Governance and Debt

The governance antecedents of the Zero Leverage Puzzle

In this paper, we take a novel theoretical approach to understand the puzzling phenomenon of zero-leverage firms. First, we delve into different theories of finance, management, economics and entrepreneurship seeking to arrive at a more integrative model of a firm’s financial behavior. This effort culminates in the presentation of a novel construct called rule taking, which reflects the degree which a manager has their discretionary power constrained. We, then, outline two hypotheses concerning how the interplay of governance and innovation can affect a firm’s financial outcomes in apparently surprising ways. Firstly, we hypothesize that corporate risk-taking is positively associated with zero leverage. Second, we hypothesize that our novel construct of rule taking is negatively associated with zero leverage. Using a cross-sectional regression with a sample of around 17,000 firms, our results corroborate our hypothesis. By taking a detailed look at subtle determinants of managerial and corporate behavior, we can provide a novel alternative explanation to a phenomenon that have puzzled researchers for decades.

Co-authored with Michael Araki.

Henrique Castro Martins
Henrique Castro Martins
Assistant Professor of Finance