External vs Internal Finance

Question 1

Froot, Scharfstein and Stein (1993) JF

Answer 1

When external finance is more costly than internally generated sources of funds, it can make sense for firms to hedge. In short, hedging is beneificial if it reduces variability of cash flows such that funding, less hedging costs, always equals or exceeds the cost of investment opportunities.

Question 2

Jung, Kim Stulz (1996) JF

Answer 2

Empirical horserace of the pecking-order model (Myers (1984), the agency model, and the timing model’s ability to explain firm decision to issue debt or equity. Results support agency model: many firms issue equity even though they have ample debt capacity and few investment opportunities and the market reacts negatively when these types of firms issue equity.

Question 3

Lamont (1997)

Answer 3

Comparing the nonoil segments owned by oil companies with similar segments owned by companies less dependent on oil, finds that oil companies significantly reduced nonoil investment in 1986 when oil prices dropped significantly. Consistent with research that suggests diversified companies tend to subsidize and overinvest in poorly-performing sectors.