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Applied Economics Letters

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Do derivatives affect the use of external financing?

a

Peter J. DaDalt , Bing-Xuan Lin & Chen-Miao Lin

Department of Finance, College of Business Administration , University of Rhode Island ,

Kingston, RI, 02881, USA
b

Department of Economics, Accounting & Finance, College of Business , Clayton State

University , Morrow, GA, 30260, USA
Published online: 14 Oct 2011.

To cite this article: Peter J. DaDalt , Bing-Xuan Lin & Chen-Miao Lin (2012) Do derivatives affect the use of external
financing?, Applied Economics Letters, 19:12, 1149-1152, DOI: 10.1080/13504851.2011.617677
To link to this article: http://dx.doi.org/10.1080/13504851.2011.617677

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Applied Economics Letters, 2012, 19, 11491152

Do derivatives affect the use

of external financing?
Peter J. DaDalta, Bing-Xuan Lina and Chen-Miao Linb,*
a

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Department of Finance, College of Business Administration, University of

Rhode Island, Kingston, RI 02881, USA
b
Department of Economics, Accounting & Finance, College of Business,
Clayton State University, Morrow, GA 30260, USA

We examine whether derivatives use reduces the utilization of external

financing for a large sample of nonfinancial firms over the period 2002 to
2004. Using the measures of net external finance as discussed in Bradshaw
et al. (2006), we find a negative association between corporate derivative use
and the use of external financing. Further, we find the relationship is driven
by differences in the use of debt, as opposed to equity financing.
Keywords: risk management; financing policy; derivatives; capital structure
JEL Classification: G30; G32
I. Introduction
In a Modigliani and Miller (1958) framework, risk
management decisions should not affect a firms
value. However, financial economists have proposed a
number of channels through which firms could benefit
from using derivatives to manage financial risks. These
include reductions in the expected costs of financial
distress (Smith and Stulz, 1985), decreased tax liabilities in the presence of a convex tax schedule (Graham
and Rogers, 2002), smoother earnings (Barton, 2001),
lower levels of information asymmetry (DeMarzo and
Duffie, 1995; DaDalt et al., 2002), lower cost of debt
(Leland, 1998) and the alleviation of underinvestment
problems (Froot et al., 1993; Gay and Nam, 1998).
We focused on the relation between hedging and the
underinvestment problem raised by Froot et al. (1993)
and examined whether hedging reduces a firms need
for external financing. Froot et al. (1993) developed a
model where information asymmetry regarding
investment quality results in a gap between the costs
of internal and external financing and thus leading to
the firm foregoing positive-Net Present Value (NPV)
projects. Hence, hedging increases value by decreasing
the variability of internal cash flows and the need for

costly external funds. Empirical support for their

model is provided in Deshmukh and Vogt (2005),
Gay and Nam (1998) and Adam (2002), who found
that hedging by reducing investment/cash-flow sensitivity lowers the need for external financing.
In contrast, other studies imply that derivatives use
could increase (rather than decrease) the use of external finance. The value of firms in financial distress is
reduced because payments must be made to parties
other than bondholders or shareholders. Smith and
Stulz (1985) demonstrate that by reducing the variability of the future value of the firm, hedging lowers
the probability and expected costs of financial distress.
Similarly, Gay et al. (2011) found that derivatives
users have a lower cost of equity than nonusers, with
the reduction attributable to decreased risk of financial distress. Leland (1998) argues that by reducing
the variability of cash flow, hedging leads to a lower
cost of debt. Taken as a whole, these studies imply
that hedging could lead to a lower cost of capital
and therefore increase the use of external sources of
financing. Given these conflicting predictions, the
relation between companies derivatives use and their
use in external financing remains an empirical issue.
We find that derivatives users use external financing

*Corresponding author. E-mail: chen-miaolin@clayton.edu

Applied Economics Letters ISSN 13504851 print/ISSN 14664291 online # 2012 Taylor & Francis
http://www.tandfonline.com
http://dx.doi.org/10.1080/13504851.2011.617677

1149

P. J. DaDalt et al.

1150
sources to a lesser extent than do their nonderivativesusing counterparts. Further, we find evidence that this
pattern is driven by a decreased reliance on debt financing among derivatives users.
The remainder of the article proceeds as follows:
Section II presents data and research methods.
Section III discusses empirical results, and Section IV
concludes.

II. Methodology and Data

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We use several measures of net external finance developed by Bradshaw et al. (2006), defined as follows
(note: all measures are scaled by total assets):
External Equity Financing: Funds obtained from or
paid out to common shareholders, defined as the
change in the book value of common equity from
the prior year, less net income;
External Debt Financing: Funds obtained from or
paid out to creditors, defined as the sum of the
change in long-term debt, the current portion of
long-term debt, convertible debt and notes payable
(all relative to the prior year);
Total External Financing: The net use of new external
financing over the prior year, defined as the sum of
External Equity Financing and External Debt
Financing.
We then estimate several variants of the following
regression capturing the relationship between external
financing and firms derivatives usage:
External Financei,t fDerivativesi,t , R&Di,t ,
Dividend Yieldi,t , Working Capitali,t ,
Cash Deficiti,t , Sales Growthi,t , Sizei,t

where External Financei,t could be Total External

Financing, External Equity Financing or External
Debt Financing. The regressors in the above specification are defined as follows:
Derivatives: A dichotomous variable equal to 1 if a
firm reports the use of any type of derivatives, and 0
otherwise.
R&D: The ratio of research and development
expenses to total assets.
Dividend Yield:
price.

Dividend per share divided by stock

Working Capital:
total assets.

The ratio of working capital to

Cash Deficit: The sum of capital expenditures,

acquisitions and common dividends, less the sum
of operating income before depreciation and amortization and depreciation scaled by total assets
(Helwege and Liang, 1996).
Sales Growth: The average annual growth in sales
over the previous year.
Size: The natural logarithm of total assets.
We construct our sample firms by identifying the
union of all firms comprising the entire S&P 1500 at
any time during the period 2002 to 2004. Then, from
annual 10-K filings, we collect data on these firms
derivatives activities for each of the years 2002 to 2004.
We exclude financial companies such as banks, financial service firms and insurance companies. We
obtained financial data from the Standard and
Poors Compustat databases.
Consistent with underinvestment-based theories of
hedging, we expect a positive relation between external financing and R&D and between external financing and sales growth. Following Fazzari et al. (1988)
argument that firms with low dividend yields have low
internal cash and greater needs for external financing,
we expect a negative relation between external financing and dividend yield. We expect a positive relation
between external financing and the extent of a firms
cash deficit and a negative relationship between external financing and the level of working capital.

III. Results
Table 1 reports the results of univariate tests of differences in external financial needs between users and
nonusers. In addition to the mean difference tests, we
also conduct Wilcoxon signed-rank tests of differences
in median to avoid the potential influence of outliers.
We find derivatives users have significantly lower
levels of total external finance than their nonusing
counterparts, with users employing on average 3.4%
less external financing (as a fraction of total assets)
than their nonuser counterparts. The differences in
both mean and median levels are significant at the
1% level. The difference in overall use of external
financing between the two groups appears to be driven
by statistically significant (at the 1% level) differences
in the use of both external equity and debt financing.
The results are consistent with DaDalt et al. (2010)
who examined the same relation but using 19921996
derivatives use information from Swap Monitor.
Table 2 presents regression results of the three measures of external finance on derivatives use and other
firm characteristics. Models 13 present results for
regressions of (respectively) Total External Financing,

Risk management and the use of external finance

1151

Table 1. Univariate comparison of derivatives users and nonusers

Users
Number
of users
Total External Financing 2513
External Debt Financing 2513
External Equity Financing 2542

Number of
nonusers
Mean
1465
1466
1489

Nonusers

Difference test

Median Mean Median Mean t-test Median Wilcoxon test

0.012 0.023
0.016 0.016
0.003 0.000

0.022
0.001
0.020

0.001
0.000
0.009

0.034***
0.017***
0.017***

0.023***
0.016***
0.009***

Note: ***Significant at the 1% level.

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Table 2. Regressions of external financing on derivatives use

Dependent variable

Model 1: Total External

Financing

Model 2: External Debt

Financing

Model 3: External Equity

Financing

Intercept
Derivatives dummy
R&D
Dividend yield
Working capital
Cash deficit
Sales growth
Size
R2
Number of observations

0.021 (0.013)*
0.018 (0.005)***
0.145 (0.043)***
1.010 (0.150)***
0.060 (0.012)***
0.507 (0.020)***
0.110 (0.008)***
0.002 (0.002)
0.239
3489

0.028 (0.013)**
0.016 (0.005)***
0.107 (0.043)**
0.072 (0.149)
0.055 (0.012)***
0.312 (0.020) ***
0.004 (0.008)
0.003 (0.002)
0.076
3490

0.013 (0.009)
0.004 (0.003)
0.228 (0.029)***
0.858 (0.102)***
0.002 (0.008)
0.203 (0.013)***
0.107 (0.006)***
0.001 (0.001)
0.209
3518

Notes: SEs are in parentheses.

***,** and *Significant at 1%, 5% and 10% levels, respectively.

External Debt Financing and External Equity

Financing on the derivatives user dummy variable and
control variables. The coefficient on the derivatives
user dummy variable in model 1 is negative and statistically significant at the 1% level, indicating that derivatives users employ significantly less total external
finance than do nonusers. The coefficient on the derivatives user dummy variable in model 2 is negative and
also statistically significant at the 1% level, which indicates that derivative use is associated with decreased use
of external debt financing. Finally, the coefficient on
the derivatives user dummy is negative and statistically
insignificant in model 3, indicating that derivatives
users do not employ significantly less additional equity
financing than do nonusers.
With respect to the other explanatory variables, we
find that the coefficient on dividend yield is negative
and significant at the 1% level in models 1 and 3. We
also find a positive relation between external financing
and working capital, cash deficit and sales growth.

IV. Conclusions
We find that corporate derivatives use is strongly
associated with decreased utilization of external
sources of financing. Our results are consistent with

the argument in Froot et al. (1993) that firms hedge to

avoid using costly external funds. In addition, we find
that the decreased utilization of external financing is
driven by decreases in the use of additional external
debt financing.

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