Trade-Off Or Pecking Order: Evidence From South African Manufacturing, Mining, And Retail Firms

Abstract

This study tests the trade-off and pecking order hypotheses of corporate financing decisions and estimates the speed of adjustment toward target leverage using a cross-section of 42 manufacturing, 24 mining and 21 retail firms listed on the Johannesburg Stock Exchange (JSE) for the period 2000-2010. It uses the generalised least squares (GLS) random effects, maximum likelihood (ML) random effects, fixed effects, time series regression, Arellano and Bond (1991), Blundell and Bond (1998) and random effects Tobit estimators to fit the two versions of the partial adjustment models. The study finds that leverage is positively correlated to profitability and this supports the trade-off theory. The trade-off theory is further supported by the negative correlation on non-debt tax shields. Consistent with the pecking order theory, capital expenditure and growth rate are positively correlated to leverage while asset tangibility is inversely related to leverage. The negative correlation on financial distress and the positive correlation on dividends paid support both the pecking order and trade-off theories. These results are consistent with the view that the pecking order and trade-off theories are non-mutual exclusive in explaining the financing decisions of firms. The results also show that South African manufacturing, mining and retail firms do have target leverage ratios and the true speed of adjustment towards target leverage is 57.64% for book-to-debt ratio and 42.44% for market-to-debt ratio.

What Drives Security Issuance Decisions Of Firms Listed On The Johannesburg Stock Exchange: Market Timing Or Dynamic Trade-Off Theory Or Both?

“…The results of the study further confirm the fact that the trade-off and pecking order theories are not mutually exclusive. This finding is consistent with the findings of Moyo et al (2013) and Ramjee and Gwatidzo (2012).…”

“…Myers (1984:576) contends that the trade-off and pecking order theories are the two leading capital structure theories that explain the financing behaviours of firms. These theories are however, not mutually-exclusive (Barclay & Smith, 2005;Moyo, Wolmarans & Brümmer (2013) and Mukherjee & Mahakud, 2012). The trade-off theory which Kraus and Litzenberger (1973) developed from the seminal work of Modigliani and Miller (1963) and other traditional theorists states that firms have an optimal financing mix where firm value is maximised.…”

“…The SOA is a function of firm-specific factors, target deviation spread and macro-economic factors (Drobetz & Wanzernried, 2006;and Hovakimian & Li, 2011). Table 1 below, adapted from (Moyo et al, 2013) shows the SOA results from selected empirical studies. According to the dynamic trade-off theory, the security issuance decision is driven by the need to reduce or eliminate the target deviation spread, thus maximising firm value (Hovakimian et al, 2001).…”

“…This financing behaviour is in line with the pecking order theory. A number of studies, including those of Elsas and Florysiak (2011), Hovakimian and Li (2011), Huang and Ritter (2009), Leary and Roberts (2005), Moyo et al (2013), Mukherjee and Mahakud, (2012), and Ramjee and Gwatidzo (2012), found that firms actively rebalance their capital structures towards the optimal capital structure. This implies that the security issuance decisions are mainly driven by the need eliminate the target capital structure deviation spread.…”

“…The target SOA results validate the dynamic trade-off theory and reject the market timing and pecking order theories. Using the same random effects Tobit estimator, Moyo et al (2013) documented a target SOA of 42.44% (MDR) and 57.64% (BDR) for JSE-listed manufacturing, mining and retail firms. The results of the current study are therefore consistent with these findings.…”