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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A firm with risky debt has a project requiring new investment, but any gains would accrue largely to bondholders if the firm is near default. Shareholders therefore decline positive-NPV projects. Which concept does this describe, and how can hedging help?

This is debt overhang, or underinvestment: shareholders pass up positive-NPV projects because creditors capture the gains. Hedging reduces the probability of distress and stabilizes cash flow, so the firm is more likely to fund value-adding investments.

  1. AAsset substitution; hedging increases the firm's risk-taking incentives
  2. BDebt overhang (underinvestment); hedging reduces the probability of distress so positive-NPV projects are fundedCorrect
  3. CAgency cost of free cash flow; hedging forces dividends to be paid
  4. DAdverse selection; hedging signals project quality to rating agencies

Explanation

Rejecting positive-NPV projects because benefits go to creditors is debt overhang, or underinvestment. Hedging lowers the chance of financial distress and stabilizes internal cash flow, making it more likely that value-adding investments are undertaken. Asset substitution concerns taking excessively risky projects, which is a different problem.

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