“Testing the Pecking Order Theory of Capital Structure” by Vidhan GOYAL
Hong Kong University of Science and Technology
University of British Columbia
The pecking order theory of corporate leverage is tested against the static tradeoff theory of corporate leverage, using a broad cross-section of US firms over the period 1980-1998. A derivation of the conditional target adjustment framework is provided as a better empirical test of mean reversion. None of the predictions of the pecking order theory hold in the data. As predicted by the static tradeoff theory, robust evidence of mean reversion in leverage is found. This is true both unconditionally and conditionally on financial factors. Leverage is more persistent at lower levels than at higher levels. When debt matures, it is not replaced dollar for dollar by new debt and so leverage declines. Large firms increase their debt in order to support the payment of dividends. By contrast, small firms reduce their debt while they pay dividends.