The capital structure decisions of firms: is there a pecking order?

This paper considers the "trade-off" and "pecking order" theories, the two most influential approaches to understanding firms' capital structure decisions. The paper adopts two approaches to examining capital structures using firm-level panel data for firms in both Spain and the United Kingdom. First, debt ratios are examined and found to be decreasing in cash flow or profitability and increasing in the investment of the firm in both countries. Second, aspects of the two different financial systems are examined. In Spain, a bank-based financial system, there is some modest evidence that such effects are weaker for larger firms and for firms with equity held by financial institutions. In the United Kingdom, a market-based financial system, the propensity to issue additional debt is compared to that for issuing new equity and found to be more sensitive to financial characteristics of the firm. The results are consistent with the pecking order approach and generally inconsistent with the tradeoff approach suggesting behaviour consistent with the existence of a hierarchy of finance faced by firms in Spain and the United Kingdom.