Why do Non-financial Firms Have Negative Net-Financial-Obligation? Implications for Financial Leverage and Expected Stock Returns

We find over 30% of public U.S. non-financial companies have negative net-financial-obligation (NFO) during the sample period of 1965 to 2014. According to the modified DuPont analysis, NFO is defined as total debt minus excess cash and passive investments. The persistence of negative-NFO observations suggests that its occurrence is not random, raising the questions of why these firms hold such a large amount of liquid assets, and/or so little debt. We explore several reasons for this phenomenon, including weak corporate governance, equity financing, and tax. Overall the evidence is most consistent with the equity financing and tax deferral hypotheses. Understanding the reason behind the prevalence of negative NFO helps us make proper adjustments/inferences when analyzing these firms. Our findings support the treatment of excess cash and passive investments as part of financing rather than operating activities, as prescribed by the modified DuPont method. We document a “crowding out” effect of firms maintaining negative NFO due to financing through long-term tax deferral. By not paying dividend to shareholders, firms retain income overseas to avoid repatriation tax. This long-term tax deferral creates a wedge between equity and debt financing, favoring equity financing. Because of the relatively high intensity of intellectual property, these firms also tend to have high cost of equity, creating a negative correlation between observed leverage ratio and the average stock return. Once we remove these negative-NFO firms, the correlation between financial leverage and cost of capital becomes positive, consistent with intuition. Our analysis thus uncovers an explanation for the puzzling negative correlation between leverage and expected stock returns documented in Penman et al. (2007).