Financial Conservatism: Evidence on Capital Structure from Low Leverage Firms

Abstract

A persistent and puzzling empirical regularity is the fact that many firms adopt conservative financial policies. These under-leveraged firms carry substantially less debt than predicted by dominant theories of capital structure (Graham (2000) and Myers (1984)). This paper examines the phenomenon of financial conservatism by studying firms that adopt a persistent policy of low leverage. Our major findings are as follows. 1) Conservative firms follow a pecking order style financial policy. A high flow of funds and substantial cash balances allow them to fund the bulk of discretionary expenditures internally. 2) Financial conservatism is largely transitory. Seventy percent of low leverage firms drop their conservative financial policy; almost 50% do so within five years. 3) Conservative firms stockpile financial slack or debt capacity. Their stockpiles are utilized later to finance discretionary expenditures, particularly acquisitions and capital expenditures. 4) Financial conservatism is not an industry-based phenomenon. Conservative firms do, however, have relatively high market-to-book and operate relatively frequently in industries thought to be sensitive to financial distress. 5) Conservative firms do not have low tax rates, high non-debt tax shields or face severe information asymmetries.