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Integrating uncertainty and governance into a capital structure puzzle: can risk-taking and rule-taking explain zero-leverage

Michale Araki Martins, H. C.
Review of Managerial Science. November 9, 2021

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This study uses a multidisciplinary lens to investigate new determinants of the puzzling phenomenon of zero leverage, where firms contain only equity in their capital structure. We draw on insights from entrepreneurship and creativity theories, alongside traditional corporate governance (CG) literature, to reframe the construct of risk-taking and develop the novel construct of rule-taking, which entails compliance with powerful outside parties and current best practices of CG. We hypothesize that risk-taking is associated with a wider wedge of information and costs regarding internal and external financing, leading to a greater likelihood of debt eschewing. Conversely, rule-taking is hypothesized to reduce the range of acceptable choices in the firm, which makes the adoption of the “aberrant” behavior of zero-leverage less likely. Using 9222 firm-observations from 37 countries, the results corroborate our hypotheses, showing a positive (negative) association between risk-taking (rule-taking) and zero leverage. The results are robust to several alternative specifications and matching samples. Our study offers insights to policymakers and investors to clarify the antecedents of zero-leverage behavior as a strategy to deal with the information gap between insiders and outsiders. Our perspective underscores the existence of an inherent communication penalty between an insider and an outsider when the former is performing actions that are non-typical under the oversight of the latter. Thus, by deepening understanding on risk-taking and rule-taking, we provide a more nuanced view of how firms can optimize capital and CG structures, with special implications for the adoption of well-tailored bundles of CG mechanisms under different circumstances.