Ebook Testing the Trade-off and Pecking Order Theories of Capital Structure: Empirical Evidence from Chinese Listed Companies
Since the seminal Modigliani and Miller (1958) irrelevance propositions, financial economists have developed a number of theories in which the capital structure choice becomes relevant. The two most important and dominant theories of capital structure include the trade-off and pecking order theories (see Harris and Raviv, 1991 for a review). The trade-off theory, based on research on taxes (Modigliani and Miller, 1963) and bankruptcy and financial distress costs (Warner, 1977) and the insights from the agency literature (Jensen and Meckling, 1976), suggests that firms have a unique optimal capital structure that balances between the tax advantage of debt financing (i.e. debt tax shields), the costs of financial distress and the agency benefits and costs of debt (see Bradley et al., 1984; Leary and Roberts, 2005; Strebulaev, 2007).
The pecking order theory developed by Myers and Majluf (1984) and Myers (1984) does not predict an optimal capital structure. Under the assumption of asymmetric information whereby outsider investors know less about the value of the firm and the new investment opportunities than inside managers, firms avoid issuing equity and risky securities that are sensitive to mis-pricing and adverse selection. The pecking order theory predicts a strict preference of corporate financing, in which new investments are financed by internal funds first, then by low-risk debt and hybrid securities such as convertibles, and equities as the last resort. There is no optimal capital structure and the observed debt level is the cumulative result of the ‘pecking order’ financing behaviour over time.
A large body of recent empirical research on capital structure focuses on testing the validity of the trade-off and pecking order theories. Shyam-Sunder and Myers (1999) develop a simple empirical model that nests both theories and find strong support for pecking order theory. However, Frank and Goyal (2003) examining a larger sample of U.S firms document weak evidence for the pecking order theory. Fama and French (2005) further argue that the pecking order theory fails to explain why firms issue too much equity via seasoned equity issues and at the ‘wrong’ times. Recent research provides strong support for the trade-off theory. Flannery and Rangan (2006) find that U.S. firms do have long-run target leverage, to which they undertake partial adjustment at a relatively fast speed of 30% per year. Byoun (2008) develops a financing-need-induced adjustment framework and documents some evidence that firms adjust towards the target leverage ratio in an asymmetric way, consistent with the dynamic trade-off framework (see Leary and Roberts, 2005).
The majority of the empirical literature on capital structure has focused on U.S. firms. Recently, research has paid more attention to other developed and developing countries. Rajan and Zingales (1995) examine the capital structure choice of firms in the G-7 countries and find that the factors influencing capital structure in the U.S. and other industrialised countries are generally similar. Booth et al. (2001) investigate the determinants of capital structure in ten developing countries. They find a similar group of factors that explain corporate financing decisions in these countries, but there are persistent differences across countries that are caused by different institutional structures. While most existing studies focus on developed countries, it is interesting and important to assess the validity of the dominant theories of capital structure in the largest transition economy, the People’s Republic of China, within which the corporate environment and institutional structures are different from those in the developed world as well as in many other developing countries.
Some recent studies have started to investigate the capital structure choice of Chinese firms. Tong and Green (2005) examine the factors explaining leverage as predicted by the trade-off and pecking order theories for a small sample of 50 listed firms from 2001 to 2003. Huang and Song (2006) investigate the determinants of capital structure in China using large a sample of more than 1200 Chinese listed firms over the period 1994-2003. Most recently, Ni and Yu (2008) test the pecking order theory using Shyam and Sunder’s (1999) empirical model and analysing a sample of more than 400 Chinese listed firms in 2004. Bhabra et al. (2008) focus on investigating the impact of different ownership structures on the capital structure choice of a full sample of Chinese firms over the period 1992-2001. While the existing studies have provided interesting and important insights into many factors determining the financing decision of Chinese listed firms, they do not test directly the two most dominant theories of capital structure, i.e. the trade-off and pecking order theories. Technically, these studies generally estimate a static model of leverage that does not capture the dynamic (partial) adjustment process toward the target leverage as predicted by the trade-off theory (Flannery and Rangan, 2006; Byoun, 2008). Similarly, the use of a static model of leverage is unable to examine whether the incremental capital structure choice is affected by pecking order considerations (e.g. Shyam-Sunder and Myers, 1999; Frank and Goyal, 2003).
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