Long and Short-Run Capital Structure Dynamics in the UK - An Industry Level Study

Abstract

Despite significant theoretical and empirical developments in the capital structure literature, the trade-off theory and the related question of the optimality of the gearing ratio remain the subject of intense debate. The pecking order theory emerged to directly contrast with the implications of the trade-off theory. This paper investigates whether industry-optimal gearing ratio targeting behavior arises in the long run while a hierarchy of financing (or pecking order) arises in the short run. The relationship between components of common corporate gearing ratios is investigated using a Johansen co-integration methodology. Evidence of target adjustment is found, though only with respect to certain gearing ratios. Further, adjustment speed coefficients of the error correction representation imply that UK firms close the majority of any deviation from the target with retained earnings rather than external financing. However, while firms in mature industries appear to close the second largest part of any deviation with debt, firms in younger industries appear to close the second largest part of any deviation with equity. A general version of the pecking order theory can reconcile these results.

Keywords: Capital Structure, Trade-off, Pecking Order, Optimal Dynamic Debt Equity Choice, UK Quoted Firms, Cointegration of Capital Structure Ratio Components

JEL Classification: G32, G15