Reconciling capital structure theories in predicting the firm's decisions.

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Past literature attempts to resolve the issue of the motivation behind managers' choice of a given capital structure. Despite several decades of intensive research, there is still no consensus about which theory dominates capital structure decisions. The present study empirically investigates the relative importance of two prominent theories of capital structure- the trade-off and the pecking order theories by exploring the conditions under which each theory can explain the financing choices of firms. These conditions are defined along two dimensions: (i) a firm's degree of information asymmetry, and (ii) its observed leverage relative to target leverage. The results show that, ... continued below

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Palkar, Darshana December 2006.

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  • Palkar, Darshana

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Description

Past literature attempts to resolve the issue of the motivation behind managers' choice of a given capital structure. Despite several decades of intensive research, there is still no consensus about which theory dominates capital structure decisions. The present study empirically investigates the relative importance of two prominent theories of capital structure- the trade-off and the pecking order theories by exploring the conditions under which each theory can explain the financing choices of firms. These conditions are defined along two dimensions: (i) a firm's degree of information asymmetry, and (ii) its observed leverage relative to target leverage. The results show that, in the short-run, pecking order theory has more explanatory power in explaining the financing choices of firms. The target leverage theory assumes limited importance: Over-leveraged firms, when faced with low adverse information, are more inclined to adapt to the trade-off policies. In the presence of high information asymmetry, however, firms appear to be more concerned about adverse selection costs and make financing decisions that are more consistent with the pecking order theory. An analysis of the market reaction to seasoned equity issuances during announcement periods reveals that firms with high information asymmetry are penalized more than firms with low information asymmetry. This may explain the contradiction when over-leveraged firms continue to issue debt. However, the situation is reversed in the long run. Firms' long term financing goals appear to follow the leverage re-balancing theory. An analysis of financial activities over a five-year period, subsequent to security issuance decisions when they appear to be inconsistent with trade-off theory, reveals that firms follow an active policy of moving closer to the target leverage. In sum, the notion of target capital structure appears to exist. In the short-term, the management's financing decisions are consistent with the modified version of the pecking order theory, leading to tactical deviations from the optimal capital structure. However, long-term analysis indicates that the pecking order effect is largely transitory in nature and firms actively pursue strategic reversals towards an optimal capital structure.

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  • December 2006

Added to The UNT Digital Library

  • May 5, 2008, 3:10 p.m.

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  • Jan. 14, 2014, 3:02 p.m.

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Palkar, Darshana. Reconciling capital structure theories in predicting the firm's decisions., dissertation, December 2006; Denton, Texas. (digital.library.unt.edu/ark:/67531/metadc5403/: accessed September 26, 2017), University of North Texas Libraries, Digital Library, digital.library.unt.edu; .