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I Introduction
Microsoft and Google have at least one thing in common: they have virtually no debt and hold large cash positions. Google has a market capitalization of $116 billion (at the beginning of March 2009), cash holdings of $16 billion, and no debt. Microsoft with a market capitalization of $172 billion holds $20 billion in cash and a mere $2 billion debt position[1] . These two examples are not exceptions. In fact, [28] Strebulaev and Yang (2006) report that, over the time period from 1987 to 2003, 11 percent of the publicly traded non-financial US firms do not have any debt and 29 percent have less than 5 percent debt. When considering net debt positions, defined as debt minus cash holdings, an astounding 36 percent of publicly traded non-financials have zero or negative net debt.
Firms having no debt and holding large cash positions are difficult to reconcile with any of the two major theories on the optimal choice of debt versus equity, i.e. a firm's capital structure. First, the static tradeoff theory is based on the fact that debt offers tax savings because interest payments are tax deductible. This theory suggests that firms should use debt up to the point where the tax advantage of debt and the disadvantage of debt in form of costs of a potential bankruptcy balance out. [15] Graham (2000) studies the tax advantages of debt and concludes that the low average debt-equity ratios of US firms are puzzling[2] .
Second, the pecking order theory put forward by [24] Myers (1984) and [25] Myers and Majluf (1984) predicts (based on asymmetric information arguments) that firms prefer financing their investments by cash, then debt, and as a last resort they would issue equity. This would result in low cash balances and high levels of debt[3] .
These two main capital structure theories are an integral part of any course syllabus or textbook chapter on capital structure. However, these theories fail to explain the widespread existence of no debt (and very low debt) firms. In addition, [26] Opler et al. (1999) and [17] Hartford (1999) point out that also the observed accumulated cash balances of firms appear too large to be in line with existing theories.
The low debt ratios...