Firm Financing Decisions

Abstract

We examine whether firms make financing decisions to correct deviations from target ratios, as predicted by the tradeoff theory with transaction costs. We find that while the theory can well explain debt reduction activities, it does a poor job in explaining the issuance decisions - the choices among the use of internal funds, debt issuance, and equity issuance. The key variables of the theory - deviation-from-target, past leverage ratios, marginal corporate tax rate, and transaction costs - all predict the issuance decisions in the wrong direction. We further show that incorporating transaction costs into the tradeoff theory is unlikely to provide the main interpretation for the empirical patterns documented in Baker and Wurgler (2002) and Welch (2004).