Zero-Leverage Puzzle Revisited: Evidence from Acquisition Behaviors

The prevalence of zero-leverage firms is a puzzle in corporate finance. We analyze the acquisition behavior of zero-leverage firms and offer a new venue to the studies on zero-leverage puzzle and the interdependence of capital structures and investment decisions. The prior literature suggests three explanations regarding the zero-leverage puzzle: limited access to the debt market, managerial preference, and financial flexibility. While non-persistent zero-leverage firms show similar behavior as moderately leveraged firms, persistent zero-leverage firms are conservative in their acquisition behaviors. These firms are less likely to make acquisitions, acquire smaller targets, and are more likely to acquire zero-leverage targets than are moderately leveraged firms. Meanwhile, both persistent and non-persistent zero-leverage firms are not financially constrained, since they are likely to use cash in their offers, and they increase leverage post-acquisition. Overall, our evidence on persistent zero-leverage firms supports the managerial preference hypothesis, while the evidence on non-persistent zero-leverage firms is consistent with the financial flexibility hypothesis. Therefore, studies on corporate investment strategy should be aware of persistent firms' unique behavior of debt and investment conservatism that differentiates these firms from other under-leveraged firms and non-persistent zero-leverage firms.