Introduction
Majority of firms have a huge amount of cash flows that are susceptible to fluctuation in exchange rates, interest rates and product prices. These firms seek to measure their currency exposures and manage these risks through hedging, so as to increase their net cash flow, profitability and market value (Eiteman et al, 2007). They further proceed with the following definition.
"Hedging is the taking of a position, acquiring a cash flow, an asset, or a contract (including a forward contract) that will rise (fall) in value and offset a fall (rise) in the value of an existing position" (Eiteman et al, 2007: 255).
Now the answer to the question as whether hedging increases the shareholder value at firm level or not? This question has been hotly debated among the researchers. Smithson (1996) answers this question by explaining Modigliani & Miller (1958) proposition-I, by proceeding that hedging can increase the value of a firm by enhancing its cash flows through reduced tax liabilities, reducing the cost of financial distresses and facilitating the enhanced investment. Smith & Stulz (1985) and Froot; Scharfstein & Stein (1993) further transformed Modigliani & Miller proposition-I into a more rationale to use in risk management. Aretz and Bartram (2009) quote the financial theory describing that hedging can enhance the shareholder value when the capital market imperfections, both the direct and indirect expenses of financial distresses, expensive external finances (either through borrowing or the issue of shares) and taxes exist at the firm level.
There are a number of financial theoretical arguments which motivate hedging that leads to the foundation of enhancing shareholder value at the firm level.
Theoretical and empirical evidence of shareholder's value foundation through Hedging
Bartram (2002) and Stulz (2000) argue that the basic economic theory like the Modigliani and Miller (1958) propositions states that in the presence of perfect capital market the risk management decisions cannot enhance firm value because they can be easily imitated by the shareholders. As corporate risk management being a financial strategy cannot lead to the formation of the firm value according to M & M propositions. Some of the assumptions of the M & M proposition need to be violated for the hedging to create shareholder value or in the presence of capital market imperfections that would make shareholders unable to imitate completely corporate risk management at the firm level (Stulz 2001).
As mentioned above that capital market imperfection including both direct and indirect expenses of financial distress, expensive external finances and taxes result in positive hedging and creation of shareholder value at the firm level. There are some other motives like the lawful and financial situation of the country in which the firm is operating also affect the hedging decisions (Aretz and Bartram 2009).
Binary variables show if a firm uses derivatives, or not can be used to test empirically the hedging theories. Generally derivatives use shows the sign of risk management (Bartram; Brown and Fehle 2009). However, in industries like gold and oil more data about the derivatives use is accessible. In these cases variables like (net) estimated values of derivatives, the percentage of the quantity hedged weighing correctly the degree of hedging (Lel 2006; Dionne & Triki 2005). A huge number of various proxies as shown in the table 1 given at the end are used to examine the theories empirically. It has been evident from many empirical research data which associate the use of proxies for hedging to organisation, and firm. These proxies assess a firm with specific features and also explain whether these firms use various derivatives and get the advantages from risk management (Bartram; Brown & Fehle 2009).
1. Hedging enhances shareholder by lowering the tax liability
Stulz (2001) and Bartram (2000) describe that when the firm's tax agenda is convex meaning when taxes are greater than the taxable income, then the unpredictable taxable income will lead to greater tax load than the established pre-tax return. Hedging makes taxable return steady as reserves or savings from greater return situations surpass extra taxes from lesser return situations and so reduce the tax load. There is a positive correlation exist between tax loss carry forwards and corporate hedging (Dolde 1995). According to Mayers & Smith (1990) the impact of legislative progressivity may create the situation of convex tax function. Although this lawful progressivity is comparatively limited in many of the tax structures, however, the indirect impacts as a result of particular tax choice stuffs that is clearly tax-loss carry-forwards and investment tax credits (liable to rules and regulations) lead to the tax convexity. So unsuccessful firms cannot take advantages of most of these influences (MacKie-Mason (1990).
Howton & Perfect (1998) describe that average taxable income for various years is normally used to examine if the taxable return of firms lies in the convex area of the tax function or not. A suitable proxy is used to make a 95 % of assurance interval around present incomes. If the interval lies in the convex area then the firm is supposed to have tax convexity. A more precise method is to calculate the tax reserves from a 5% decrease in revenue volatility. In tax convexity area decreases in income volatility results in tax revenues. For tax preference stuffs that is investment tax credits and tax-loss carry forwards various proxies are used for measurement.
2. Hedging enhances shareholder by lowering the cost of financial distress
Smith & Stulz (1985) and Froot; Scharfstein & Stein (1993), argue that firms facing higher financial distresses are more vulnerable to adopt corporate hedging. The firms having insufficient cash flows are unable to make their payment obligations face bankruptcy. In such a situation shareholders and creditors struggle to improve their savings in the firm (Warner 1977a). Firms already bankrupted may face indirect and direct costs of bankruptcy in future. These costs are actually because of the unwillingness of customers and providers in dealings with the firm, ignorance of management and compensating employee etc. The direct costs of bankruptcy counting for 1% to 3 % of shareholder value are paid to lawyer's fee, management and accounting charges. Indirect costs are likely to be 20 % greater than direct costs (Cutler & Summers 1988). The predicted expenses of financial distress as a result of low firm value can be decreased by corporate hedging (Stulz 2001). Hedging enhances value of firm further by making firms to bear additional debt,i.e, enhancing the optimal debt-equity ratio to have strong tax shields (Graham & Rogers 2002).
The hypothesis that the present value of financial distress and bankruptcy expenses should adopt risk management can be analysed using long-term debt ratio and the interest coverage ratio (Table 5). Normally firms with more leverage face more payment responsibility have higher motivation for risk management. The interest coverage ratio should have negative correlation with the hedging as increased interest coverage ratio demands more pre-tax money to meet the payment obligations (Aretz & Bartram 2009).
3. Hedging enhances shareholders value by facilitating increased investments
Allayannis & Mozumdar (2000: 29) study the effect of currency hedging on investment and the cash flows of a firm. They quote Fazzari: Petersen & Hubbard (1988) that a firm needs to lower its investment when costs of external finances are greater than the internal finances, as internal cash flow drops. They further describe Froot, Scharfstein and Stein (1993) model that in order to lessen this underinvestment difficulty, firms adopt hedging with use of derivatives. They support their hypothesis using the empirical data on the foreign exchange volatility and derivatives for a sample of 500 from 1993 to 1995. They state that underinvestment problem of firms using derivatives is highly lesser than those who don't use derivatives.
Lewent and Kearney (1990) of Merck & Co describe volatility in income causes underinvestment. They explain that as the company's income is expressed in US $, its income before tax varies with changes in dollar. When the dollar falls (rise) in value, the net earnings in dollars generated from foreign trade activities will increase (decrease). The company realised that volatility in income had affected their investment decision in the past. The company had to decrease the expenditure on research and development (R&D) as the dollar was risen and tax before income was low. As there is a strong relationship between R & D and the pharmaceutical companies' value they would need to cope with foreign currency volatility. Nance; Smith & Smithson (1993) locate important statistical value and the interrelation between the outflow of R & D of the firm and Hedging. The correlation between the firm's R & D expenses and hedging can be related with the market-to-book ratio. Samant (1996) supports the above phenomenon while Mian (1994) favours a negative relationship between hedging and the market-to-book value.
Conclusion
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