482 Part Five Payout Policy and Capital Structure
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- Tangible assets. Firms with high ratios of fixed assets to total assets have higher debt ratios.
- Profitability. More profitable firms have lower debt ratios.
- Market to book. Firms with higher ratios of market-to-book value have lower debt ratios.
These results convey good news for both the trade-off and pecking-order theories. Trade-off
enthusiasts note that large companies with tangible assets are less exposed to costs of financial
distress and would be expected to borrow more. They interpret the market-to-book ratio as a mea-
sure of growth opportunities and argue that growth companies could face high costs of financial
distress and would be expected to borrow less. Pecking-order advocates stress the importance of
profitability, arguing that profitable firms use less debt because they can rely on internal financ-
ing. They interpret the market-to-book ratio as just another measure of profitability.
It seems that we have two competing theories, and they’re both right! That’s not a comfort-
able conclusion. So recent research has tried to run horse races between the two theories in
order to find the circumstances in which one or the other wins. It seems that the pecking order
works best for large, mature firms that have access to public bond markets. These firms rarely
issue equity. They prefer internal financing, but turn to debt markets if needed to finance
investment. Smaller, younger, growth firms are more likely to rely on equity issues when
external financing is required.^31
There is also some evidence that debt ratios incorporate the cumulative effects of market
timing.^32 Market timing is an example of behavioral corporate finance. Suppose that investors
are sometimes irrationally exuberant (as in the late 1990s) and sometimes irrationally despon-
dent. If the financial manager’s views are more stable than investors’, then he or she can take
advantage by issuing shares when the stock price is too high and switching to debt when the
price is too low. Thus lucky companies with a history of buoyant stock prices will issue less
debt and more shares, ending up with low debt ratios. Unfortunate and unpopular companies
will avoid share issues and end up with high debt ratios.
Market timing could explain why companies tend to issue shares after run-ups in stock
prices and also why aggregate stock issues are concentrated in bull markets and fall sharply
in bear markets.
There are other behavioral explanations for corporate financing policies. For example,
Bertrand and Schoar tracked the careers of individual CEOs, CFOs, and other top managers.
Their individual “styles” persisted as they moved from firm to firm.^33 For example, older
CEOs tended to be more conservative and pushed their firms to lower debt. CEOs with MBA
degrees tended to be more aggressive. In general, financial decisions depended not just on the
nature of the firm and its economic environment, but also on the personalities of the firm’s
top management.
The Bright Side and the Dark Side of Financial Slack
Other things equal, it’s better to be at the top of the pecking order than at the bottom. Firms
that have worked down the pecking order and need external equity may end up living with
excessive debt or passing by good investments because shares can’t be sold at what managers
consider a fair price.(^31) L. Shyam-Sunder and S. C. Myers found that the pecking-order hypothesis outperformed the trade-off hypothesis for a sample of
large companies in the 1980s. See “Testing Static Trade-off against Pecking-Order Theories of Capital Structure,” Journal of Finan-
cial Economics 51 (February 1999), pp. 219–244. M. Frank and V. Goyal found that the performance of the pecking-order hypothesis
deteriorated in the 1990s, especially for small growth firms. See “Testing the Pecking Order Theory of Capital Structure,” Journal
of Financial Economics 67 (February 2003), pp. 217–248. See also E. Fama and K. French, “Testing Trade-off and Pecking Order
Predictions about Dividends and Debt,” Review of Financial Studies 15 (Spring 2002), pp. 1–33; and M. L. Lemmon and J. F. Zender,
“Debt Capacity and Tests of Capital Structure Theories,” Journal of Financial and Quantitative Analysis 45 (2010), pp. 1161–1187.
(^32) M. Baker and J. Wurgler, “Market Timing and Capital Structure,” Journal of Finance 57 (February 2002), pp. 1–32.
(^33) M. Bertrand and A. Schoar, “Managing with Style: The Effect of Managers on Firm Policies,” Quarterly Journal of Economics 118
(November 2003), pp. 1169–1208.