Based on Deshmukh (2005), which of the following statements is correct? A) When external funds are more costly than internal funds, hedging cannot mitigate the underinvestment problem faced by firms. B) Their findings suggest that the sensitivity of investment spending to cash flow is higher when firms engage in more hedging, holding other factors constant. C) Their main results are that the investment spending of hedgers is more sensitive to prehedged cash flow than is that of nonhedgers. D) Their paper is based on the assumption that there is no information asymmetry between insiders and outsiders. E) None of the above.
The correct answer and explanation is:
The correct answer is A) When external funds are more costly than internal funds, hedging cannot mitigate the underinvestment problem faced by firms.
Explanation:
Deshmukh (2005) explores how corporate risk management, specifically hedging, influences firms’ investment decisions, especially under conditions of financial constraints and market imperfections. One key insight from the study is that when external financing is more expensive than internal funds, firms face the underinvestment problem. This problem arises because costly external funds discourage firms from undertaking profitable investments if internal cash flow is insufficient.
Hedging is typically considered a tool to reduce cash flow volatility and thus mitigate the underinvestment problem by smoothing the availability of internal funds. However, Deshmukh points out that hedging cannot fully solve this issue if the fundamental cost structure remains unfavorable—namely, when external funds remain significantly more costly than internal funds. In such cases, hedging does not eliminate the high cost of external financing, and the underinvestment problem persists.
The other options are incorrect or inconsistent with Deshmukh’s findings:
- B is incorrect because Deshmukh finds that hedging reduces the sensitivity of investment to cash flow, not increases it. Hedging smooths cash flows, so investment depends less on fluctuating internal cash flows.
- C is false as the study shows investment spending of hedgers is less sensitive to prehedged cash flow compared to nonhedgers, indicating that hedging reduces dependence on volatile internal funds.
- D is incorrect because the paper explicitly considers information asymmetry between insiders and outsiders as a crucial element affecting investment and financing decisions.
- E is invalid since option A is the correct statement.
In summary, Deshmukh’s 2005 work highlights that while hedging can help reduce investment sensitivity to internal cash flow fluctuations, it does not fully overcome underinvestment problems if external financing costs remain prohibitively high. This nuanced understanding emphasizes the limits of risk management tools within corporate finance.