Introduction to Corporate Finance

23: Introduction to Financial Risk Management

bankruptcy or severe financial distress. Many of the indirect costs are contracting costs involving relationships

with creditors, suppliers and employees. For example, a credible promise to hedge can sometimes entice

creditors to lend the company money on more favourable terms than they would be willing to lend to an

unhedged borrower. Similarly, suppliers are more likely to extend trade credit when the likelihood of financial

distress is low. In addition to potential cost savings, hedging may increase revenue for companies that sell

products with warranties or service contracts. Warranties or service contracts are more likely to be honoured,

and customers will place a higher value on them, if the company has a lower likelihood of financial distress.

Similarly, if the products will require replacement parts or if there is the possibility of future upgrades,

minimising the likelihood of financial distress can promote sales.

Hedging can also reduce a company’s expected tax liability. If a company’s tax rate increases as income

increases, hedging can reduce the expected tax liability and increase expected after-tax earnings. For example,

suppose that a company thinks its taxable earnings over the coming year will be one of three equally likely

levels, depending on the actual realised price of a key input. If the input price is very high, the company will

generate no earnings at all. If the input price is very low, then earnings will be $20,000. In the intermediate

case with a medium price for the key input, the company’s earnings are $10,000. Managers believe that each

of these outcomes is equally likely Probability=

1

3









. To highlight the tax incentive to hedge, we will make two

assumptions. First, assume that by hedging, the company can lock in the price of its key input at the medium

level, and thereby ensure that its pre-tax earnings will be $10,000. Second, assume that the company pays a

10% tax rate on the first $10,000 in earnings and a 20% tax rate on all earnings above $10,000. Table 23.1

illustrates how the company’s hedging decision can affect its value.

If the company hedges to lock in the key input price, then its after-tax earnings equal $9,000. The tax

schedule drives the difference in the two scenarios. When the company does not hedge, it pays a higher tax

rate when the input price is low and earnings are high than at other times. As a result, the expected tax bill is

higher and earnings are lower than when the company hedges and earns $10,000 before taxes. Hedging can

also reduce expected tax liabilities by smoothing the profit stream and reducing the likelihood that the company

will pay high taxes in one period while having to forgo (or delay) the benefits of tax shields in another period.

Current tax laws limit the extent to which corporations can use losses in one period to offset gains in another

period. For this reason, it is in the interest of some corporations to hedge their risk exposures; otherwise they

could lose some of the tax benefits associated with losses experienced in periods of poor performance.

FIGURE 23.2 PROBABILITY DISTRIBUTION OF POSSIBLE CASH FLOWS FOR A CORPORATION

Hedging reduces the volatility of the cash flows, thereby reducing the probability of cash flows falling below point A, where
financial distress occurs.

Unhedged

distribution

A Cash flow

Hedged

distribution

John Graham, Duke

University

‘There can be a tax

incentive to hedge.’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

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