The International Zero-Leverage Phenomenon (Digest Summary)

More and more firms are managed with a debt-free capital structure, and this phenomenon is global. The authors investigate the reasons why.

Conventional capital structure theory fails to explain why over the past several years more firms have chosen to pursue a zero-leverage policy. The authors investigate the trend covering a 23-year period starting in 1988. They note that this trend is not limited only to the United States because countries with a common law system (rather than civil law) have a higher proportion of zero-leverage firms. The study also reveals that zero-leverage firms are more prevalent in countries with greater creditor protection and dividend imputation. Additionally, firms that have recently gone public tend to use less debt and instead rely on equity financing. Some industries, such as health care, information technology, and energy, display a high degree of debt conservatism. Furthermore, an increase in asset volatility and a decrease in corporate tax rates are also behind the upward trend in debt conservatism.

In examining the impact of financial constraints on zero-leverage firms, the authors classify firms into financially constrained and financially unconstrained firms. They discover that most firms are not zero-leverage by choice but rather because of their limited debt capacity. These financially constrained firms are smaller and riskier and finance their growth through equity issuance. Such firms hoard cash in order to take advantage of investment opportunities that would otherwise be undertaken by using a bond issuance. Deliberate adoption of zero-debt financing is restricted to a small number of profitable firms for whom this approach is unconstrained. These firms are afforded financial flexibility in that they may strategically pursue leverage when profitable investment opportunities arise.

Students of corporate finance and tax law will find this article interesting because it follows an unconventional thread of thinking in the area of capital structure theory.

The authors survey the existing literature on firm financing and debt conservatism. Their goal is to add to this body of work by showing that the zero-leverage phenomenon is global in scope and by analyzing both supply- and demand-side explanations for it. Finally, the division of zero-debt financing into constrained and unconstrained categories is a novel approach.

The authors collect and analyze balance sheet and market data of exchange-listed firms from the Compustat North America and Global databases over a 23-year period beginning in 1988 and ending in 2011. Firms from 20 developed countries are included in the sample. The sample also contains firms from the United States, other common law countries, and civil law countries. Financial and utility firms are excluded because of the nature of their businesses. The full dataset includes 31,820 industrial firms with 315,464 firm-year observations.

Using regression analysis of the traditional capital structure variables, the authors try to ascertain whether there is an increasing propensity among firms to maintain a debt-free capital structure over the time period under consideration. They then expand this approach to a more robust set of firm- and country-level variables. Results confirm a heightened trend toward maintaining zero-debt financing. Increased stock price volatility over time would tend to support a more risk-averse approach to raising capital debt free. Country-level effects determine the degree to which firms adopt this approach. A greater prevalence of it can be seen in countries with a common law system and a tax system that favors dividend imputation.

Leverage can exert an insidious effect on a firm’s ability to prosper. On the one hand, leverage can facilitate opportunity, but on the other hand, in different circumstances, it can destroy it. The authors consider how and why some firms eschew the use of debt. The decision is a function of a firm’s business model, its financial circumstances, and the legal and tax system of the country in which it operates. Only a small number of firms are what the authors call “financially flexible” to the extent that they can selectively use debt to pursue the right business opportunity. Such companies tend to be extremely profitable.