On Modified DuPont Method: Analysis of Firms with Negative Net-Financial-Obligations

Abstract

We find over 30% of public U.S. non-financial companies have negative net-financial-obligation (NFO) during the sample period of 1965 to 2014. According to the modified DuPont analysis, NFO is defined as total debt minus excess cash and passive investments. The prevalence of these observations casts doubt over the validity of the modified DuPont method, especially the treatment of holding excess cash and passive investments as financing rather than operating activities. We explore several reasons for this phenomenon, including weak corporate governance, equity financing, and tax deferral. Overall the evidence is most consistent with the equity financing and tax deferral hypotheses. Understanding the reason for having negative NFO helps us make proper adjustments/inferences when analyzing these firms. This study also provides a new explanation for the puzzling negative correlation between leverage and expected stock returns documented by prior research. Negative-NFO firms enjoy low-cost financing from the government, via long-term tax deferral, by retaining earnings overseas. These firms have incentive to reduce costly financing from traditional venues, especially debt. Negative-NFO firms also tend to have a high cost of capital due to their intangible-intensive asset structure. We show that these characteristics of the negative-NFO firms create a negative correlation between the observed leverage ratios and the average stock returns. Once we remove the negative-NFO firms, the correlation between leverage and stock returns becomes significantly more positive.