Finite-horizon zero-leverage firms

ABSTRACT

We develop a binomial lattice model of zero-leverage behaviour using a real option on debt issuance. With the option, firms may delay issuance even when debt is feasible and adds value to the firm. We find that firms are more likely to delay debt issuance when facing shorter debt horizons and longer option horizons. Our results suggest that firms earlier in their life cycle are more likely to be debt-free. This finding is consistent with empirical evidence that young firms are more likely to forgo debt. Our results also suggest that firms unable to access long-term debt markets are more inclined to be free of debt, even if short-term debt issuance is feasible.

KEYWORDS:

• Zero leverage
• binomial lattice
• real option
• trade-off theory
• capital structure

JEL CLASSIFICATION:

• G32
• G13

Acknowledgments

Babak Lotfaliei is thankful to Jan Ericsson, Aytek Malkhozov, and his PhD thesis committee.

Disclosure statement

No potential conflict of interest was reported by the authors.

Supplementary material

Supplemental data for this article can be accessed here.

Notes

¹ El Ghoul et al. (2017) documents similar patterns in developing markets.

² These are standard assumptions in much of the trade-off literature. See, e.g., Leland (1994); Leland and Toft (1996); Goldstein, Ju, and Leland (2001); Ericsson and Reneby (1998); Elkamhi, Ericsson, and Parsons (2012); Lotfaliei (2018b).

³ Admati et al. (2018) document the difficulty firms face in debt repurchase because debt repurchase is costlier than default.

⁴ With the project option, the firm will delay if expected future NPV exceeds the current NPV.

⁵ Our approach is extendable to multinomial lattices.

⁶ Optimizing both coupon rate and face value results in a zero coupon to avoid bankruptcy before maturity, which is an unrealistic degenerate case in this capital structure.

⁷ $K>0$ or $IC>0$ alone is sufficient for a well-specified optimization problem.

⁸ Negative net benefits means the option is out-of-the-money and it is not even feasible to issue debt.

⁹ Faulkender and Petersen (2006) report an upper quartile asset volatility of around 70% while Lotfaliei (2018b) describes a volatility boundary of around 70% that characterizes ZL firms. Furthermore, our choice of asset volatility is within one SD from the reported mean of 40% in Faulkender and Petersen (2006). For robustness, we also report results for a more conservative asset volatility rate of 40% in the Appendix to show that our results are not substantively affected by asset volatility.

¹⁰ By delaying debt issuance until relatively better states (the $u-u$ path vice the $u$ path), the firm hedges against default costs associated with the shorter debt maturity.

¹¹ This is analogous to the effect of time to maturity on standard American call and put options.