Financial Flexibility, Risk Management, and Payout Choice

Abstract:     
Risk management and payout decisions affect a firm’s financial flexibility — the ability to avoid costly financial distress as well as underinvestment. This paper is the first to document the connection between hedging and payout decisions using samples of both financial and non-financial firms. We find that a more flexible distribution, favoring repurchases over dividends, is negatively related to financial hedging within a firm, consistent with financial flexibility in payout decisions and hedging being substitutes. Using fixed effects, instrumental variables, and seemingly unrelated regressions, we are able to reject the hypothesis that causality runs simply from hedging through cash flow volatility to payout policy and find a within firm substitution between these two forms of financial flexibility. Our main analysis focuses on a quarterly measure of payout flexibility defined as the ratio of repurchases to total payout, but our results are robust to measuring payout flexibility over two years, which captures aggregate repurchase and dividend activity. In addition, we address the potential concern that variation in our flexibility measure is driven by the variation in repurchases by calculating three alternative measures of payout flexibility. The substitution of payout flexibility and hedging continues to hold in all cases. Our findings also are robust to controlling for other determinants of payout policy and risk management, including institutional ownership and firm size. These results suggest that risk management decisions and distributions are jointly determined and that payout flexibility offers operational hedging benefits.

Number of Pages in PDF File: 40

Keywords: Payout policy, risk management, financial flexibility, hedging, repurchases, dividends

JEL Classification: G35, G21

working papers series