Abstract
This study tests the Pecking Order Theory for the capital structure of listed firms in Pakistan. As per Pecking Order Theory in capital structure formulation, internally generated resources would have first priority, followed by debt issuance where equity is used as a last resort. In its strong form, the Pecking Order Theory sustains that equity issues would never occur, whereas in its weak form, limited amounts of issues are acceptable. The methodology adopted in this empirical study involves cross-section regressions and the testing of hypotheses stemming from the underlying theory in its strong and weak forms. A sample of capital structure of non-financial firms listed at KSE is considered from 2001 to 2008. A statistical tool of panel data regression analysis is used to test different firms' data. The value of R2, t-test and F-Stat indicate firms in KSE supporting the weak form of pecking order theory, i.e., the option of using internal equity and debt is more preferred and a limited amount of external equity is used for reinvestment and fund raising purposes.
Highlights
Pecking order theory to date remains essential part of corporate finance
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
Summary
Pecking order theory to date remains essential part of corporate finance. It is considered as one of the most influential theories. In 1958 Modigliani and Miller (1958) presented their theory of investment and held that capital structure decision has no impact on a firm’s value, it becomes irrelevant how it is financed given that under perfect market conditions exist and in absence of bankruptcy, tax and other associated costs. After their initial research many modern theories such as Trade-off theory and Pecking order theory came into being. Equilibrium selection appears to be related to the potential earnings of a more valuable firm that can signal its type successfully by defecting from the sequential equilibrium
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