Abstract
We build a model of debt for firms with investment projects, for which flexibility and free cash flow problems are important issues. We focus on the factors that lead the firm to select the zero-debt policy. Our model provides an explanation of the so-called “zero-leverage puzzle”. It also helps to explain why zero-debt firms often pay higher dividends when compared to other firms. In addition, the model generates new empirical predictions that have not yet been tested. For example, it predicts that firms with zero-debt policy should be influenced by free cash flow considerations more than by bankruptcy cost considerations. Additionally, the choice of zero-debt policy can be used by high-quality firms to signal their quality. This is in contrast to most traditional signalling literature where debt serves as a signal of quality. The model can explain why the probability of selecting the zero-debt policy is positively correlated with profitability and investment size and negatively correlated with the tax rate. It also predicts that firms that are farther away from their target capital structures are less likely to select the zero-debt policy when compared to firms that are close to their target levels.
Highlights
A firm’s capital structure is one of the top issues in corporate finance theory
We build a model of debt for firms with investment projects for which flexibility and free cash flow problems are important issues
We focus on the factors that lead firms to select the zero-debt policy
Summary
A firm’s capital structure is one of the top issues in corporate finance theory. Over the years, financial economists have formulated and tested various theories, including trade-off theory, pecking-order theory, and market timing. These firms will use internal funds for financing and will not pay any dividends (keep internal cash for future investments) This is consistent with the zero-debt policy of the non-payers group in Dang (2013). Our model predicts that firms that can potentially adopt the zero-debt policy are firms for which the free-cash flow problem is relatively more important than potential bankruptcy costs. Hart and Moore (1994) analyze a model with long-term debt, where managers have both an incentive to overinvest (similar to the free cash flow problem) and underinvest (debt overhang) They argue that a company with high debt will find it hard to raise capital, since new security holders will have low priority relative to existing creditors.
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