Tuesday, October 23, 2012

Paper: "The Mystery of Zero-Leverage Firms"

Here's a fascinating paper called "The Mystery of Zero-Leverage Firms". Traditional corporate finance says that firms should use leverage to take advantage of the income tax savings on interest payments, at least up to the point that the increased leverage threatens shareholders' control of the firm (which is included in optimal leverage models as "cost of distress").

"Dividend-paying zero-leverage firms leave a lot of money on the table by not levering up. Were an average such firm to increase its leverage to the level of its dividend-paying proxies, potential tax benefits amount, under the conservative scenario, to more than 7% of the market value of equity. Were the same firm to refinance to the point where its marginal corporate tax rate is zero, gains would be much larger at about 15% of the equity value."
The authors find that a significant fraction of public U.S. firms have either zero or very little (sub-optimal) leverage and look for explanations of this "zero-leverage puzzle". As usual, you can chalk this managerial puzzle up to a principal-agent conflict,
"A plausible explanation of the zero-leverage phenomenon is that the manager’s personal preferences differ from those of shareholders. For example, if the manager is endowed with substantial stock ownership and thus under-diversified, he would find debt more costly than shareholders. [...Also,] family members can be altruistic and derive utility from passing on the family legacy and safeguarding the well being of other family members. Desire for the long-term survival increases the perceived risk of default-risky debt. Consistent with this intuition, we find that family firms are substantially more likely to be zero-levered."
The authors cite another study (Lewellen 2006) which argued that the larger the stock ownership of CEOs and the smaller their option grants the more likely their firms are to have lower leverage. Another study they mention (Coles, Daniel, and Naveen 2006) argued that managers with greater delta and smaller vega to their own common stock used less debt. Company leverage has also been linked to Great Depression experience of the CEO.

In thinking about the amount that companies could lever up (in order to calculate the foregone tax savings), they used the minimum cash flow in the past five years as the threshold for thinking about the interest coverage and leverage possibilities. That is a conservative approach that minimizes the chances that the firm would default.

This paper is very timely for us to think about because of our underleveraged, family-owned firm: Conrad Industries. Let's do a thought experiment about Conrad using debt for tax savings and accretive share buybacks.

Suppose the company borrowed $10 million for 5 years at 5%. Also, suppose that they could tender and buy back 500k shares at $20 per share. The interest cost would be $500,000 pretax, but actually only $325,000 after the interest savings. This would mean retiring about 8.2% of the public float. The company has averaged $30 million in EBITDA annually since 2007, so we'll assume that they would earn $2.46 million in EBITDA on these repurchased shares. This deal would increase pretax earnings by $2.14 million. Tremendously accretive - just from one small transaction.

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