8. Info Frictions, Pecking Order, Free Cash Flow, Risk Management & Hybrids

Free cash flow problem

• Managers control excess cash and may invest in negative NPV “empire building” projects or perks

• Debt, dividends and buybacks can reduce free cash flow under management’s discretion and limit overinvestment

Adverse selection problem in external financing

• Managers know more about firm value than outside investors

• If they issue new risky securities when the firm is overvalued, existing shareholders gain and new investors lose

• Outside investors anticipate this and demand a discount, making external finance costly.

Effect of adverse selection on investment decisions

• Because external finance is costly, some positive NPV projects may be rejected if they must be financed with new risky securities

• Underinvestment is more likely in firms with little cash and high leverage

Pecking order theory – basic idea

• Firms prefer financing sources that minimize adverse selection costs for current shareholders

• Internal funds first, then safe debt, then risky debt, and equity as last resort.

Pecking order – financing sequence

• Use retained earnings / cash first

• If more funds needed use relatively safe debt

• Issue new equity only when necessary or when information asymmetry is low

Why firms hoard cash in pecking order theory

• Internal funds avoid adverse selection discounts and underinvestment

• Cash reserves allow the firm to fund future positive NPV projects without going to external markets when information asymmetry is high

Risk-shifting (asset substitution) problem recap

• With risky debt, equity behaves like an option on firm assets

• Shareholders may prefer very risky projects because they capture upside while debt holders bear more downside

• Can destroy total firm value

Debt overhang problem recap

• Large existing debt means much of the gain from new projects would go to debtholders

• Shareholders may reject positive NPV projects, leading to underinvestment

Corporate risk management – risk control vs risk financing

• Risk control changes operations or assets to reduce exposure (e.g. safer equipment, diversification of suppliers)

• Risk financing transfers financial consequences of risk using contracts like insurance or derivatives

Risk transfer instruments – insurance vs derivatives vs cash

• Insurance transfers specific risks to an insurer in exchange for a premium

• Derivatives (forwards, futures, options, swaps) transfer market price risks

• Holding cash is self-insurance that absorbs shocks but ties up capital

Why risk transfer is irrelevant in perfect markets

• With complete frictionless markets investors can costlessly hedge on their own

• Firm hedging does not change total value because investors can undo it in their personal portfolios

Main reasons why hedging can create value in reality

• Reduces probability and costs of financial distress or debt overhang

• Stabilizes internal funds and lowers costly external financing needs

• Mitigates underinvestment when investment opportunities are sensitive to cash flows

• Can reduce expected taxes or increase debt capacity

Example intuition – hedging and investment policy

• A firm with valuable growth options may be forced to cut investment when cash flows are volatile and financing is constrained

• Hedging stabilizes cash flows so more positive NPV projects can be undertaken

Futures / forwards vs options for hedging

• Forwards and futures lock in a price and remove most price risk but also remove upside

• Options protect downside while keeping upside but require paying a premium

Costless collar intuition

• Combine a purchased put and a written call to keep price within a band

• Limits both downside and upside but can be structured so the option premiums offset

Key caveats in corporate hedging

• Hedging can become speculation if positions exceed underlying exposures or are left uncovered

• Poorly designed hedges can increase risk (basis risk, liquidity needs)

• Hedging decisions must consider impact on investment opportunities and financing

When not to hedge or to hedge less

• If an exposure has little effect on firm value because investors can diversify it and it does not affect distress or investment

• If hedging costs are high relative to the reduction in distress, tax or financing costs

Classification of hybrid securities in WACC

• Treat a hybrid (e.g. convertible bond) as debt in WACC if it is senior to equity and non-payment can lead to default or bankruptcy

• Treat as equity if payments are fully discretionary and non-payment cannot trigger default (e.g. common equity, some preferred with full discretion).

Preferred stock in cost of capital

• Preferred shares usually pay fixed dividends and are junior to debt but senior to common equity

• In WACC they are often treated as a separate claim class or grouped with equity depending on how they behave economically

Effect of risk management on capital structure choices

• Effective hedging can support higher target leverage by lowering volatility of cash flows and distress probability

• This strengthens the trade-off theory channel “hedging increases tax shield capacity”

Link between risk management and performance evaluation

• Hedging isolates operational performance from external shocks (e.g. commodity or FX)

• Makes it easier to judge management skill and to design better compensation schemes.

Virtual hedging problem

• Managers may argue that operating choices already hedge risks, but these “soft” hedges may be hard to monitor and verify

• Derivative or insurance contracts create clearer, enforceable risk positions