Zero-Debt Policy under Asymmetric Information, Flexibility and Free Cash Flow Considerations

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.

Impact of Capital Structure on Corporate Value—Review of Literature

“…T. Nguyen, M. Bai, Y. Hou, and M. Vu noted that, according to the trade-off theory, any deviation of the financial leverage from the optimal capital structure may result in a reduction in a company's value (Nguyen et al 2021). However, this theory does not seem to explain those situations in which debt is completely absent (Miglo 2020). The existence of a tax shield increases the market value of the enterprise along with an increase in debt, because the financial costs reduce the tax base (Gajdka and Szyma ński 2019).…”

An Inductive Approach to Quantitative Methodology—Application of Novel Penalising Models in a Case Study of Target Debt Level in Swedish Listed Companies

“…These findings suggest that determining target debt levels may depend on factors with enduring stability. Miglo (2020) discovered that firms that deviate further from their target debt levels are less inclined to adopt the zero-leverage policy compared to those closer to their targets. According to their model, this reluctance stems from the potential for a significant tax shield when moving towards the target, all else being equal.…”

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“…The New Strategy of High-Tech Companies -Hidden Sources of Growth (Graham, 2003). Выбор подобной стратегии обусловлен множеством факторов, включая финансовые ограничения (Devos et al, 2012), потребность в гибкости (DeAngelo et al, 2011), агентские проблемы (Butt, 2020) и сигнальные теории (Miglo, 2020). Несмотря на убедительные подступы к объяснению этого феномена, сохраняется значительный разрыв между теоретическими и эмпирическими данными для разных секторов.…”