Tests of the Pecking Order Theory and the Static Tradeoff Theory of Optimal Capital Structure

Abstract

We investigate implications of the static tradeoff theory and the pecking order theory. The results suggest that firms adjust their debt levels according to target debt ratios as well as the pecking order. By combining the two theories we find that firms are more likely to increase debt when they face financing needs as well as below-target debt level while they are more likely to decrease debt level when they have surplus cash flows as well as above-the-target debt level. The pecking order is found to be a much more binding force for small firms, supporting the hypothesis that small firms are more likely to follow the pecking order because of the difficulty in accessing external financing sources due to asymmetric information. We also find that small firms are significantly slower than large firms in adjusting the debt level when the adjustment requires an increase in debt level The existence of debt financing generates agency costs of debt under informational asymmetry: the stockholders ’ incentive to take sub-optimal risky projects which transfer wealth