Determinants of debt and dividend decisions: Trade-off vs. pecking order.

Document Type

Article

Publication Date

2009

Abstract

This study tests the trade-off and pecking order theories about the dividend and debt decisions for stock firms. The decision of a firm to use debt to finance investment opportunities is important since the firm's choice between debt or equity determines the optimal capital structure. Under the trade-off theory, there is some optimal balance between debt and equity, and the firm will use debt until the cost of taking on more debt is more expensive than the cost of issuing equity. The firm uses internal fonds first under the pecking order theory, and then if more financing is needed, the firm will use debt, then equity. Using Ordinary Least Squares (OLS) Regression, this study tests the effects of selected financial variables on the debt and dividend decisions for samples of firms screened through Yahoo! Stock Screener. As anticipated, profitability and growth relate positively to the debt decision in support the trade-off theory. In support of the pecking order view, only the growth variable related positively with the debt decision. Results for size, risk, and dividend payout opposed both theories. For the dividend decision study, variable results for operating margin, beta, and the current ratio support both the trade-off and pecking order theories while results for sales growth, market cap, debt ratio, insider ownership and institutional ownership do not support either theory. Profitability related positively and risk and liquidity negatively to the dividend decision. Also, firms with higher liquidity support lower dividend payout.

Original Citation

Farrell, C., Bacon, F. W. (2009). Determinants of debt and dividend decisions: Trade-off vs. pecking order. Journal of Business and Behavioral Sciences/ASBBS, 20(1), 19-28. http://www.asbbs.org/jsbbs.html

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