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.