Supply-Side Factors, CEO Overconfidence and Zero-Leverage Policy

Abstract

This paper investigates the effects of credit rating downgrades, equity mispricing and CEO overconfidence on zero-leverage policy, using data for listed United States firms during the period 1980-2012. The results show that (1) the likelihood of zero-leverage increases significantly following a downgrade in credit rating; (2) zero-leverage is the outcome of the past attempts by firms to issue more overvalued equity capital; (3) firms with overconfident CEOs are more likely to choose zero-leverage. The results clearly suggest that the conditions 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