Testing capital structure theories using error correction models: Evidence from China, India, and South Africa

Abstract

The objective of this study is to empirically examine the capital structure theories that can explain the capital structure choice made by the firms that are operating in China, India, and South Africa. The study tests the capital structure theories as a stand-alone basis as well as an integrated framework of nested models using advanced dynamic panel data methods with a data-set of 1,183 firms with 12,187 firm-year observations spanning the period 1999–2016. Findings suggest that the firms adjust toward target leverage very quickly and trade-off theory explains the firms’ capital structure choice better than pecking order theory in the stand-alone model as well as the model nesting these two theories. This study contributes to the empirical literature of capital structure in the following way. First, this study uses error correction framework as a general specification of the widely used partial adjustment model. Second, the study uses advanced panel data estimators to estimate partial adjustment model and error correction model. Finally, the different specifications are tested using a large data-set of firms in China, India, and South Africa that has not been done so far.

Keywords:

• capital structure
• error correction model
• trade-off theory
• pecking order theory
• dynamic panel data
• partial adjustment

JEL classifications:

• G15
• G30
• G32
• G35

Public Interest Statement

Over the past several years, many theories have been developed and tested to explain the capital structure decisions taken by the firms. The main theories in the forefront are the trade-off theory and the pecking order theory. These theories have been empirically tested across various countries using different methodologies. Yet, there is no consensus that which theory better explain the financing decisions made by the firms. Using advanced dynamic panel data methods, we tests these capital structure theories as a stand-alone basis as well as an integrated framework of nested models in Chinese, Indian, and South African firms. The results suggest the presence of high adjustment speed toward the target leverage in firms and better ability of the trade-off theory in explaining capital structure choices when compared to pecking order theory.

Acknowledgments

We sincerely thank the editors as well as anonymous reviewers for their valuable comments and suggestions that helped us to enhance the quality of our work.

Additional information

Notes on contributors

M. Kannadhasan

M. Kannadhasan is working as the associate professor of Finance at Indian Institute of Management, Raipur, India. His area of interest includes corporate finance, emerging stock market, and behavioral finance. He has published papers in international and national journals of repute.

Bhanu Pratap Singh Thakur

Bhanu Pratap Singh Thakur is a research scholar at Indian Institute of Management, Raipur, India. He is interested in Fixed Income Securities, Valuation, and Corporate Finance. His published work includes in the area of Fixed Income Securities and Valuation.

C.P. Gupta

C.P. Gupta, is a professor at the Department of Financial Studies, University of Delhi, Delhi, India. His areas of research, teaching, and consultancy include Investment Decisions, Risk Analysis, Project Appraisal, Security Analysis, Fuzzy Decision-Making, and Financial Modeling.

Parikshit Charan

Parikshit Charan is a faculty in the Operations Management area at IIM Raipur. His area of research includes operations strategy, sustainable operations, and supply chain management. He has published papers in international and national journals of repute.