Supply-side factors, CEO overconfidence, and zero-leverage policy

This paper investigates the effects of credit rating downgrades, equity mispricing, and CEO overconfidence on zero-leverage policy, using data for listed U.S. firms during the period 1980–2012. The results show that (a) the likelihood of zero leverage increases significantly following a downgrade in credit rating; (b) zero leverage is the outcome of the past attempts by firms to issue more overvalued equity capital; and (c) firms with overconfident CEOs are more likely to choose zero leverage. The results clearly suggest that the conditions prevailing in both credit and equity markets exert significant influence on zero-leverage policy. The analysis also advocates the inclusion of managerial biases in conjunction with the market-wide conditions in the analysis of zero-leverage policy. Overall, the findings reveal that zero-leverage firms find that the benefits of issuing overvalued equity outweigh the benefits associated with debt financing. These results are robust to a battery of checks.