Hedging, Leverage, and Shareholder Wealth

Abstract

This paper deals with the joint influence of a firm's hedging and leverage decisions on shareholder wealth. We extend the traditional approach to optimal capital structure, which trades off the market values of bankruptcy costs and corporate taxes, by giving management the opportunity to hedge the firm's output price risk with a forward contract. Firstly, it is shown that a unique optimal debt level exists for any given hedge ratio and that the optimal amount of outstanding debt is increased by an exogenous marginal increase in the forward position, if and only if, the firm's probability of bankruptcy is reduced. Secondly, we prove that, for any given capital structure, shareholder wealth is generally a (not strictly) monotonically increasing function of the firm's hedge ratio, as this influence is due to the (vanishing) convexity of the deadweight claims' payoff profiles. In the simultaneous optimum, however, the firm insulates its future payments completely from hedgeable risk. Hence, our model may be seen as a step towards reconciliation between the variance-minimization paradigm popular among the practitioners in risk management and the value maximization approach that forms the cornerstone of modern corporate finance theory.