Testing capital structure theories using error correction models: evidence from the UK, France and Germany

Abstract

We employ an error correction model of leverage to test the trade-off and pecking order theories of capital structure for firms in the UK, France and Germany. The error correction framework extends the partial adjustment model by explicitly modelling changes in target leverage and past deviations from such target as determinants of firms’ dynamic leverage adjustment process. We also augment our empirical models to test the pecking order theory. Using appropriate and advanced dynamic panel data methods, we find that UK, French and German firms adjust towards target leverage quickly in both the partial adjustment and error correction models, which is consistent with the trade-off theory. We further show that the trade-off theory explains these firms’ capital structure decisions better than the pecking order theory in the models nesting the two theories.

Keywords:

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

JEL Classification:

• G32
• G30

Acknowledgements

We would like to thank an anonymous referee, Dan Coffey, Deborah Lucas, Evgeny Lyandres, Kevin T. Reilly, Yongcheol Shin and Mark Taylor (editor) for their helpful comments and suggestions. Partial financial support from the ESRC (grant No. RES-000-22-3161) is gratefully acknowledged. The usual disclaimer applies.

Notes

¹ Recent research has also developed two alternative hypotheses, namely the market-timing hypothesis (Baker and Wurgler, 2002) and managerial inertia hypothesis (Welch, 2004), in which capital market conditions are of first-order importance to firms’ external financing decisions (see Frank and Goyal, 2007 for a review). Nevertheless, these two hypotheses are not the focus of this article.

² Recent US evidence documents a slower speed of adjustment, in the range between 17% and 25% (see, for example, Lemmon et al., 2008; Huang and Ritter, 2009). Hence, the question of whether US firms do undertake active and fast adjustment towards target leverage is not yet settled.

³ Note, however, that high-quality firms may signal their type to the market through capital structure decisions. See a series of signalling models by Leland and Pyle (1977), Ross (1977) and Heinkel (1982).

⁴ See also Fama and French (2005), who reveal some patterns of corporate equity issues that are in stark contrast with the pecking order theory.

⁵ For example, a firm's probability of financial distress and the associated costs are determined by its size, profitability, earnings’ volatility and credit ratings etc, which do not remain constant over time.

⁶ The two-stage procedure involves estimating target leverage before estimating the partial adjustment and error correction models. It is different from the one-stage approach where target leverage is not estimated but is substituted into the latter models to be estimated in one step. We discuss this procedure in detail in the Section ‘Partial adjustment model’.

⁷ There is a growing literature examining UK firms. See, for example, Bennett and Donnelly (1993), Ozkan (2001), Bevan and Danbolt (2002, 2004), Watson and Wilson (2002). However, these studies have only examined the determinants of capital structure, or either the trade-off theory or the pecking order theory.

⁸ An exception is Dang (2010), who also develops an error correction model of leverage to investigate the trade-off and pecking order theories jointly. However, his sample is limited to a small sample of UK firms over a short period between 1996 and 2003 while, methodologically, his two-stage model is estimated using the OLS or the fixed-effects estimators as in prior research, which are most likely to produce biased estimates.

⁹ See also Fischer et al. (1989) and Leary and Roberts (2005) for models with costly adjustment.

¹⁰ While this procedure is intuitive and easy to implement, it has a potential limitation in that any estimation errors in the first stage will be carried into the second stage when Equation 2 is estimated. An alternative procedure involves substituting Equation 3 directly into Equation 2, yielding a dynamic panel data model that can be estimated in one-stage (see, among others, Ozkan, 2001; Flannery and Rangan, 2006).

¹¹ This is equivalent to having no second-order correlation in the first-differenced equation (4). Hence, the consistency of the GMM depends on the absence of second-order correlation.

¹² Shyam-Sunder and Myers (1999) and Frank and Goyal (2003) consider three main proxies for the dependent variable in Equation 8, including total leverage change, net debt issued and gross debt issued, all scaled by the firm value. We focus on the first proxy in our empirical analysis because it allows us to develop the augmented partial adjustment and error correction models that nest both the trade-off and pecking order theories. However, the (unreported) results for the pecking order theory are qualitatively similar when we use the other two proxies.

¹³ Recent research shows that the coefficient on DEF, β, may be asymmetric, depending on whether there is a financing deficit (DEF > 0) or surplus (DEF < 0). See, for example, de Jong et al. (2010).

¹⁴ Shyam-Sunder and Myers’ (1999) pecking order model has been criticized for having a low power in rejecting alternative theories. See Chirinko and Singha (2000).

¹⁵ Note that if the relations between leverage and its determinants are inconsistent with the trade-off theory then target leverage is not well-defined, at least empirically, and so testing adjustment towards target leverage is likely to capture mechanical mean reversion behaviours (see Chang and Dasgupta, 2009).

¹⁶ There are two potential reasons why our results differ from Antoniou et al. (2008). First, we adopt a two-stage estimation procedure in which we first estimate target leverage in (3) before estimating the partial adjustment model in (2), while Antoniou et al. (2008) substitute Equation 3 into Equation 2 and estimate the resulting model in one stage. Second, Antoniou et al. (2008) examine a sample of the UK, German and French firms over a relatively short period 1987–2000, which is a subset of the longer sample period between 1980 and 2007 used in our article.