Why Are Firms Unlevered?

Abstract

In this paper, we examine the relative explanatory power of three motivations for firms to remain debt free - managerial entrenchment, need for financial flexibility, and credit constraints. Consistent with the hypothesis that they lack access to debt markets, these firms are small, young, profitable, and lack a credit rating, and make fewer investments than their control firms. We reject the hypothesis that zero-leverage policies are driven by entrenched managers attempting to avoid the disciplinary pressures of debt. These firms do not have weaker internal or external governance mechanisms. The debt initiation decisions of these firms are not preceded by shocks to their entrenchment, such as takeover threats or the emergence of activist blockholders. These firms are able to access debt financing when profitable investments arise, allowing them to credibly certify the use of funds to lenders, who are mainly banks or other private lenders. A majority of the firms explicitly state in their 10-Ks that they raise debt to finance investments, indicating a causal link between debt initiation and investments.