2. Survey of Literature
2.2. Previous Research on “Marginal Debt” Companies
tax shield is still a debating topic, some researchers pretending that it might have been overstated until now, its existence has not been questioned. From capital structure theories, first possible reason which could explain the absence of debt on the books of some companies is their inability to raise debt. Companies would not be able to raise debt either because their financial health is critical, or because of the absence of tangible assets to secure loans. This study focuses on successful companies. On the next section, the methodology which has been used to select tested companies will be explained. As mentioned there, only financially healthy companies will be studied as they might represent a paradox. Another element to be analyzed in order to see if those companies have access to debt is a comparison of their tangible assets compared to their peers having debt.
The trade off theory might be consistent with marginal-debt company as soon as they do not use equity to finance their growth. Low tangible assets companies might represent a special case where equity might be used before debt. Hence, the trade off theory should serve as a good tool to explain the behavior of marginal-debt companies. However, this is beyond the scope of this study, and could be analyzed in further research.
2.2. Previous Research on “Marginal Debt” Companies
In an article titled, “Debt-free Zara looks beyond pain in Spain” published in Reuters on October 26, 2008, S. Dowsett studied the financial conditions of Inditex, the leading Spanish clothing retailer. The article highlights the high performance of the retailer despite the severe economical downturn in Spain. As a reason for its outstanding performance, the geographical diversification of the company and well established fast retailing strategy is key. However, the fact that the company self finances its operation and that it does not use debt to finance
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expansion is described as another success factor. According to the article and to some financial analysts interviewed, this debt free capital structure provides Inditex some flexibility which allows the company to better deal with economical shocks, at a cost of slower growth. This explains why Inditex outperformed its competitors in an economic downturn.
While capital structure theories tell us that debt is beneficial for the company performance and can either increase company value due to the tax shield effect, Inditex is not an isolated case.
Apple used to be a popular example until it issued debt to buy back shares for $55 billion in order to avoid tax from offshore cash usage. Apple still has large amount of cash on its book.
According to its management, the large cash position allows the company to invest quickly in attractive projects, which would not be the case had debt financing been required. Then, the question is now to analyze how those companies perform in the long run, and to try to figure out elements explaining their performance and behaviors. Actually, many researchers tried to understand the low-leverage puzzle by questioning the overestimation of benefits of leverage on company value. Graham (2008), by analyzing the potential outcome of tax shield provided by debt, finds that “Paradoxically, large, liquid, profitable firms with low expected distress costs use debt conservatively.” The increase of companies with no debt in their book is a specific case of this phenomenon.
Agrawal and Nagarajan (1990) were the first to study the phenomenon. They found 104 all equity firms. All equity companies are defined as US companies having a ratio of book value of long term debt to firm value below 5% for five consecutive years between 1979 and 1983. They compared those all equity firms with an indebted firm from the same industry, and with a similar size. Their objective was to identify shareholding and managerial structures between all equity and indebted companies. They found that managers of all-equity companies had
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significantly larger stockholdings, greater family involvement, and had safer liquidity positions.
All together, they pointed out that those all equity companies were more averse to debt, and risk in general, as the company often serves as a source of income for the whole family.
Strebulaev and Yang (2012), show that between 1962 and 2009, on average, 10.2% of large (e.g.
firms having more than $10M in asset book value) US public companies had neither short term or long term financial debt. This number reached a 19.9% peak in 2005. They define zero-leverage companies as companies having neither short term or long term debt for a given year. They also study companies with zero long term debt, and companies with a book leverage ratio below 5%, which they call “almost zero leverage” companies. Strebulaev and Yang then separated their sample into two groups: dividend paying firms , and non dividend paying firms.
Their study focuses on financial performance variables, and financial debt substitutes (e.g.
pension liabilities) As a result of their study, they show that among zero debt companies, some of them are more profitable, pay higher dividend, and have better cash balance. They also find that marginal-debt companies do not have higher financial debt substitutes. Finally, they claim that those companies could save about 7% of market equity value by issuing some debt to increase their financial leverage. Like Agrawal and Nagarajan (1990), they find that family owned companies are more likely to follow the marginal-debt policy. They also find evidence that companies with large CEO ownership and more CEO-friendly boards are more likely to avoid financial debt.
Devos et al. (2013) are more restrictive in their definition of marginal-debt companies as they define them as companies having strictly no short-term and long-term financial debt for three consecutive years. Between 1990 and 2008, they compare their marginal-debt sample with companies from the same industry, with a similar size, and similar operating performance. They
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find out that only 4% of their sample matched their marginal-debt definition in 1990, against 5.4% in 1997, and 11.3% in 2008. Like Agrawal and Nagarajan (1990), they study the governance and monitoring of marginal-debt companies. In addition to that, they study the financial health of those marginal-debt companies and their tax variables. As a result, they reject the hypothesis that the zero-leverage policy is due to the manager´s behaviors or preferences. They find no evidence supporting the entrenchment hypothesis and argue that marginal-debt companies have similar corporate governance mechanisms as their indebted peers. On the other hand, Devos et al. (2013) argue that those companies might simply not have access to debt due to their poor performance and low credit accessibility. Absence of assets which could be used as collateral is another factor constraining the access to debt. Also, those companies are younger and/or smaller, which could explain their difficulty to penetrate the debt market. This is contradictory with the two previously mentioned papers.