An Empirical Assessment of the Reality of Pecking Order Theory

Abstract

Purpose: The main objective of this study is to examine whether firms follow the financing hierarchy as suggested by the Pecking Order Theory (hereinafter POT). The External Funds Needed (hereinafter EFN) Model offers a financing hierarchy that can be used for examining the POT. As far as the EFN considers growth of sales as a driver for changing capital structure, it follows that shall firms plan for a sustainable growth of sales, a sustainable financing can be reached and maintained.

Design/methodology/approach: This study uses data about the firms listed in two indexes; Dow Jones Industrial Average (DJIA30) and NASDAQ100. The data cover quarterly periods from 30th June 1999-31st March 2012. The methodology includes (a) Cointegration analysis in order to test for model specification and (b) causality analysis in order to show the generic and mutual associations between the components of External Funds Needed.

Findings: The results conclude that: (a) in the majority of the cases, firms plan for an increase in growth sales but not necessarily to approach sustainable rate, (b) In cases of observed and sustainable growth of sales, firms reduce debt financing persistently, (c) firms use equity financing to finance sustainable growth of sales in the long-run only, while in the short-run firms use internal financing, i.e., retained earnings as a flexible source of financing, (d) the EFN model is quite useful for examining the hierarchy of financing.

Originality/value: This study contributes to the related literature in terms of utilizing the properties of the External Financing Needed model in order to examine the practical aspects of the Pecking Order Theory. These practical considerations are extended to examine the use of the Pecking Order Theory in cases of observed and sustainable growth rates. The findings contribute to the current literature that there is a need to offer an adjustment to the financing order suggested by the POT. Equity financing is the first source of financing current and sustainable growth of sales, followed by retained earnings and debt financing is the last resort.

Keywords: Pecking Order Theory, External Funds Needed Model, Co-integration, Granger Causality, DJIA30, NASDAQ100