Firms’ Debt-Equity Decisions When the Static Tradeoff Theory and the Pecking Order Theory Disagree

Abstract

This paper tests the static tradeoff theory against the pecking order theory. We focus on an important difference in prediction: the static tradeoff theory argues that a firm increases leverage until it reaches its target debt ratio, while the pecking order yields debt issuance until the debt capacity is reached. For a sample of U.S. firms in the period 1985-2005, we find that the pecking order theory is a better descriptor of firms’ issue decisions than the static tradeoff theory. In contrast, when we focus on repurchase decisions we find that the static tradeoff theory is a stronger predictor of firms’ capital structure decisions.