An Investigation of the Most Appropriate Capital Structure Theory and Leverage Level Determinants

Abstract

In this paper, we investigate the most appropriate capital structure theory and leverage level determinants. There are several theories in a capital structure decision area and it is still controversial as to what is the best theory that can explain firms' debt ratio adjusting behaviours. Therefore, we have compared three different capital structure theories, trade-off, pecking order and market timing theories, and find that a firm's size, asset tangibility, profits, cash holding, market-to-book ratio and bankruptcy probability are generally the most important capital structure determinants. As most of these determinants are closely related to trade-off theory, although our findings suggest that no one theory dominates the others, the trade-off theory is probably the most appropriate capital structure theory. However, our results are also consistent with the expectations of the pecking order and market timing theories. This implies that all three theories have a certain level of explanation power in understanding firms' capital structure adjustments. In this paper, we consider an endogeneity problem, when using panel data, therefore, we use a GMM estimator to increase the reliability of our research.