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Why Not Zero Leverage?

Some large, publicly held companies have no-debt policies. Is that really so puzzling?
Vincent Ryan, CFO.com | US
April 12, 2012

If you could run your company with zero leverage, would you?

For years, finance professors have been trying to solve what they call puzzling behavior - companies that practice zero-debt policies. Why would any large, publicly held company not borrow money and take advantage of the tax deductibility of interest payments? But a more interesting question might be, why wouldn't you like your company to have zero leverage?

After all, lenders and bondholders are not exactly the most motivated business partners - their biggest concerns, when you strip their motivation to its bare bones, are the liquidation value of the borrower's assets and ensuring that the borrower doesn't put another creditor in line before them for when the liquidation sale takes place.

In addition, bank refinancings can take up large amounts of time and energy - a company only just negotiates a three-year term loan and six months later the CFO is already thinking about how and when to how to push out the maturity date.

And, finally, while financial leverage can multiply returns to shareholders, it can also take down a company  swiftly if there is a liquidity crisis, or even put a company into a liquidity crisis (if a counterparty decides to pull the company's credit line because of its own liquidity issues). All this, and, according to the theories of Franco Modigliani and Merton Miller, capital structure in some cases will be irrelevant to shareholder returns.

What do zero-leverage firms look like? A quick screen on S&P Capital IQ for publicly held U.S. companies with zero debt and more than $500 million in revenue (as of their latest annual report) turns up 126 companies, including some well-known names: Apple, Netgear, Red Hat, Mastercard, Columbia Sportswear, and Paychex among them. These are not small companies, they have solid, rising cash flows, and their revenue is growing- 36 of them had topline growth in excess of 20% the last 12 months.

In a paper updated last March, "The Mystery of Zero-Leverage Firms," Ilya Strebulaev of Stanford University and Baozhong Yang of Georgia State examine the characteristics of zero-leverage firms. They found that between 1962 and 2009, on average, 10.2% of large, publicly held non-financials in the U.S. had no debt in their capital structure, and 32% had zero or negative net debt.

ost times zero leverage is a persistent policy, not a one off, the Strebulaev study found. Sixty-one percent of the firms that had no debt in their capital structure in any year displayed no inclination to take on debt in the following year. Strebulaev and Yang also found that neither industry nor age was a determinant of no-debt policies.

Zero-leverage firms were profitable, but also paid a lot of taxes, according to the study; they accumulated large cash balances, but they also paid larger dividends. Indeed, "[these] firms effectively replace interest expense with dividends and share repurchases, so that the total payout ratio is relatively flat across the whole spectrum of leverage," say Strebulaev and Yang.

That's one of the potential downsides to being a zero-leverage company: you still have to pay the piper, and it's not tax deductible. Shareholders expect dividends to come regularly and increase steadily, so nonlevered firms may have to pay out a percentage of earnings consistently anyway - they're just called dividends rather than interest payments. 

Another characteristic of some zero-leverage firms, or at least the ones that Strebulaev and Yang studied, was that their boards of directors were smaller and less independent. Family-controlled firms, for example, were 7% more likely to pursue a zero-leverage policy than non-family firms. That could be due to the goal of the controlling shareholders to pass on the family legacy and safeguard the well-being of other family members. "Desire for the long-term survival [of the company] increases the perceived risk of default-risky debt," say the authors. That approach, of course, is not one that outside, minority shareholders would embrace. A manager-friendly board wouldn't exactly go over well either.

But even if these traits were prerequisites - after all, the firm with zero leverage needs to be able to circle the wagons quickly when targeted by an activist investor or financial sponsor looking for its next meal - I don't think they'd be a dealbreaker. Apple is far from the poster child for corporate governance, but look at its share price.

Finally, of course, zero-leverage firms leave some amount of value on the table by not optimizing their capital structure for the tax benefits of debt. If the average zero-levered firm were to leverage up to the level of similar companies in its industry, says the Strebulaev study, the potential tax benefits would amount to more than 7% the market value of the firm's equity. And, yes, in many cases, leverage does magnify the returns of a company, when measured by earnings per share and return on equity.

But I think that list of 126 companies - and their performance records - makes a compelling counter-argument for the no-leverage policy. It certainly can be done. What's puzzling to me? Why more companies don't try it.




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