An Empirical Investigation of the Trade-Off Theory: Evidence from Jordan

Imad Zeyad Ramadan

doi:10.5539/ibr.v8n4p19

Abstract

This study aims to test if the Jordanian industrial listed firms follow the trade-off theory in their funding needs strategy during the period 2000-2014. Utilizing data from a sample of the Jordanian industrial firms, the results show that the inverse relationship between profitability and leverage result is not consistent with the trade-off theory, indicating that more profitable Jordanian manufacturing firms tend to issue more equity and less debt to finance their need of funds. The direct relationship result between firms’ size and leverage is in line with the trade-off theory, indicating that large firms tend to finance their needs of fund through issuing debt rather than equity. As for the growth leverage relation, the result supports the trade-off theory, but the relation is not statistically significant. In summary, The Jordanian manufacturing firms follow the trade-off theory partially, and the industrial sector have an impact on the financing decision.

Highlights

The trade-off theory of capital structure is based on the idea that companies choose between funding through debt or equity by balancing between costs and benefits of each source
This study aims to tests the existence of the trade-off theory in the industrial sector of Amman stock Exchange (ASE) for the period 2000 2014, as it seeks to find if Jordanian industrial listed firms follow trade-off theory in their funding needs strategy during the period 2000-2014
If the results show a statistically significant positive relationship between profitability (ROA) and debt ratio (Leve.) it means that the trade-off theory is valid for the Jordanian industrial firms

Summary

Introduction

The trade-off theory of capital structure is based on the idea that companies choose between funding through debt or equity by balancing between costs and benefits of each source. The original version of this theory goes back to Kraus and Litzen berger (1973), who took into account the balance between the costs of bankruptcy and the benefits of the tax shield resulting from financing through debt. Under the theory that there is an advantage of financing through debt which is the tax shield, and there is a cost of financing through debt which is the interest paid and the costs of financial distress of the possibility of bankruptcy of the company Within this fact, companies seek to reach to the optimal capital structure by balancing between the benefits and the costs of the each source of funds

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Methods

Conclusion