Testing Static Trade-off Against Pecking Order Models of Capital Structure

Abstract

This paper tests traditional capital structure models against the alternative of a pecking order model of corporate fmancing. The basic pecking order model, which predicts external debt fmancing driven by the internal fmanciai deficit, has much greater explanatory power than a static trade-off model which predicts that each firm adjusts toward an optimal debt ratio. We show that the power of some usual tests of the trade-off model is virtually nil. We question whether the available empirical evidence supports the notion of an optimal debt ratio.