CORPORATE FINANCING STRATEGIES AND FUTURE GROWTH OPPORTUNITIES

CORPORATE FINANCING STRATEGIES
AND FUTURE GROWTH OPPORTUNITIES
Scott Besley
Department of Finance
College of Business Administration, BSN 3403
University of South Florida
Tampa, FL 33620
Voice mail: (813) 974-6341
Fax: (813) 974-3030
E-mail: sbesley@coba.usf.edu

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CORPORATE FINANCING STRATEGIES
AND FUTURE GROWTH OPPORTUNITIES
In this study firms are examined to determine the relationship between the current valuation of
future growth opportunities and the firms’ hedging behaviors. The results suggest that firms
mostly follow a long-hedge, or conservative, financing strategy, but that firms considered more
growth oriented tend to follow less conservative financing strategies than do other firms. The
results also indicate that the firms following more conservative financing policies earn higher
risk-adjusted market returns than firms that more closely match maturities. This finding might
suggest that the price movement for a growth stock is only impacted slightly by current, or
near-term, actions of the firm, because most of the stock's value is based on long-term growth
prospects that are not significantly altered by temporary, or short-term, disturbances. However,
further analysis, which currently is underway, is needed to provide more concrete conclusions.

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CORPORATE FINANCING STRATEGIES
AND FUTURE GROWTH OPPORTUNITIES
Most financial management textbooks contain discussions regarding the maturity of
corporate claims relative to corporate assets.1 According to these texts, generally it is assumed
that firms that match the maturities of liabilities with the maturities of assets follow a hedged, or
matching, financing strategy. Financial theory suggests that such hedging is optimal because firms
only finance needed assets and do not have liabilities maturing that cannot be repaid. Polar
alternative strategies would include capital structures that are overweighted with either permanent
financing or short-term financing. The advantages of overweighting with permanent financing
would be to assure adequate financing for the firm in times of peak product demand and to insure
that these funds are available at a known cost. This long-hedging strategy is seen as a means of
reducing the probability of technical bankruptcy during any economic period.2 The advantages of
overweighting the capital structure with respect to short-term financing are that short-term funds
generally are cheaper than long-term funds (i.e., the yield curve typically is upward sloping) and
this strategy would utilize borrowing only when it is necessary because it would increase during
business expansions and decrease during contractions. But, such a short-hedging strategy (i.e.,
overloading with temporary financing) might create a "crisis at maturity" due to tight money and
high interest rates (Johnson, 1967).
Whether financial managers prefer to follow the hedging concept or the more conservative
approach of financing with more long-term funds than needed involves an examination of the risk
and return tradeoff of the strategy pursued. Firms generally are considered to be in a riskier
posture if the hedging approach rather than the conservative approach is followed because there is
1See, for example, Brigham, Gapenski, and Ehrhardt (1999), Levy (1998), Ross, Westerfield, and Jaffe
(1996), and Van Horne (1998), among others.
2See Silvers (1976) and Van Horne (1969).

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less liquidity when the temporary assets are kept at a minimum and the temporary financing just
matches that amount. That is, the probability of the firm becoming technically insolvent is greater
with less liquidity. Consequently, all else equal, it might be expected that its return increases as a
firm more closely follows the hedging approach.
The results of previous research suggest that firms generally do not hedge; instead, for the
most part, firms pursue a long-hedge or conservative strategy. Further, it has been shown
long-hedged firms earn significantly higher returns than hedged firms, which, in turn, earn
significantly higher returns than short-hedged firms. Using the standard deviation of the returns
as a measure of risk, long-hedged firms and short-hedged firms have been found to be
significantly riskier than hedged firms as suggested by theory. The higher risk of the long-hedged
firms results from increased financial leverage that is created by long-term funds, while the higher
risk of the short-hedged firms can be attributed to market and financial conditions that create the
"crisis at maturity." When evaluated on a risk-adjusted basis, it appears that long-hedged firms
provide the greatest reward to variability while short-hedged firms provide the poorest (Besley
and Meyer, 1988).
Many financial management textbooks also include a discussion of the valuation of the
growth opportunities of firms.3 This subject generally is integrated into topical areas associated
with the valuation of long-term assets. In their seminal work, Miller and Modigliani (1961)
characterized growth stocks as those that are representative of firms having investment
opportunities with returns sufficiently large to attract capital; that is, stocks of companies with
positive net present value investment opportunities. According to capital market theory, the value
of growth opportunities somehow should be captured in current stock prices via existing market
pricing mechanisms.
Over the years, investors have exhibited a special fascination for stocks of young,
technologically innovative firms that promise significantly high risk-adjusted returns at some
3See Brealey and Myers (1996).

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point. These securities, traditionally called growth stocks, are considered extremely speculative
because the actual returns realized normally are derived solely from capital gains that represent
current valuation of the future growth opportunities available to corporations. The risk investors
take is that these growth opportunities either never materialize, materialize slower than expected,
or are much less than originally anticipated.
Malkiel (1963) has shown that growth stocks are inherently more volatile than non-growth
stocks. That is, the percentage change in price for a growth stock for a given percentage change
in required return will be greater than the percentage change in price for a non-growth stock given
the same change in required return. Basically, this result occurs because growth stocks have
longer durations than non-growth stocks. Those stocks that have a great proportion of price
accounted for by the present value of growth opportunities (PVGO) fall in the growth stock
category because a large portion of the present value is accounted for by more distant cash flows.
Hagin (1984) has shown that stocks of firms that failed to achieve forecasted growth rates that
were optimistic tended to experience large negative returns. He labeled these stocks "torpedo"
stocks because their large negative returns could cause the return for an entire portfolio to be
much less than expected even if just a few were held.
The combination of volatility that accrues naturally to growth stocks and the potential for
disastrous returns in stocks where much of the current price is a bet on the growth opportunities
suggests that these securities might be subject to below average risk-adjusted performance.
Earlier findings confirm that stocks for which a low portion of total value was accounted for by
PVGO showed greater returns than those for which PVGO represented a large portion of the
stock price during the period 1976-1994 (Besley, Meyer, and Wieand, 1995). Further, not
surprisingly, the risk associated with growth stocks was significantly greater than the risk
associated with non-growth stocks.
The evidence concerning the performance of growth stocks suggests that growth firms
might also exhibit the characteristics of firms that are more inclined to be short hedgers, or follow
riskier strategies with respect to decisions concerning the mix of permanent and temporary

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financing—both growth firms and firms with greater proportions of temporary financing relative
to total financing display high degrees of risk. The purpose of this research is to provide empirical
evidence on the extent to which firms practice the hedging concept relative to the future growth
opportunities available for investments, and to investigate the risk and return characteristics of
firms' operations. It is expected that those firms that can be classified as growth investment
opportunities also are the firms most likely to follow hedging strategies that exhibit an
overweighting of their capital structures with respect to short-term financing. The rationale is
that such firms have sufficient positive net present value investment opportunities to require the
investment of most funds, whether long-term or short-term, in long-term assets with high returns
relative to short-term assets.
I. Methodology
A.
Hedging Strategy
The ratio of current assets (CA) to fixed assets (FA) was calculated on a
quarter-by-quarter basis for each of the companies in the initial sample. The lowest figure found
for each company among the quarters of data was assumed to be that company's permanent
current asset ratio, PCAR. This ratio then was multiplied by the fixed assets in each quarter, t, to
estimate the amount of permanent current assets held by a given firm. That is,
(1)
This particular approach was taken to recognize an increase in the level of permanent
current assets as the firm grew in size over time. Once the permanent current assets were found,
temporary current assets (TCA) were easily calculated as the difference between current assets
and permanent current assets
(2)

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Permanent assets (PA) were defined as the sum of fixed assets and permanent current
assets, or equivalently, as total assets less temporary current assets
(3)
Spontaneously generated liabilities (SL) were found by taking the difference between
current liabilities and interest-bearing current liabilities; i.e., SL = current liabilities  interest-
bearing liabilities. These spontaneous liabilities then were allocated to temporary and permanent
current assets by multiplying the ratios of temporary current assets to current assets and
permanent current assets to current assets by the amount of spontaneous liabilities
(4)
(5)
Here, TSL and PSL represent “temporary” spontaneous liabilities and “permanent” spontaneous
liabilities, respectively.
Next, we determined what the financial structure of each firm would look like if it was
hedged. The hedged amount of interest-bearing short-term debt (HSTD) was calculated by taking
the difference between temporary current assets and the allocated portion of spontaneous
liabilities
(6)
The hedged amount of long-term financing (HLTF) was defined as the difference between
permanent assets and allocated spontaneous liabilities
(7)

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The firm's hedged position (HP) then was determined by taking the difference between the
actual amount of short-term interest-bearing debt (STD) and the hedged amount of short-term
debt. To adjust for differences in firm size this figure was divided by total assets
(8)
If the sign of this ratio was positive, the firm was termed short-hedged; if zero, it was
perfectly hedged; and if negative, it was long-hedged. Because few firms would be perfectly
hedged, it was assumed that the firm followed a maturity-matching strategy if its hedged position
fell in the range of 0.05 to +0.05. All firms were then placed in one of the three groups
(short-hedged, hedged, or long-hedged) on a quarter-by-quarter basis. If a firm was placed in a
single category in more than sixty percent of the quarters, it was assumed to follow that hedging
strategy. Those firms not meeting this qualification were not classified.
B.
Present Value of Growth Opportunities
Brealey and Myers (1996) and Myers (1987) illustrate that the traditional discounted cash
flow model for valuation cannot be strictly applied to value firms with significant growth
opportunities because such firms generally pay little or no dividends. A more appropriate
evaluation can be made by capitalizing earnings when there is no growth (i.e., current earnings)
and determining the present value of expected growth opportunities. Using this relationship, the
value for a share of stock, V , can be written as
0
(9)
where E is the current earnings per share, k is the firm's required rate of return, and PVGO
0
represents the present value of the firm's expected growth opportunities.

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Both the current value per share and the current earnings per share are directly
observable. The required rate of return can be estimated using the security market line, where the
beta coefficient is calculated using the market model with the S&P 500 as a proxy for market
returns. Monthly data are used for the computation of beta and the returns associated with the
stocks.
Using observed values for price and the risk-free rate of interest, and estimated values for
stock betas, earnings, and the required return to the market, the quarterly PVGO is estimated for
each stock by rearranging Equation 9 such that
(10)
where V is the price per share of stock at the end of March (the rationale for this timing is given
0
in the next section) and E is the normalized earnings based on a five-year computation. For each
0
company, the proportion of stock price represented by estimated PVGO is calculated by dividing
the computed PVGO by V . The results are evaluated with respect to the three hedging groups
0
created when the hedge ratios are calculated.
II. Sample Characteristics
The sample for this study was constructed using Standard and Poor's Compustat
databases for the years 1977-1995. Companies were included if (1) the company had a December
31 fiscal year; (2) the industrial code (SIC) was between 2000 and 4000; and, (3) all relevant data
existed. These criteria produced a database that contained 490 manufacturing firms over the
period of study. Firms included in the sample were required to have a December 31 fiscal year
because, for this study, portfolios were assumed to be formed and adjusted at the end of March
each year; thus, the annual investment horizon was from April of one year through March of the
following year. The reason for this assumption was to account for the fact that financial data
(e.g., annual reports) often are not available until two to three months following the close of the

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fiscal year. Requiring firms included in the sample to have a December 31 fiscal year allowed
formation of portfolios and any subsequent adjustments to be accounted for at the same time
during the calendar year.
A five-year hold-out period was used for estimation of long-term (permanent) beta
coefficients and normalized earnings for each firm. Therefore, the actual period of study during
which investment portfolios were formed was from 1982 to 1995. A company was excluded from
the sample for a particular year if the relevant data did not exist during that year or the
information from the previous five years was not sufficient to estimate a beta coefficient or to
compute the normalized earnings.
Monthly risk-free returns and market risk premia were collected from Stocks, Bonds,
Bills and Inflation - 1996 Yearbook. The U.S. Treasury bill index was used as a proxy for the
risk-free rate of return. The remainder of the data were derived from the Compustat databases.
III. Results
Table 1 and Table 2 show the results of the computations for both the proportion of
value represented by PVGO and the proportion short-hedged broken down by industry and by
period, respectively. These tables also contain the results of the statistical tests performed to
determine whether firms hedge (i.e., the hedge ratios are different from zero) and whether
significant portions of stocks' prices are accounted for by PVGO (i.e., the PVGO ratios are
different from zero). The hypothesis that the PVGO ratio was not significantly different from
zero was rejected overwhelmingly, both for the aggregated data and when the data were analyzed
either on an industry basis or on a quarter-by-quarter basis. Consequently, these results suggest
firms' values, to some extent, are affected by PVGO factors. The results for the hypothesis test
that firms follow hedging strategies that produce hedge ratios that are not significantly different
from zero are mixed. It is interesting that the more recent data indicate, in aggregate, the hedge
ratio has shifted more toward short hedging. (A negative value for the hedge ratio indicates a
negative percentage short hedge, which represents a long hedge.) This might suggest the high

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