Investment, Debt and Risk Management in a Context of Uncertain Returns to Investment

Abstract

In a context of uncertain returns to investment, a firm may face increasing costs of borrowing and uncertain value of its internal finance. By trading derivatives on the financial markets, the firm can hedge against the fluctuations of its cash flow, in order to better coordinate investment and financing decisions. This work shows how optimal investment, debt and hedging strategy can be strongly dependent on the mechanism linking the firm's cash flow to its returns on investment. Using the framework provided by Froot-Scharfstein-Stein (1993), two alternative mechanisms are compared. In the first one, the firm's cash flow is linked to the shocks to the price of the final product, whereas, in the second one, it is linked to the non neutral shocks to the production technology. The properties of the optimal hedging strategies and the comparison between the models are shown by deriving approximated analytical solutions. Numerical simulations of the first model's non-closed-form optimal solution are also obtained to validate the approximation, which is thus supported by numerical evidence. From the comparison, it turns out that the two models react differently to the same productivity shock: when cash flow is linked to a prospective price change, investment and debt are positively correlated; when cash flow is linked to the productivity shock, investment and debt are either negatively correlated (no hedging) or uncorrelated (hedging).