Supply‐side factors, CEO overconfidence, and zero‐leverage policy

• Date: 01 October 2020
• Published date: 01 October 2020
• DOI: http://doi.org/10.1002/ijfe.1765
• Author: Jairaj Gupta,Aydin Ozkan,Tahera Ebrahimi

RESEARCH ARTICLE

Supply‐side factors, CEO overconfidence, and zero‐leverage

policy

Tahera Ebrahimi

1

| Jairaj Gupta

2

| Aydin Ozkan

1

1

Department of Accountancy, Finance

and Economics, University of

Huddersfield, Huddersfield HD1 3DH, UK

2

Department of Finance, University of

Birmingham, Birmingham B15 2TY, UK

Correspondence

Jairaj Gupta, Department of Finance,

University of Birmingham, Birmingham

B15 2TY, UK.

Email: J.Gupta@outlook.com

Abstract

This paper investigates the effects of credit rating downgrades, equity

mispricing, and CEO overconfidence on zero‐leverage policy, using data for

listed U.S. firms during the period 1980–2012. The results show that (a) the

likelihood of zero leverage increases significantly following a downgrade in

credit rating; (b) zero leverage is the outcome of the past attempts by firms to

issue more overvalued equity capital; and (c) firms with overconfident CEOs

are more likely to choose zero leverage. The results clearly suggest that the con-

ditions prevailing in both credit and equity markets exert significant influence

on zero‐leverage policy. The analysis also advocates the inclusion of managerial

biases in conjunction with the market‐wide conditions in the analysis of zero‐

leverage policy. Overall, the findings reveal that zero‐leverage firms find that

the benefits of issuing overvalued equity outweigh the benefits associated with

debt financing. These results are robust to a battery of checks.

KEYWORDS

Zero leverage, credit rating, equity mispricing, CEO overconfidence

JEL CLASSIFICATION

G32; G34

1|INTRODUCTION

The relationship between firm leverage and value has

been investigated intensively in the corporate finance lit-

erature. In their seminal paper, Modigliani and Miller

(1958) show that under perfect capital markets, the capi-

tal structure of a firm has no impact on the firm's cost

of capital and the market value of its assets. Their analysis

suggests that firm value is only determined by a firm's

investment policy and cash flows. In this framework,

firms are indifferent to the allocation of capital between

debt and equity financing, and investors will not be will-

ing to pay a premium for a specific capital structure.

The assumptions and predictions of the Modigliani

and Miller analysis are known to be inconsistent with

the observed capital structure of firms. Relaxing the

assumptions has led to various theoretical explanations

of capital structure policy, which are better aligned with

the empirical findings.

1

Although the predictions derived

under capital imperfections vary, they all imply a signifi-

cant relation between firm value and leverage. The rele-

vance of leverage arises mainly from trading‐off the tax

benefits of debt financing against the expected bank-

ruptcy costs (Kraus & Litzenberger, 1973). Leverage also

plays a significant role in reducing the costs of asymmet-

ric information and agency conflicts (Jensen & Meckling,

1976). Despite ample theoretical and empirical research,

it is puzzling why some firms still do not fully exploit

the benefits of debt financing; in particular, the tax

advantages arising from the deductibility of interest pay-

ments from taxable income (Graham, 2000). In extreme

cases, firms choose to have zero debt in their capital

Received: 19 December 2017 Revised: 28 January 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1765

Int J Fin Econ. 2019;1–18. © 2019 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 1

Int J Fin Econ. 2020;25:547–564. wileyonlinelibrary.com/journal/ijfe © 2019 John Wiley & Sons, Ltd. 547

structures, which has led to what has become known as

the zero‐leverage (ZL) puzzle in the literature (Strebulaev

& Yang, 2013). Clearly, given the benefits of debt financ-

ing, ZL firms are unlikely to maximize value and hence

damage shareholder.

The ZL policy of firms has received a great deal of

attention in recent years (see, e.g., Bessler, Drobetz,

Haller, & Meier, 2013; Strebulaev & Yang, 2013). The

main explanations of ZL revolve around the lack of ability

and significantly limited access of firms to debt markets.

It is also argued that ZL can be a strategic capital struc-

ture decision (Dang, 2013; Joaquim, Dias, & Paula,

2016). The limited access hypothesis is consistent with

the view that highlights the need to consider the role of

supply effects in debt financing decisions (see, e.g.,

Faulkender & Petersen, 2006; Baker, 2009; Bolton, Chen,

& Wang, 2013). However, previous research fails to con-

sider all the possible supply channels that can help

explain the ZL phenomenon. Motivated by this gap in

the literature, we aim to provide new insights into ZL pol-

icy by investigating the impact of the supply‐side aspects

of financing choices on the zero‐debt choice of firms.

Our general approach to identifying the supply‐side fac-

tors to include in the analysis of ZL is influenced by the

previous studies of Baker (2009) and Bakera and

Wurglerb (2013). It is argued that there are channels

through which supply factors can have an impact on cap-

ital structure, which are mainly shaped by the beliefs and

preferences of managers and investors. Although the

changes in investor preferences and market sentiment

can move the market value of a firm from its fundamental

value, the responses of managers to these changes may

strengthen the misvaluation and hence delay any possible

corrections. It is also possible that the gap can close more

quickly as a result of the actions taken by managers.

Clearly, managers can also impact the supply‐side factors

as they are able to influence the issuance processes and

pricing of financial securities. Consequently, in this

paper, we investigate the impact of both the shifts in

credit and equity markets conditions and several impor-

tant managerial characteristics, including behavioural

biases, on the likelihood of firms having ZL policies.

This paper provides several important contributions to

the literature on ZL and debt financing in general. Our

first contribution stems from the detailed analysis of the

interactions between credit constraints and the ability of

firms to borrow. Contrary to the existing ZL studies that

mainly focus on firm characteristics such as size, tangibil-

ity, and dividends in measuring the extent of credit con-

straints, this paper investigates how the pricing of debt

financing through credit rating can affect the ZL decision.

In a similar vein to Lemmon and Zender (2010), we

employ a predictive model using data on a number of

observable firm characteristics to estimate the likelihood

that a firm can access the public debt market. Clearly, rat-

ing downgrades motivate firms to reduce leverage in their

capital structure as lower credit rating levels are generally

associated with higher cost of borrowing (Kisgen, 2006,

2009). In our analysis, the difference in fitted values from

the estimated predictive model is used as a proxy for the

borrowing ability of firms. The results show that ZL firms

are mostly credit constrained, and there is a significant

increase in transformations from nonzero to ZL policies

following a downgrade in credit rating.

Our second contribution lies with the inclusion of the

supply‐side conditions of equity capital in the analysis of

ZL policy. Prior research focuses only on the impact of

the availability of debt financing on the choice of a zero‐

debt policy. To the best of our knowledge, there is no

study that considers the interactions between the supply

of equity capital and the ZL decision. Our study comple-

ments Bessler et al. (2013) who focus only on the impact

of the supply of debt financing on ZL. We extend it by

arguing that when market frictions create a wedge

between the costs of external debt and external equity,

managers attempt to time the market by considering the

supply‐side conditions in relation to both debt and equity

capital markets in deciding the type of securities to issue

or repurchase (Baker, 2009; Bakera & Wurglerb, 2013).

Specifically, in addition to the credit rating conditions of

firms, we examine whether the lower cost of overvalued

equity capital can explain the ZL choice of firms. To

examine the effect of equity mispricing, we sort firms into

different mispricing quintiles. As expected, the greatest

portion of ZL firms belongs to the most overvalued group,

implying that these firms enjoy the lower cost of equity

financing. The analysis also suggests that the level of

investment in ZL firms depends strongly on equity valua-

tion. This is evidenced by the finding that the only group

of ZL firms that does not exhibit underinvestment is the

group with overvalued equity. Additionally, we find that

the more severe underinvestment problem is observed in

the most undervalued group. We also document that the

capital structure of ZL firms is the cumulative result of

the past attempts by firms to issue more equity capital

in response to higher favourable valuation by the market

(see Figure 1). It appears that, although on average these

firms gradually deviate from their target debt ratios for

several years prior to ending up with zero debt,

overvalued equity capital induces firms to raise more

equity capital. Overall, the results suggest that ZL firms

find that the benefits of issuing overvalued equity out-

weigh the benefits associated with debt financing.

Our third contribution is to investigate the effects of

CEO overconfidence and the probability of ZL policy. To

the best of our knowledge, the influence of overconfident

2EBRAHIMI ET AL.

548 EBRAHIMI ET AL.