Zero-Leverage Puzzle

TL;DR

This paper investigates why some firms choose zero leverage, finding that financial constraints, rather than managerial entrenchment or market valuation effects, primarily drive this behavior.

Contribution

It provides strong empirical evidence that financial constraints are the main reason for zero-leverage firms, challenging alternative explanations like managerial entrenchment and market valuation effects.

Findings

Zero-leverage firms are financially constrained.

Financial constraints are the primary driver of zero-leverage behavior.

All-equity firms increase investments after levering, but leverage decreases during crises.

Abstract

In this paper, I examine why some firms have zero leverage. I fail to find evidence that firms are unlevered because of managerial entrenchment since these firms do not have weaker corporate governance. I reject the hypothesis that firms become zero-leverage after prolonged periods of high market valuation, since before levering these firms do not suffer from declining valuations and continue to issue large amounts of equity. I find strong evidence in favor of the financial constraints explanation of the zero-leverage puzzle. Zero-leverage firms appear to be financially constrained using three different measures of financial constraints. I obtain mixed evidence on the financial flexibility hypothesis since all-equity firms increase investments and acquisitions after levering, but the probability of their levering decreased during the financial crisis. My results suggest that financial constraints are the first-order the driver of zero-leverage behavior and are more important than less obvious explanations such as managerial entrenchment.