Abstract
To form optimum firm capital structure strategies to face unanticipated economic events, firm managers should understand the stability of a firm’s capital structure. The aim of this research was to study whether the debt ratio is stationary in listed firms on the Dow Jones Industrial Average (DJIA). Two vital capital structure concepts regarding pecking order and trade-off theory are fairly contradictory. Using opposing theoretical contexts, the Sequential Panel Selection Method apparently categorizes which and how many series are stationary processes in the panel. This method was used to test the mean reverting properties of the 25 companies listed on Dow Jones Industrial Average between 2001 and 2017 in this study, which is expected to fill the current gap in the literature. The overall results show that stationary debt ratios exist in 10 of the 25 studied firms, supporting the trade-off theory. Moreover, the 10 firms utilizing trade-off theory are affected by firm size, profitability, growth opportunity, and dividend payout ratio. These results provide vital information for firms to certify strategies to optimize capital structure.
Highlights
The Dow Jones Industrial Average (DJIA) represents 30 of the most highly influential as well as capitalized firms in the US economy
To form an optimum firm capital structure policy to deal with unanticipated economic events, firm managers ought to understand the stability of a firm’s capital structure
Except for McDonald’s Corp., the debt ratio is non-normally distributed for all firms, according to the Jarque–Bera (J–B) statistics results
Summary
The Dow Jones Industrial Average (DJIA) represents 30 of the most highly influential as well as capitalized firms in the US economy. Examining the capital structure of these firms restrains their capability to manage external combative circumstances (Abor 2005), with each firm requiring optimization of the capital structure regarding financial system stability. Two major theories describing the corporate capital structure are pecking order and trade-off theory, with Modigliani and Miller (1958) offering optimal capital structures replicating both with debtless, default-cost tax advantages. As a trade-off between interest tax shields and financial distress costs (Miller 1977; Leland 1994; Brealey and Myers 2003; Frank and Goyal 2009), trade-off theory sustains the occurrence of an optimal debt ratio to maximize firm value; this static theory predicts reversion of the factual debt ratio to an optimal or objective value. In terms of the pecking order theory, no definite optimal debt ratio is obvious because of information asymmetry costs. Companies utilize less risky debt prior to risky external equity financing while favoring internal financing (retained earnings) over other sources, e.g., issuing and debt security (Myers and Majluf 1984; Myers 1984)
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