TESTS OF OF THE PECKING ORDER THEORY AND THE TRADEOFF THEORY OF OPTIMAL CAPITAL STRUCTURE

Abstract

This paper investigates 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, the research finds 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-target debt level. The pecking order is found to be a much more bindingforceforsmallfirms, supportingthehypothesisthatsmallfirmsaremorelikelytofollowthepecking order because o f the difficulty in accessing external financing sources due to asymmetric information. The research also finds that small firms are significantly slower than large firms in adjusting the debt level when the adjustment requires an increase in debt level according to the target adjustment model.

Keywords

• pecking order theory
• the tradeoff theory
• capital structure
• debt level
• asymmetric information