# Zero-Debt Policy under Asymmetric Information, Flexibility and Free Cash Flow Considerations

## Abstract

**:**

## 1. Introduction

## 2. Literature Review

#### 2.1. Debt Overhang

#### Flexibility Theory of Capital Structure

#### 2.2. Free Cash Flow Theory

#### 2.3. Signalling under Asymmetric Information

## 3. The Model and Basic Results

#### 3.1. Model Description

#### 3.2. No Free Cash Flow Problem and No Financial Constraints

#### 3.3. Financially Constraint Firm with Free Cash Flow Problem

#### 3.3.1. Manager’s Decision at the End of T = 1

**Lemma**

**1.**

**Proof.**

#### 3.3.2. Entrepreneur’s Dividend Decision at T = 1

**Proposition**

**1.**

**Proof.**

#### 3.3.3. Entrepreneur’s Capital Structure Decision at T = 1

**Proposition**

**2.**

**Proof.**

**Proposition**

**3.**

**Proof.**

## 4. Comparative Statics

**Corollary**

**1.**

**Corollary**

**2.**

**Corollary**

**3.**

**Corollary**

**4.**

## 5. Asymmetric Information about Firm’s Investment Opportunities/Performance

#### 5.1. Separating Equilibrium

**Proposition**

**4.**

**Proof.**

**Proposition**

**5.**

**Proof.**

#### 5.2. Pooling Equilibrium

**Proposition**

**6.**

**Proof.**

## 6. Model Implications

## 7. Model Extensions and Robustness

## 8. Summary and Conclusions

## Funding

## Acknowledgments

## Conflicts of Interest

## Appendix A

**Proof**

**of**

**Proposition**

**4.**

**Proof**

**of**

**Proposition**

**5.**

**Proof**

**of**

**Proposition**

**6.**

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1. | See, for example, Strebulaev and Yang (2013), Dang (2013), Bessler et al. (2013), Sundaresan et al. (2015), and Byoun and Xu (2013). |

2. | See, for example, https://www.macrotrends.net/stocks/charts/AAPL/apple/debt-equity-ratio. |

3. | |

4. | |

5. | Hart and Moore (1994) show that long-term debt has its advantages in dealing with the debt overhang problem. |

6. | See also Haddad and Lotfaliei (2019). |

7. | |

8. | A related result is the costly state-verification theory (see Townsend 1979; Gale and Hellwig 1985). It considers an environment where a firm’s earnings are unobservable by investors, the verification of earnings is costly, and managers can report earnings at their discretion (ex-post moral hazard). |

9. | High payout policy is often considered to be an alternative tool for disciplining managers (Easterbrook 1984; Brav et al. 2005), but usually not in combination with zero-debt policy. |

10. | In Section 7, we discuss the model’s robustness with regard to this assumption as well as other assumptions. |

11. | Later, we discuss other strategies. |

12. | Throughtout the model’s solution F and not D is used as the main variable in our model to describe the amount of debt. Technically, F is a better variable, since it includes the interest amount and does not affect any results while simplifying the solution presentation. Obviously, in equilibrium, D and F are connected with each other. |

13. | |

14. | The assumption about the existence of ${F}^{*}$ is quite natural. One can assume that, if the amount of debt raised by the firm goes beyond some threshold, then the debt becomes very costly/impossible to bear. It can be related to expected bankruptcy costs, credit rating problems, relationship with banks, etc. Note that this assumption is technically not crucial, but it helps to generate some interesting comparative static results. |

15. | These assumptions will be discussed in Section 7. |

16. | Corporate bankruptcy costs are not considered. It complicates mathematics without adding significantly new intuitions. |

17. | See Grinblatt and Sheridan (2001) for an example of calculations for the present value of tax shield. |

18. | Hart and Moore (1994) formally show how the use of long-term debt can mitigate managerial incentives for ineffcient investments. |

19. | The following cases are consistent with the spirit of our results (we discussed the Apple 2012 case previously). As we mentioned, this company had a lot of cash at that time, had no debt, and paid relatively high dividends. SEI Investments Company is a financial services company that is headquartered in Oaks, Pennsylvania, United States, with offices in Indianapolis, Toronto, London, Dublin, The Netherlands, Hong Kong, South Africa, and Dubai (see https://en.wikipedia.org/wiki/SEI_Investments_Company) SEI manages, advises or administers $809 billion in hedge funds, private equity, mutual funds, and other managed assets. This includes $307 billion in assets under management and $497 billion in client assets under administration. The company has no debt and it pays steady dividends (https://seic.com/investor-relations). In addition to its large amounts of cash available, the company has had agency problems that are related to some of its managers. Note the case of Allen Stanford, for example, (https://www.businessreport.com/article/stanford-group-money). Another example is the multinational corporation Amdocs that specializes in software and services for communications, media and financial service providers, and digital enterprises. The company is quite successful and consistently pays stable dividends (https://en.wikipedia.org/wiki/Amdocs). Additionally, it constantly penetrates new markets, develops new projects etc. Accordingly, one can assume that, on one hand, the company needs flexibility, since it is often involved in important investments projects. Additionally, the moral hazard and agency problems seem to be quite important, since the company often creates new legal entities, replaces management, creates joint ventures with other companies, etc. For more examples of companies with no debt that pay dividends, see https://www.investopedia.com/articles/investing/032116/10-companies-no-debt-doxnhtcpayx.asp. |

20. | We have analyzed a model’s variation that included the possibility of using debt-based crowdfunding. Under debt-based crowdfunding, the firm promises to return the inital investments from funders with interest. We found that the main results of the model are not affected. Some slight differences exist. For example, when debt is risk-free (which can be the case without demand uncertainty) debt-based crowdfunding can be used as a signalling tool along with reward-based crowdfunding. However, in a more realistic scenario when demand is uncertain and debt is risky, the main result stands, which favors reward-based crowdfunding. The same holds when modelling moral hazard. |

21. | Proofs are available upon demand. Note that the calculations become much longer and technically more complicated, which is very typical for multiple type games with asymmetric information. |

22. | The proofs for other cases are available upon demand. |

23. | Proofs for other cases are available upon request. |

24. | Proofs for other cases are available upon request. |

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**MDPI and ACS Style**

Miglo, A. Zero-Debt Policy under Asymmetric Information, Flexibility and Free Cash Flow Considerations. *J. Risk Financial Manag.* **2020**, *13*, 296.
https://doi.org/10.3390/jrfm13120296

**AMA Style**

Miglo A. Zero-Debt Policy under Asymmetric Information, Flexibility and Free Cash Flow Considerations. *Journal of Risk and Financial Management*. 2020; 13(12):296.
https://doi.org/10.3390/jrfm13120296

**Chicago/Turabian Style**

Miglo, Anton. 2020. "Zero-Debt Policy under Asymmetric Information, Flexibility and Free Cash Flow Considerations" *Journal of Risk and Financial Management* 13, no. 12: 296.
https://doi.org/10.3390/jrfm13120296