An empirical analysis of zero-leverage firms: New evidence from the UK

This paper examines why some firms have no debt in their capital structures despite the potential benefits of debt financing. It adds new insights to this zero-leverage phenomenon by addressing two unexplored questions: Does a firm have zero leverage as a consequence of financial constraints or because of a strategic decision to mitigate underinvestment incentives and preserve financial flexibility? Is the decision to follow a zero-leverage policy affected by macroeconomic conditions? Analyzing a new sample of UK firms over the period 1980–2007, we show that the zero-leverage policy is prevalent but that zero-leverage firms are not homogeneous. There are two distinct groups of unlevered firms with different levels of constraints as measured by their dividend policy, namely payers and non-payers. Importantly, we find new evidence that these groups have different motives for eschewing debt. Firms in the second group (non-payers) have zero leverage mainly due to financial constraints. Firms in the first group (payers) deliberately eschew debt to mitigate investment distortions, as predicted by the underinvestment and financial flexibility hypotheses. Macroeconomic conditions have a significant effect on the zero-leverage decision, especially for this less constrained group.     

To be or not to be all-equity for firms that eliminate long-term debt

Despite the advantages of debt, a significant number of firms that have an established leverage policy deliberately become all-equity. These firms eliminate a substantial amount of long-term debt as the average firm’s leverage ratio is approximately 30 percent at the year-end prior to debt elimination. Firm-level “shocks” such as CEO turnover and changes in credit ratings cannot explain the dramatic recapitalization decision. Consistent with the tradeoff theory, firms that eliminate debt have lower benefits (less tax shield benefits, agency costs) and higher costs (probability of financial distress, access to capital markets, etc.) of leverage in the three prior years compared to a matched sample. We also find that the factors influencing the decision to eliminate all debt is different from those to significantly reduce leverage or to have very low debt levels. Firms primarily finance the approximately $70 million of average long-term debt eliminated using proceeds from sales of relatively unproductive assets and from equity issues. Interestingly, over half of these firms issue significant amount of new debt within three years of becoming all-equity. Firms with lower liquidity and non-debt tax shields, higher potential overinvestment agency costs, and those that issue equity at the debt elimination year are more likely to relever quickly.     

Liquidity crisis,relationship lending and corporate finance

This paper investigates the consequences of the liquidity shocks in wholesale funding markets during the 2007–2009 financial crisis on bank lending and corporate financing. We show that banks that relied more heavily on wholesale funding contracted lending more severely than banks that relied more on insured deposits. We then examine the effects of loan contraction on the financial positions of publicly traded firms. We find that both during and after the crisis, the change in leverage of bank-dependent firms is less than that of firms with access to public debt markets. In addition, bank-dependent firms rely more on cash than net equity issuance to finance operations. We also find that firms with established bank lending relationships weather the crisis better. Such firms are able to attain higher levels of leverage during the crisis, add to their cash holdings, secure new bank credit, and achieve higher profitability as a result.     

Financial leverage changes associated with corporate mergers

We empirically examine whether firms increase financial leverage following mergers. Firms could increase financial leverage either because of an increase in debt capacity or because of unused debt capacity from pre-merger years. We find that financial leverage of combined firms increases significantly following mergers. A cross-sectional analysis shows that the change in financial leverage around mergers is significantly positively correlated with the announcement period market-adjusted returns. Further tests indicate that the increase in financial leverage is an outcome of an increase in debt capacity, although there is weak evidence that some of the increase in financial leverage is a result of past unused debt capacity.     

Bank soundness and bank lending to new firms during the global financial crisis

This paper examines how the soundness of financial institutions affected bank lending to new firms during the 2008 financial crisis by using a unique firm–bank match‐level dataset of 1,467 unlisted small and medium‐sized enterprises incorporated in Japan. We employ a within‐firm estimator that can control for unobserved firms’ demand for credit through firm ? time fixed effects. The major findings of this paper are the following four points. First, sounder financial institutions may be generally less likely to provide financing to new firms. Second, our results suggest that sounder financial institutions were less likely to provide loans to new firms during the 2008 financial crisis. Third, financial institutions were less likely to provide financing to new firms during such crisis as compared to those with the same soundness during non‐crisis periods. Finally, such lending relationships to new firms that are established during the financial crisis by sounder financial institutions are more likely to be continued than such lending by less sound financial institutions.     

Equity and debt issuance by firms violating GAAP

We examine security issuance in restated periods by firms that misreport financial statements and find that only a small per cent of such firms issues securities in the restated period. Investors are misled by mistakes made by firms issuing equity more so than other restating firms at the initial announcement of misreported earnings, but are not misled by mistakes made by debt‐issuing firms. Equity‐issuing firms that manage earnings to beat analyst expectations experience abnormally high returns in the restated period prior to security issuance. Firms that restated more reports and have higher pre‐mistake returns are more likely to issue equity. High leverage, firm size and number of restated periods are positively associated with the likelihood of debt issuance by restating firms.     

How common are credit-less recoveries? Firm-level evidence on the role of financial markets in crisis recovery

We study firm recoveries from systemic sudden stops in developing countries, where firms' cash flows suffer exogenous shocks. Contrary to macro studies suggesting that output recovery precedes that of the financial sector, firm-level data shows that only in less than a third of firms, operating cash flows recover without a recovery in external credit, and even these firms have access to other sources of cash. Specifically, firms with high prior short-term debt exposure do experience a sharp reduction in short-term credit but increase operating cash flows during a crisis. Firms with high prior cash holdings experience negative cash flows and deplete their cash holdings. Thus, firms' financial prepositioning predicts recovery in cash flows and is consistent with trade-off theories of capital structure and with precautionary motives for cash holdings. We find no support for the maturity mismatch hypothesis, which predicts that firms with high short-term debt should have harder recoveries post crisis.     

On the Corporate Demand for Insurance: The Case of Korean Nonfinancial Firms

Several theories have been developed to explain the motives for corporate insurance purchases, but there are few empirical tests of these theories. Furthermore, the empirical results are not consistent across studies, suggesting the need for further research. This study uses accounting data for 433 publicly listed nonfinancial firms in Korea to test the determinants of insurance demand for the period 1990 through 2001. Our results support the theory that firm size, tax considerations, and firm ownership are important determinants of insurance demand. Firms that are members of chaebols demand more insurance than unaffiliated firms, all else equal. Contrary to theory, our results also indicate that firms that have higher debt‐to‐equity ratios demand less insurance than less leveraged firms, and that firms that have greater liquidity demand more insurance. This might be related to the overall high debt levels of firms in the period leading up to the Korean financial crisis in 1997, but that investigation is beyond the scope of this study.     

Corporate Bankruptcy in Korea: Only the Strong Survive?

We analyze whether the build‐up of financial vulnerabilities led listed Korean companies to bankruptcy. We find that pre‐crisis leverage is systematically high for both poor performing/slow growing firms and for profitable/fast‐growing firms. Pre‐crisis leverage raises the probability of bankruptcy, which is lower for firms: (1) relying more on (renegotiable) bank credit; (2) with less inter‐firm debt; and (3) having higher interest coverage ratios. Finally, none of these liquidity variables help predict bankruptcies for chaebol‐firms, suggesting that liquidity constraints are more stringent for non‐chaebol. Thus, in a systemic crisis it is not only the strong/healthy that survive.     

The global financial crisis and the capital structure of firms: Was the impact more severe among SMEs and non-listed firms?

Using a dataset covering about 276,998 firms across 75 countries over the period 2004–2011, this paper examines the short-run evolution of firms' capital structures following the start of the global financial crisis and its immediate aftermath, comparing the experience of already levered SMEs, large non-listed firms, and listed companies. We find that firm leverage and debt maturity declined both in advanced economies and in developing countries, even in those that did not experience a crisis. The deleveraging and maturity reduction were particularly significant for non-listed firms, including both SMEs as well as large non-listed companies. For SMEs, these effects were larger in countries with less efficient legal systems, weaker information sharing mechanisms, less developed financial sectors, and with more restrictions on bank entry. In contrast, there is weaker evidence of a significant decline in leverage and debt maturity among listed companies which are typically much larger than other firms and likely to benefit from the “spare tire” of easier access to capital market financing. Though our results are robust to many changes in sample and specification, we cannot rule out that survivorship bias and attrition could affect our estimates to some degree.     

Have Rating Agencies Become More Conservative? Implications for Capital Structure and Debt Pricing

Rating agencies have become more conservative in assigning corporate credit ratings over the period 1985 to 2009; holding firm characteristics constant, average ratings have dropped by three notches. This change does not appear to be fully warranted because defaults have declined over this period. Firms affected more by conservatism issue less debt, have lower leverage, hold more cash, are less likely to obtain a debt rating, and experience lower growth. Their debt spreads are lower than those of unaffected firms with the same rating, which implies that the market partly undoes the impact of conservatism on debt prices. This evidence suggests that firms and capital markets do not perceive the increase in conservatism to be fully warranted.     

Private benefits of control and firm leverage: An analysis of Korean firms

This paper investigates the leverage choices of an entrenched controlling party. If debt effectively curbs the private benefits of control, the controlling shareholder is given incentives to avoid debt. Using estimates of the private benefits of control and financial statement data from selected Korean firms, we find that a controlling party with large private benefits tends to lower debt. This relationship was concentrated after the Asian financial crisis. However, before the crisis, firms that affiliated with Korean conglomerates, chaebols, used more debt as private benefits increased. A financial reform program triggered by the crisis seems to have actuated the disciplining role of debt. JEL Classification G32, G34     

Leverage changes and growth options in mergers and acquisitions

We develop and empirically test a trade-off model for the analysis of leverage changes in mergers and acquisitions. Our study extends prior findings of a post-merger increase in leverage for the acquiring firm, by linking this leverage increase to merging firms that are less correlated, create significantly larger growth options, and have lower bankruptcy costs and lower volatility. Specifically, we show that acquiring firms are more likely to finance diversifying acquisitions with debt as equity holders exploit the increased debt capacity with higher leverage resulting in total merger gains that are positively associated with financial synergies. We also provide evidence of a U-shaped relationship between growth options and leverage changes theoretically and empirically in the context of mergers.     

Firms' Off-Balance Sheet and Hybrid Debt Financing: Evidence from Their Book-Tax Reporting Differences

We match large U.S. corporations' tax returns during 1989–2001 to their financial statements to construct a firm‐level proxy of firms' use of off‐balance sheet and hybrid debt financing. We find that firms with less favorable prior‐period Standard & Poor's (S&P) bond ratings or higher leverage ratios in comparison to their industry report greater amounts of interest expense on their tax returns than to investors and creditors on their financial statements. These between‐firm results are consistent with credit‐constrained firms using more structured financing arrangements. Our within‐firm tests also suggest that firms use more structured financing arrangements when they enter into contractual loan agreements that provide incentives to manage debt ratings. Specifically, we find that after controlling for S&P bond rating and industry‐adjusted leverage, our sample firms report greater amounts of interest expenses for tax than for financial statement purposes when they enter into performance pricing contracts that use senior debt rating covenants to set interest rates. Furthermore, we find that the greatest book‐tax reporting changes occur when firms become closer to violating these debt rating covenants. These latter findings are consistent with firms' contractual debt covenants influencing their use of off‐balance sheet and hybrid debt financing.     

Firm dynamics and financial development

Using comprehensive firm-level datasets, this paper studies the impact of cross-country variation in financial market development on firms' financing choices and growth. In less financially developed economies, small firms grow faster and have lower leverage than large firms. As financial development improves, the growth difference between small and large firms shrinks, while the leverage difference rises. The paper then develops a quantitative model where financial frictions drive firm growth and debt financing through the availability of credit and default risk. The model explains the observed cross-country variations in firm size, leverage and growth in response to changes in financial frictions.     

Corporate distress and lobbying: Evidence from the Stimulus Act

The literature on distressed firms has focused on these firms’ investment, capital structure, and labor decisions. This paper investigates a novel aspect of firm behavior in distress: how financial health affects a firm?s lobbying and, consequently, its relationship with the government. We exploit the shock to nonfinancial firms during the 2008 financial crisis and the availability of the stimulus package in the first quarter of 2009. We find that firms with weaker financial health, as measured by credit default swap spreads, lobbied more. We also show that the amount spent on lobbying was associated with a greater likelihood of receiving stimulus funds.     

Leverage change,debt overhang,and stock prices

We document a significant and negative effect of the change in a firm's leverage ratio on its stock prices. We find that the negative effect is stronger for firms that have higher leverage ratios, higher likelihood of default, and face more severe financial constraints. Moreover, firms with an increase in leverage ratio tend to have less future investment. These findings are consistent with Myers' (1977) debt overhang theory that an increase in leverage may lead to future underinvestment, thus reducing a firm's value.     

Firm-level political risk and corporate leverage decisions

This study examines the effects of firm-level political risk on firm leverage decisions and speed of adjustment. We uncover that firm-level political risk has a negative impact on a firm's total and long-term leverage. We also find that firms facing high political risk tend to prefer debts with short-term maturity. However, firm-level political risk is positively related to debt specialisation, suggesting that firms are more inclined to adopt fewer debt types when they face high political risk. Further analysis reveals that firms with high political risk are associated with a faster speed of adjustment to target than those with low political risk. Our results are robust to endogeneity concerns and the effects of financial crisis.     

Sources of Financing,Profitability and Productivity: First Evidence from Matched Firms

This paper contributes to the literature on capital structure and firm performance. Using firm‐level data covering over 11,000 firms from 47 countries over a recent period of 1997‐2007, we address the effect of different sources of financing on corporate performance, employing a matching process, which allows an adequate `like‐for‐like’ comparison between high and low level of financing by firms. Robust to different matching estimators, the main findings are consistent with the theories of capital structure, in that firms with high debt‐to‐equity ratio tend to have lower returns to shareholders (profitability) and lower internal efficiency (productivity). The results become more robust when we separate the firms into advanced and emerging country‐groups or countries with high/low levels of financial development. Given the lower level of leverage below 50% on average in emerging markets (or in countries with lower level of financial reforms), firms in these economies face lower risk of financial distress and thereby less adverse effect on firm profitability and productivity, relative to their counterparts in advanced economies. We also find that retained earnings and equity financing improve performance, while debt financing by firms particularly in the form of bank loans leads to lower performance, although not so in the case of debt raised through issuing bonds.     

Capital Structure and Firm Efficiency

Abstract:  This paper investigates the relationship between firm efficiency and leverage. We consider both the effect of leverage on firm performance as well as the reverse causality relationship. In particular, we address the following questions: Does higher leverage lead to better firm performance? Does efficiency exert a significant effect on leverage over and above that of traditional financial measures of capital structure? Is the effect of efficiency on leverage similar across different capital structures? What is the signalling role of efficiency to creditors or investors? Using a sample of 12,240 New Zealand firms we find evidence supporting the theoretical predictions of the Jensen and Meckling (1976) agency cost model. Efficiency measured as the distance from the industry's 'best practice' production frontier is positively related to leverage over the entire range of observed data. The frontier is constructed using the non-parametric Data Envelopment Analysis (DEA) method. Using quantile regression analysis we show that the reverse causality effect of efficiency on leverage is positive at low to mid-leverage levels and negative at high leverage ratios. Firm size also has a non-monotonic effect on leverage: negative at low debt ratios and positive at mid to high debt ratios. The effect of tangibles and profitability on leverage is positive while intangibles and other assets are negatively related to leverage.