When Taking a Gamble on Corporate Debt Isn’t a Safe Bet
Nearly 20 percent of publicly-traded U.S. firms do not carry any debt. These companies are known as zero leverage (ZL) firms and some of the best known ZL firms include Facebook, Chipotle Mexican Grill and Garmin Ltd, which are listed in S&P 500 top companies.
While many people would say that being debt-free is a good thing, several scholars and executive managers would argue that having a certain amount of corporate debt is beneficial to an organization.
Having No Debt May Not Be Logical
For companies paying dividends to their shareholders (Garmin, for example), having no debt may fly in the face of logic since holding debt offers corporate tax incentives, provides an additional cash infusion needed for dividend transactions, and results in positive cash flow. Debt also motivates managers to work harder towards making a profit and reduces luxury corporate expenditures (also known as “empire building”) because they have to make enough money to pay their interest bills.
Playing the Waiting Game May Pay Off
However, research conducted by Dr. Babak Lotfaliei, finance professor at San Diego State’s Fowler College of Business indicates that “patience is a virtue” when ZL companies consider incurring debt.
“Few ZL firms have negative gain and most would eventually benefit from having debt
– it’s just a question as to when corporate management determines the value of taking
on debt outweighs the risks,” he said. “This is particularly true when the company
faces high business risk, such as a pending lawsuit or the introduction of a new product
“If the firm’s value does fall, the lack of debt hedges exposure to non-recoverable and irreversible debt costs, such as default,” he explained. “And should the firm go into bankruptcy, debt would add substantial default costs.”
Stability is the Key
While it would be tempting for corporate management of ZL companies to take on debt in a time of uncertainly, Lotfaliei’s research shows the company may see clear benefits from other financing sources, such as tapping cash reserves. “Once the company’s future stabilizes and there is less volatility, they might reap benefits from taking on debt at that time,” noted Lotfaliei.
Lotfaliei summed things up this way: “I tell my students, it’s a little like marrying your significant other: If you and your fiancé get married right away, you may be happy, but you may also face a more uncertain future. If you wait until you’re relationship is more mature to get married, you may be happy and you would reap the benefits of less uncertainty and a more stable future.”