Financing practices on the JSE - an empirical test of the trade-off and pecking order theories of capital structure

Jardine, Adrian
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This study offers an empirical test of the trade-off and pecking order theories of capital structure by examining the financing practices of a panel of 104 non-financial JSE-listed companies observed over the 1999-2011 period. At its core, the trade-off theory predicts that firms will balance the marginal benefits of additional leverage against the marginal costs, such that achieving an optimal, value-maximising, target debt-to-equity ratio becomes the focal point of the capital structure decision. On the other hand, the pecking order theory rejects the notion that firms focus on a target debt-to-equity ratio and instead make the financing decision based on a hierarchy of preference derived from the relative informational costs of internal and external financing (in the form of debt and equity issuances). Although the two theories have classically been viewed as mutually exclusive characterisations of the capital structure decision, an examination of the available empirical evidence reveals that it is difficult, if not impossible, to clearly reject any one theory in favour of another. Indeed, Myers (1984) famously speaks of the ‘capital structure puzzle’. This study will argue and attempt to demonstrate that in a dynamic sense, it is likely that firms apply aspects of each theory when making the capital structure decision, and the relevance of each is context-dependent and time-varying. In other words, these theories are not applied with mutual exclusivity through time, and thus one should find that aspects of each appear to hold a degree of explanatory power in an empirical capital structure model. Although beyond the scope of this study, it is likely that dynamic market-timing, industry and macroeconomic conditions play an important role too. Against this backdrop, it is unsurprising that this study finds varying levels of support for both the trade-off and pecking order theories. Examining the relationship between leverage and firm-specific factors, there is evidence of a negative relationship between profitability and leverage; a positive relationship between size and leverage; a positive relationship between asset tangibility and leverage; a positive relationship between the industry median debt ratio and leverage; and a positive (but insignificant) relationship between perceived growth opportunities and leverage. This suggests that larger firms and firms with a higher degree of asset tangibility tend to carry greater levels of debt in their capital structures, while firms experiencing greater profitability tend to carry less leverage. The positive coefficient on industry median leverage suggests a significant role played by industry-specific factors. A test of Frank and Goyal’s (2003) pecking order model shows that decreases in both sales/turnover and profitability are associated with increases in leverage; and a financing deficit (surplus) is associated with an increase (decrease) in leverage. This is notably consistent with the pecking order model, in which declining sales and profitability puts pressure on the ability of the company to generate sufficient internal funds to meet investment and payout demands (thus creating a possible financing deficit), which shows up as an increased demand for external funds (with debt as the first choice) and consequently higher leverage. Finally, the speed of adjustment for JSE-listed firms is estimated to lie in the 30-50% range (i.e. a half-life for capital structure shocks of between 1 – 2 years), slightly higher than US-based estimates, and suggesting that achieving and maintaining an optimal leverage outcome may be an important aspect of the capital structure decision (as per the trade-off model). It must be noted, however, that methodological drawbacks make it difficult to effectively disentangle true adjustment (as per the trade-off model) from mean reversion. Overall, these results suggest that the predictions of the trade-off and pecking order theories each seem to play a role in the capital structure decision of JSE-listed companies, which is consistent with the idea that they are not applied with mutual exclusivity in practice. An accurate characterisation of financing practices in this context should thus incorporate aspects of both theories. Further studies in this area should look into the role played by capital market, macroeconomic and industry conditions in the capital structure decision of JSE-listed companies.