
purchasing of forward contract, holding foreign currencies, trading of futures contract in a
derivative exchange and corporate mergers are all considered to be a form of hedging. Smith
and Stulz (1985) uses a fairly general definition of hedging, where firm’s value are preserved
regardless of any state changes. In their words, “Hedging reduces or eliminates the
dependence of firm value on changes in state variable. Alternatively, we can say that firm A
hedges more than firm B if absolute value of covariance of the value of firm A with value of
an unhedged firm with the same production policy and capital structure is less than or equal
to that of firm B.” Other form of hedging known as natural hedge is a position of a company
that establishes assets or borrowings in a currency that provides an offset to expected cash
flow. In this paper, we are primary concern with hedging with the use of financial derivative
instruments specifically futures, forwards and swap. Hedging is measured by the total
notional value of the hedge. The gross notional value is a better measurement but due to lack
of data, we are only able to proxy the degree of hedging through the total notional value.

The research of hedging can be categorized into a few mainstreams. Tufano (1996) separates
hedging research by looking at the motivation of hedgers. In Tufano’s view, the two main
studies of motivation of hedge are maximization of shareholder value (Smith & Stulz 1985,
Froot 1985, Culp 2001) and maximization of managerial utility (Stulz 1984, 4 Smith & Stulz
1985, DeMarzo and Duffie 1995, Breeden and Viswanathan 1996). Schrand (1998)
categorizes the research of hedging by focusing on the practicality of hedging research that
investigates the needs and cost of hedging.

Triki (2005) consolidates past twenty years of research on corporate hedging theories and
identifies the determinants for hedging. From Triki’s summary, it appears that tax convexity,
firm’s exposure, firm’s size, substitution of hedging, board characteristics, information
asymmetry, ownership structure, managerial risk aversion, financial distress cost and
underinvestment are correlated with firm’s hedging practices.

Capital Structure & Hedging Theories

i. Static Trade-off Theory

As its name suggest, the static trade-off theory is a compromise between conflicting financing
decisions due to market imperfection. Myers (1984) proposed that taxation, bankruptcy cost
and agency cost are the major determinant in deciding the trade-off that requires compromise.
Haris and Raviv (2001) categorize the cost of financial distress into two components. One is
the direct cost and the other is known as the indirect cost. Direct cost is the cost in direct
relation with the action of the company at the bankruptcy state. It normally includes the
administrative expenses such as legal fees. The indirect cost is the cost that affects the firm's
value indirectly. The bulk of the indirect cost comes from the devaluation of the stock price
where the market value of the share is reduced substantially. Employee's morale that affects
the firm’s productivity indirectly can also be considered as a part of the indirect cost. A third
form of indirect cost comes from the loss of goodwill from the firm's suppliers and
customers. According to Haris and Raviv (2001), for a high capitalize firm, the direct cost
usually are insignificant when compared to the indirect cost whereas for a small firm, the
direct cost can also be substantial. The trade-off theory with respect to tax incentives and
bankruptcy says that a firm has the incentive to increase its percentage of debt up to the point
where the tax benefit derived from debt financing equates its bankruptcy cost. Hedging will
provide additional leverage for the firm as it reduces the firm’s financial distress cost. With
the increase in leverage, firms will benefit from the tax incentives derived from debt
financing.

ii. Agency Theory

Agency issues arise due to conflicting position between different interest parties in a firm.
The main conflicting position is between shareholders versus managers and debt holders
versus equity holders.

Jensen and Meckling (1976) form the initial theories of agency issue that build on top of
Fama and Millers (1972) work. In Jenson & Meckling paper, they propose that the conflict
between shareholders and managers occurs as managers normally claims less than 100% of
the firm's residual claims when the firm excels in their performance. Whereas as the firm is
not performing as expected, managers will have to bear the full cost (responsibility). Thus
managers do not have an incentive to act in the best interest for the firm. On the flip side,
managers might even utilize the firm's resources for their own personal benefits. Jensen &
Meckling argues that by structuring firm's capital with debt, it can reduce agency issues
between owner and managers in two ways. The first effect when the firm's capital structure
increases with debt is where the amount of free resources in terms of cash is reduced. This
reduces the manager's self-benefiting activities. The other effect when the percentage of debt
financing increases is that it will increase the manager's relative share of benefit whereby
closing the gap of inequality.

An alternative method to manage the conflict between equity holder and managers is through
the use of hedging. Managers are generally assumed to be risk averse. As bulk of the
manager’s income is generated from the firm, they are not able to diversify the systematic
risk incurred by the firm. This will provide the manager an incentive to hedge. On the flip
side, if managers are compensated through the use of stock options, the managers might not
choose to hedge as the value of options is related to the volatility of its underlying asset, the
firm’s stock.

Free cash flow occurs when there is excess of free cash after all the free cash are invested in
positive yield investments that brings positive future cash flows. Easterbrook (1984) and
Jensen (1986) proposed that companies that are stable and generates such excess steady
stream of free cash flow are typically mismanaged through cash hoarding. As such, managers
in such firms typically “plays it safe” and thus not utilizing the firm’s resources effectively.
Easterbrook and Jensen argue that the use of debt can mitigate the effects of free cash flow
issue. Excess cash can be pay out as dividend to shareholders or reinvest in a more profitable
projects. The cost of free cash flow is the opportunity cost of the cash that is underutilized.
Free cash flow hypothesis says that the increase of debt can curtail the abuse of piling up cash
where it can be channel to useful projects that requires the manager’s attention. The use of
derivative is where firms can hedge away undesirable risks rather than using free cash as a
safety net. This frees up the cash to be paid as dividend that increases the firm’s value.

Conflict between Equity holders and Debt holders arises due to the issue of moral hazard. As
equity holders have the controlling stake in the firm, they might exist a chance where the
equity holder will act in a riskier manner (immorally) in its investment decision as soon as the
firm secures its loan from its creditors. Such action is disadvantage towards the debt holders.
Debt holders that recognize such behaviour normally pre-empt by setting up costly covenants
(such as liquidity limitation & interest coverage ratio level) during the negotiation of terms of
the debt. Smith and Stulz (1985) proposed that hedging could reduce the probability of
financial distress that cause the firm unable to fulfil its debt obligation. With such risk
management policy in place through hedging, bondholders can waive the limiting condition
to be none binding thus freeing the firm to have autonomy its investment decision.

The underinvestment problem is the tendencies of managers, acting in the interest of

shareholder to forgo value-enhancing projects if the gain in the investment mainly accrues
towards debt holders instead of shareholders Myers (1977). Underinvestment predominantly
occurs on firms with high investment opportunities and risky debts Braeley and Myers
(2000). Underinvestment causes mangers to pursue sub optimal investment projects. Stulz
(1990), Froot, Scharfstein and Stein (1993) argue that hedging can reduce the cost of external
and internal finances. This is because hedging reduces the volatility of cash flow from
existing projects, thus the firm can direct the financing towards where it is most needed.

Simultaneity of Hedging and Capital Structure

Stulz (1996) Ross (1996) and Leland (1998) argues that debt financing motivates firms to
hedge because hedging reduces cash flow volatility and therefore decreases probability of
bankruptcy and financial distress. In Haushalter (2000) study, he shows that debt ratio affects
hedging decisions in the oil and gas industry and conjectures that the decisions are made
jointly. Graham & Rogers (2002) states that hedging and debt policy decision must be made
jointly and ignoring such interconnections risk omitting important variables and potentially
make incorrect inference about corporate decision making. Ross (1996) demonstrates that
simultaneous relationship exists between hedging and debt structure. This is because
reduction of financial distress cost due to hedging will increase the firm's debt capacity. Since
there are tax incentives in debt financing, firms will be induced to borrow more to take
advantage of potential tax benefits. However, increase of debt will further increase the
likelihood of financial distress, thus firms will hedge more to mitigate the increased
probability. In conclusion, there exists a simultaneous relationship between hedging and debt
policies.