To be or not to be all-equity for firms that eliminate long-term debt

Ranjan D'Mello, Mark Gruskin

Research output: Contribution to journalArticlepeer-review

Abstract

Despite the advantages of debt, a significant number of firms that have an established leverage policy deliberately become all-equity. These firms eliminate a substantial amount of long-term debt as the average firm's leverage ratio is approximately 30 percent at the year-end prior to debt elimination. Firm-level “shocks” such as CEO turnover and changes in credit ratings cannot explain the dramatic recapitalization decision. Consistent with the tradeoff theory, firms that eliminate debt have lower benefits (less tax shield benefits, agency costs) and higher costs (probability of financial distress, access to capital markets, etc.) of leverage in the three prior years compared to a matched sample. We also find that the factors influencing the decision to eliminate all debt is different from those to significantly reduce leverage or to have very low debt levels. Firms primarily finance the approximately $70 million of average long-term debt eliminated using proceeds from sales of relatively unproductive assets and from equity issues. Interestingly, over half of these firms issue significant amount of new debt within three years of becoming all-equity. Firms with lower liquidity and non-debt tax shields, higher potential overinvestment agency costs, and those that issue equity at the debt elimination year are more likely to relever quickly.

Original languageEnglish (US)
Pages (from-to)183-206
Number of pages24
JournalJournal of Empirical Finance
Volume64
DOIs
StatePublished - Dec 2021

All Science Journal Classification (ASJC) codes

  • Finance
  • Economics and Econometrics

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