An Empirical Investigation of the Pecking Order Hypothesis

Author(s): Jonathan Baskin

Source: Financial Management, Vol. 18, No. 1 (Spring, 1989), pp. 26-35
Published by: Blackwell Publishing on behalf of the Financial Management Association
International
Stable URL: http://www.jstor.org/stable/3665695
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Empirical Tests of Capital
An of
Empirical Investigation the
Order Hypothesis
JonathanBaskin
JonathanBaskinis anAssistantProfessorof EconomicsandFinance
at BaruchCollege,CityUniversity
of New York,NY.
0 Post-warcorporatefinancialtheoryhasfocusedpri-
marilyon the effect of riskand taxeson the valuation
of cash flows with known statistical characteristics.
Ignoringother factors,capital structurelogicallybe-
comesdeterminedout of a statictrade-offbetweenthe
taxadvantageof debtandthe riskof bankruptcy.How-
ever, there is strikinglylittle publishedevidencethat
the statictrade-offtheoryhasmuchempiricalvalidity.1
Instead,casualobservationsuggeststhatthe old peck-
ingorderideapromulgatedbyDonaldson[18]appears
to describecorporatepractice.Establishedfirmsnor-
mallyavoidnew equityissues,andborrowingtendsto
This paper is based upon the third chapter of my Doctoral Disserta-
tion for the Department of Economics at HarvardUniversity. Thanks
to Richard Caves, my main thesis advisor, for encouraging my re-
search. The author also benefited from useful discussion with Paul
Asquith, Joseph Kalt,StewartMyers,and StavrosThomadakis.Thanks
also to the two anonymous referees who provided needed editorial
advice. These people are, of course, absolved from responsibility for
opinions expressed and possible errors.
'See the survey in Myers [39].
26
Structure Theories
Pecking
be determinedas the residualbetweendesiredinvest-
ment anda relativelyinelasticsupplyof retainedearn-
ings.2While the peckingorderhypothesishas always
been empiricallymotivated,the lack of compelling
rationaltheoreticaljustificationapparentlylimitedits
acceptanceamongthe academicmainstream.
Now, with increasedunderstandingof the conse-
quences of asymmetricinformation,it is possible to
cast peckingorderbehavioras the rationalresponse
not only to tax and transactioncosts, but also as a
signalingequilibrium.A largequantityof accumulated
evidence now supportsthe theory.Here past studies
will be reviewedand a series of empiricaltests distin-
guishingpeckingorderbehaviorfromcontinuousad-
herenceto staticallydefinedoptimalcapitalstructure
will be presented.
2Meyer and Glauber [36] make a similar observation in regard to
financing over the business cycle: firms borrow when investment
needs are greater than the generation of internal funds.
 PECKINGORDERHYPOTHESIS
BASKIN/THE
I. Some Theory
A. The Effectof AsymmetricInformation
The lack of recognition(until only recently)given
to asymmetricinformationis a bit curiousin the his-
torical context. Remotely reliable public accounting
dataonlybecamegenerallyavailableafter1934,butthe
fundamentalfeaturesof modemfinancialarrangements
werewell establishedbythe turnof the century.3Asym-
metricinformationaffectscapitalstructurebylimiting
accessto outsidefinance.Informationalproblemsare
particularlyacutewithcommonstock,andthe resultis
an upwardslopedsupplyof equityfunds.
MyersandMajluf[40] demonstratethatwith asym-
metricinformation,equityissues are rationallyinter-
preted on averageas bad news, since managersare
motivatedto makeissueswhenthe stockis overpriced.
AsquithandMullins[4],MasulisandKorwar[35],and
MikkelsonandPartch[37] all empiricallyobservethat
announcementsof new equity issues are greeted by
sharpdeclinesin stockprices.Thisis one majorreason
why equityissues are comparativelyrareamonglarge
establishedcorporations.4
Asymmetricinformationnot onlyimpedesthe abili-
ty firmsto raisefundsthroughnewissuesof common
of
stock,but it also createsan imperfectlyelastic supply
of equityfundsbylimitingaccessto retainedearnings.
Dividendsprovidesignalsboth to currentand future
earnings-as showntheoretically, for example,by Bhat-
tacharya[9] and Miller and Rock [38]--and thus can-
not be freelyadjustedto meet fundingneeds.Thisidea
is not originaland is the predictionof the empirically
validatedLintner[31]model.5Consistentwiththe sig-
3Bycontrast,the usualemphasisplacedon incometaxationmaybe
excessive.Corporatetaxesbeganin the U.S. in 1909 and personal
taxes in 1913, and yet there is no evidenceof radicalchangein
practice.In fact,despiteno taxes,the Americanrailroadsystemwas
originallyfinancedalmostentirelywithmortgagebonds(see Baskin
[7]).IntheU.K.,despitefrequentmajortaxchanges,practiceappears
reasonablystable.For example,Thomas[48]demonstratesthe con-
tinuousheavyrelianceof Britishfirms upon internallygenerated
equityfunds from 1918-1976.Similarly,Thomasnotes respective
ratios of retainedearnings(includingdepreciation)and net new
equityissues to gross fixedinvestmentfrom 1964-1973was about
74.3%and5%in France,77%and2.8%in W. Germany,68.4%and
6.2%in Japan,84.5%and4.8%in the U.K.,and68.7%and4.6%in
the U.S. (see p. 331). The bulkof equityfinanceis usuallyinternally
generatedregardlessof taxinstitutions.
4SeeLightandWhite[30] for post-warmacro-economicdatadem-
onstratingthe relativelyinconsequentialrole of fundsfromequity
issues.Baxterand Cragg[8], Taub[47], and Marsh[34] showthat
equityissuesare particularlyrareamongverylargefirms(the latter
usingU.K data).
27
naling hypothesis,Pettit [43], Charest[15], Aharony
and Swary[1], andAsquithandMullins[3] all observe
thatannouncementsof increasesanddecreasesin divi-
dendsresultin like changesin stock prices.
B. The Effectof DirectCosts
In additionto the effectof asymmetricinformation,
taxesandtransactioncosts also tend to motivatepeck-
ing orderbehavior.The directcosts of retainedearn-
ings maybe less than those of new equityissues.First
there is the obvioussavingsin bankerfees. Second,a
firmmaybe ableto reducetaxablecurrentdividendsby
limiting securityissues. On the margin,holdingcon-
stant the amountof debt and investment,an increase
in equityissuesnecessarilyresultsin greaterdividends,
and greaterdividendsin turngive rise to a largerbur-
den of personaltaxation.The implicationis thatissues
of common stock will give rise to taxes and commis-
sions at ratesup to 50%of the fundsraised,andconse-
quently,it ought to be rationalfor the firm to try to
minimize new equity issues.6 Moreover,transaction
costs are generallysmaller for debt than for equity
issues.7These facts alone motivatethe firm to prefer
internallygeneratedfundsto those raisedfrom exter-
nal securityissues,andto preferoutsidedebtto equity.
Finally,it shouldbe emphasizedthat debt finance
escapesincometaxationat the corporatelevel, and so
the directcosts of new equityfinancemaybe immense
when comparedto those of borrowing.In addition,of
course,the issueof newequityto new investorsdilutes
currentvoting control, and this may jeopardizethe
position of management.
II.EmpiricalEvidenceof the Effectof
Growthand Profits
A. PreviousStudies
Accordingto the static theory of optimal capital
structure(e.g.,DeAngeloandMasulis[17]),bookvalue
debtratiosoughtto be positivelycorrelatedwithreturn
on assets before interest and taxes. More profitable
firmshavemore income to shelter,are more likelyto
be subjectto high marginaltax rates, and are in less
5SeeFamaandBabiak[20]fora thoroughstudyusingtime-serieson
individualfirms.See also Brittain[11].
6Theeffectivemarginaltaxrateon dividendincomemaybe currently
as highas 40%whenone includesstate and local taxes.Brokerage
fees in turnmaybe easilyas highas 10%.
7Underwritingandotherfees of debtissuesmaybe as lowas 1%but
equityissuesgenerallycost in therangeof 4%to 15%of theamount
of fundsraised.
28
dangerof bankruptcy.It follows,ceterisparibus,more
profitablefirmsoughtto maintaina higherbook ratio
of debtto assetsat the staticoptimalcapitalstructure.
The unambiguousfact is that the converseis true:all
publishedstatisticalstudiesconductedover50 yearsin
five countriesshowa prominentnegativerelationship.
This findingprovidesstrongsupportfor the pecking
orderhypothesis.
Using IRS datafrom 1937,Chudson[16]findsthat
in all size classesin all industries,profitablefirmshave
lowerbook value leverage.Arditti[2], Hall andWeiss
[25], Gale [23], and Baker [5] all observethat when
leverageis includedin a regressionof profitabilityit
assumesa significantnegativecoefficient.Hurdle[26],
CarletonandSilberman[12],NakamuraandNakamura
[41], Titman[49], Long and Malitz [32], and Titman
andWessels[50]findthatprofitabilityexertsa signifi-
cant negativeinfluencein a regressionof debt ratios.
Schmidt[46]findsthe samerelationshipin Germany.
Themostimpressivestudyof the debtpolicyof large
corporationsis Toy, et al. [51], which includes data
fromfive countries-the United States,Holland,Nor-
way,Japan,andFrance.The book valuein 1972of the
ratioof liabilitiesto total assetsis the dependentvari-
able in their regressionequation. The independent
variablesare: profitabilityas measuredby the seven
year averageof earningsbefore interestand taxesdi-
videdbytotalassets;growthasobtainedbya regression
of salesfrom 1965to 1972;andriskas operationalized
bythe coefficientof variationin returnon assets.In all
of the countriesexceptFrance,the coefficientof prof-
itabilityis significantlynegativewith t-statisticsthat
rangefrom4 to 24. The coefficientof the growthis at
least marginallysignificantandpositive,while the risk
variablehas in three countriesan unexpectedsignifi-
cant positivecoefficient.8The explainedvarianceran-
ges from 21%in Norway,to 26%in Holland,to 47%
in the U.S., to 61% in Japan. In France,while the
coefficientof profitsis negative,the entire regression
is insignificant.A possible explanationis the poor
qualityof publicaccountingdatain ContinentalEuro-
pean countries.The Toy, et al. resultswere recently
replicatedby Kester [28] with a combinedU.S. and
Japanesesampleand variousbook and marketvalue
debt ratios.Kesterfindsgrowthandprofitabilityto be
significant,but his risk variableis consistentlyinsig-
nificant.He furthershowsthatthe higherdebtleverage
8Other studies that have found a positive correlation between growth
and leverage include Gupta [24] in the U.S. and Caves, et al. [14] in
Canada.
FINANCIAL 1989
MANAGEMENT/SPRING
of Japanesefirms can be substantiallyattributedto
theirfastergrowthandlowerprofitability.Studiesem-
ployingdatafromheterogeneoussourcesthusconfirm
the basicpredictionsof the peckingorderhypothesis.
It is now shown that this relationshipbetween debt,
growth,and profits is similarlyfound in a sample of
largeU.S. firms.9
B. Data
The sampleemployedin the presentstudyconsists
of the 378firmsfromthe 1960Fortune500whichwere
still availableon Compustatin 1984. The data em-
ployed spans the years 1960-1972. This avoids the
problemsgeneratedbythe subsequentincreasedinfla-
tion thatseverelydistortedbalancesheetrelationships.
No pretenseis madethat the sampleis representa-
tive in anyultimatesense.It includesonlylargesurviv-
ing public corporationsfrom the 1960 Fortune500.
This limitation must be acknowledgedas it may be
unwise,for example,to extrapolatefromthese gargan-
tuanenterprisesto smallerprivatelyheldfirms,On the
otherhand,simplybecausethese actualfirmsin them-
selvescomprisea materialcomponentof the economy,
theirbehaviorhas inherentimportance.
C. Replicationof PreviousResults
The specificationof our regressionof debt with
growthand profits is now described.The dependent
variableis constructedto reflectthe relativerelianceof
debtandequityin the historicalfundingof investment.
Book value debt ratios are employed--despitetheir
imperfections-because they attemptto measurethe
amountof capitalactuallyobtainedfromvarioussour-
ces.10Debt is operationalizedby both shortand long-
term obligations,as the concernis not with maturity
structurebutwiththe extentof borrowing.Tradecredit
is not viewed as a source of capital,but ratheras a
deductionfromthe net quantityof investment.Suppli-
ers providecreditas a convenientmeansof sale,not in
orderto seek a return.Accordingly,the denominator
is not total assetsbut investedcapital,the book value
of debt andequitysecurities.A finaladjustmentarises
from the observationthat marketablesecurities-of-
9Another recent study by Fazzari, Hubbard, and Peterson [21] em-
piricallydemonstrates the effect of pecking order financing on invest-
ment.
1'Book value variablesare by definition stated in terms of the amounts
historically raised or expanded, and thus should reflect the cumula-
tive effect of funding pressures. Since the correlation between book
and marketvalue debt measure is about 0.8 in our sample, this choice
has little material effect upon findings, as shown in Baskin [6].
BASKIN/THEPECKINGORDERHYPOTHESIS
Exhibit1. Regressionof the Net Debt to Assets Ratio 1972
NDAR72 = 0.47 - 1.15 ROA72 - 0.45 ROA70 - 0.45 ROA65 + 0.04 GROWTH
(8.2)
R2= 0.50
t-statisticsin parenthesis.
ten treasurybills-may be best treatedas an offset to
debt obligations,and so both the numeratorand the
denominatorare reducedby the same quantity.The
independentvariablesare profitability(ROA)-the
ratio of income before interest and taxes to invested
capital-and growth-the ratio of investedcapitalin
1972 to its value in 1965. In order to make use of all
informationcontainedin the full sampleof 378 firms,
mean-substitution is employedformissingvalues(which
amountfornovariableto morethan10%of the sample).
Look now at Exhibit1, where the relationshipbe-
tweenleverage,profits,andgrowthis easilyconfirmed
with our data.The implicationof addingtogetherthe
coefficientsof profitabilityis thata permanentincrease
of 10%in ROA will resultin a decreaseof 20%in the
firm'sdebt ratio.
By anyreasonablestandard,the evidenceestablish-
es that the simplepredictionsof staticoptimalcapital
structuredo not hold. In attemptingto salvage the
static framework,Gale [23], Baker [5], and Carleton
andSilberman[12]suggestthatprofitablefirmsmaybe
riskier,andmoreprudentdebtratiosshouldbe chosen.
However,it is not obvious that successfulfirms are
riskier,andthereis littleevidencesuggestingthatearn-
ingsvolatilityhas an effectupon cross-sectionalvaria-
tion in capital structureamong large corporations.11
Williamson[52]observesa negativeeffectof valuation
on debtandsuggeststhatthe needto maintainborrow-
ing abilityfor future lucrativeinvestmentis the key
underlyingfactor;however,the effect of past profits
appearsfarmore potent thanvaluation.
Even if one could somehow creativelyexplain--
without recourseto fundinglimitations-the inverse
"Empiricalstudiesreportconflictingsignsfor the relationshipbe-
tweendebtleverageandearningsvolatility.Evidentlytherelationship
is not robust.The signsof the coefficientsin the variousstudiescan
be predictedon the basisof statisticalbiases,especiallyin regardto
the lackof controlsforprofitability.
Castanias[13]does observein a
sampleof mostlysmallerfirmsthat industrieswith high historical
bankruptcyratesappearto utilizeless long-termdebt,but this may
merelyreflectaccessto capitalmarketsandthe substituteof short-
termbankfinancefor debentures.
29
(3.1) (3.8) (5.1)
correlationof profitsanddebt,the empiricalvalidityof
the static theory of optimal capital structurewould
remain in doubt. Not only is there little convincing
positiveevidencesupportingthe staticframework,no
one has yet providedanyexplanationfor why,in such
a context,firmsshouldchooseleverageincreasingwith
past growth.The empiricalevidence,therefore,is en-
tirely consistentwith the predictionsof the pecking
orderhypothesis.
D.A Note on DebtLevelsand Asset Composition
If fundingpressuresinfluence choice of debt lev-
erage, then proper statisticalmethodologyrequires
that controlsfor growthand profitabilitybe included
in regressionsinvestigatingotherfactors.Otherwise,if
these other factorsare correlatedwith the abilityto
financewith internalequity,then one mayobtainspu-
riousconclusions.
The idea has been recently put forwardthat the
compositionof assetsinfluencesstaticoptimalcapital
structure.A numberof studieshaveindeedfoundthat
fixed assets-which maybe the basis for liens and are
likelyto havevalue independentlyof the firm'sfate-
areassociatedwithsignificantlyhigherdebtratios(see
e.g., Ferri and Jones [22] and Marsh[34]). Long and
Malitz[32]andBradley,et al. [10]furtherproposethat
intangibleassets(often lost in bankruptcy)established
throughadvertisingand researchought to discourage
debt finance, and both obtain large t-statisticswhen
spendingon these activitiesis includedin a regression
of debtratios.However,this apparentandverysizable
effect maybe a statisticalartifact,as R&D and adver-
tising may function as entry barriersin the product
market,andmaytherebybe relatedto long-termprof-
itability.Baskin[6] showsthatthe coefficientsof these
variablesare substantiallyreducedwith inclusion of
propercontrolfor pastprofits.
III.The Effectof Past Dividendson Debt:
A Key Test
While the basic pattern of correlationconsistent
with pecking order theory has been confirmed,con-
30 FINANCIAL 1989
MANAGEMENT/SPRING

Exhibit2. Regressionof GrossDebt to Assets 1972* indicatesthe fundingburdenon the corporation.In

Exhibit2, the ratio of debt to grossassetsis regressed
Equation 1 Equation 2 Equation 3 with profitability,growth,andwith the dividendyield
(Nobs=356) (Nobs = 356) (Nobs=356)
ROE60 -0.32 -0.27
(DIVEQ65)in 1965.12
It is observedthat corporationswhich paid higher
(t-Stat) (3.0) (2.5)
ROA65 -0.47 -0.40 dividendsin 1965 accumulatedgreaterdebt in 1972;
(4.6) (3.5) the coefficientis positiveandhighlysignificant.Similar
ROA70 -0.25 -0.26 -0.39 resultsare also obtainedwhen the dividendvariableis
(2.4) (2.4) (4.5) basedin 1960insteadof 1965.The standardizedcoef-
ROA72 -0.76 -0.76 -0.60
(7.9) (6.8) (6.7)
ficient of DIVEQ65 in Equation(1) in Exhibit2 ex-
GROWTH 0.039 0.041 0.032 ceeds 40%, and so the effect is sizable (i.e., a one
(6.8) (6.8) (6.7) standarddeviationchangewill induce a 0.4 standard
DIVEQ65 1.59 1.36 0.97
deviation response in the dependentvariable).The
(5.1) (4.4) (4.8)
DAR65 - - 0.46 inclusion of nineteen 2-digit SIC industrydummies
(12.8) based on the firm'sdominantindustryin 1972 little
Industry changesthe story,and it maybe noted that they have
Dummies - F(19,330)=2.7 -
little explanatorypower: intra-industryvariation in
R2 0.449 0.524 0.590
Adj R2 0.440 0.487 0.584 leverageis not distinctlysmallerthan that occurring
betweenindustries.Thepositivecoefficientof the divi-
dend variableis observed,despite the fact that the
F(19, 330) = 1.95 is the 0.01 significance level.
*Constant is included but not reported.
simplecorrelationwith the dependentvariableis -0.3,
t-statistics in parenthesis. as more profitablefirmspay more dividendsand bor-
rowless.
This effect of past dividendsmay plausiblyoccur
througheitherof two mechanisms.One is throughthe
fidence would be furtherbolstered if more nuanced direct flow of funds in the earlieryear; the other is
predictionscouldbe substantiated.Towardsthisobjec- throughthe variableindicatingconstraintsupon sub-
tive,it maybe emphasizedthatpeckingorderbehavior sequentfinancialdecisions.Both explanationsare in-
ultimatelyderives from some stickiness in dividend consistentwithcontinuousstaticoptimizationof capital
policy,whicheliminatesthe free use of retainedearn- structure,but the latter one providessupportto the
ings. idea that stickydividendsunderlypeckingorder be-
In the Lintnermodel,the amountof past dividends havior.Note thatif thedividendvariableactsonlyupon
directlyaffectsthe currentpaymentthrougha lagged the concurrentflow of funds,and if one then controls
adjustmentprocess.Additionally,the levelof pastdivi- for the debt accumulatedat a latterpoint in time, the
dends may also have an indirect effect. The target effectoughtto disappear.Inclusionof the debtratioat
payout in the Lintner model is really a focal point the end of 1965in Equation(3), Exhibit2, showsthat
aroundwhich managersand shareholderscoordinate the effectdoesnotgo away,andso the dividendvariable
theirexpectations,whicharemainlydeterminedthrough appearsto function as some indicatorof persistent
a processof historicalprecedent.If the priorpayoutis policy. Note furtherthat if firms do adhere to some
larger,then managersand shareholdersmayexpecta unchangingdividendpolicy,thenthe dividendmeasure
greaterdividendpayoutin the future. shouldactas anyotherexogenousvariable.According-
Accordingly,past dividendsact to constrainfuture ly, its implicitequilibriumcoefficientshould remain
policy both directlyand indirectly.It is hypothesized invariantwith the inclusion of a lagged dependent
that larger past dividendsact to increase the firm's
futurecashneeds,andthatthisin turnmotivatesgreater 12Notethe following differences from the equation in Exhibit 1. First,
borrowing,and thus a higherleverageratio.This pre- due to the limitations of the data available at the time, there is no
dictionis now tested. adjustment in the debt measure to account for marketable securities.
The ratio of dividendsto book value equityis em- Second, the sample is reduced to eliminate missing values (except for
16 with ROA 65). Third, return on equity in 1960 is included (ROA
ployed to operationalizethe level of past dividends. is unavailable in the data set). None of these changes ought to
Whileit is true that the marketvaluedividendyield is materially influence the results, which are robust with respect to
most relevantto investors,the book valueyield better specification.
 PECKINGORDERHYPOTHESIS
BASKIN/THE 31

Exhibit3. SerialCorrelationin DividendsandDebt low consideringthatbook debtratiosarecomposedof

1960 1965 1970 stocks.
If one comparesstocks to subsequentflows, one
Dividendsto EquityRatio
1965 0.886 obtains a much lower serial correlation.As shown in
(N = 354) SectionC of Exhibit3, the debtratioimplicitin subse-
1970 0.724 0.819 quentfinancing(i.e., changein debtdividedby change
(N = 354) (N = 356) in assets) is almost independentof debt accumulated
1972 0.714 0.828 0.908
(N = 354) (N = 356) (N = 356)
in 1965.The correlationof 0.236amountsto about5%
GrossDebttoAssetsRatio
explainedvariance.The apparentimplicationis that
1965 0.702 corporationsdo not perceiveanystrongneedto adhere
(N = 139) to invariantdebt ratios. Contraryto what one might
1970 0.555 0.666 expect in a worldwith bankruptcycosts but otherwise
(N = 139) (N = 346) perfectinformation,the need to adhereto stabledivi-
1972 0.497 0.637 0.895
dend policy appearsto be much strongerthan those
(N = 139) (N = 346) (N = 356)
motivatingadherenceto some staticallydefined op-
GrossDebttoAssetsRatiowithSubsequent FinancingRatio timalcapitalstructure.
Debtas Portionof TotalFinancing1965to 1972
1965 Debt/Assets 0.236
B. The Effectof Past Dividendson
(N = 264)
LaterBorrowing
It is nowshownthatthe smallpositiveserialcorrela-
Due to potentialnumericalinstabilityfromcreatinga ratiowitha tion in debtfinancingdisappearsonce one controlsfor
smallor negativedenominator,thiscorrelationis onlycalculated the effectsof profitability,growth,anddividendpolicy
for firmswhichgrewmorethan50%nominallybetween1965and
1972. (whichmayexerta like effect in contiguousperiods).
By expressingthe debt ratio as a weightedaverageof
the debt ratio in the previousperiod and that ratio
implicitin subsequentfinancing,one can estimatethe
coefficientof the 1965 debt ratio in Exhibit1, Equa-
variable.This equilibriumcoefficientin Equation(3),
tions (4) and(5), giventhatborrowingis seriallyuncor-
Exhibit 2, is 0.97/(1 - 0.46) = 1.73, and this is actually
related.
largerthanthe 1.59estimatedin Equation(1), Exhibit
2. The clear implicationis that the primaryimpetus
Debt (t) [Assets (t - 1) Debt (t - 1)
arisesfrompersistentpolicy.
Assets (t) Assets (t) Assets (t -1)
IV.Serial Correlationin Dividends
and Debt IAAssetsADebt
A. SimpleCorrelations + (1)
If firmsare constrainedby their historicaldividend Assets(t) AAssets
.
policy (as, for example, in the Lintner model), one
oughtto observehigh serialcorrelationin the ratioof Ignoringaggregationproblems,the averagenominal
dividendsto book equity.13Lookingat Exhibit3, this growth in assets of 111.2%implies a coefficient of
is indeedthe case. Serialcorrelationaftertwelveyears 1/2.112 = 0.437 for the 1965 debt ratio. It is striking
is 0.714andamountsto about50%explainedvariance. thatthe coefficientof laggeddebt almostmatchesthat
Dividend policy thus appearsrelativelystable. With expectedwith completelypassive borrowing.Baskin
debtratios,the twelveyearcorrelationin the grossdebt [6] shows similarresultswith a numberof specifica-
to assetsratio is 0.497.This correlationis surprisingly tions.

13Thisratio can be conceivedof as the productof the ratio of

dividendsto long-runprofits(abstractedfrom temporaryfluctua-
tions),withthe long-runreturnon equity.The formeris essentially
the targetpayoutratio.The lattermayvarysomewhatovertimeand
causeserialcorrelationin the dividendsto equityratioto understate
thetruestabilityindividendpolicy.Theratiodoeshavetheadvantage
of beingmeasuredwithlittledataat a singlepointin time.
14Ifthechangein debtratiois the dependentvariable,thecoefficient
of laggeddebt is veryclose to 0.437 - 1 = -0.563,as expectedwith
passivedebt policy.Otherstudieshave not made adjustmentsfor
regressiontowardsthemean,andmustbe heldsuspectif claimingan
activeadjustmentprocess(e.g., Javilvandand Harris[27] and Lev
[29]).
32
Why do we observe so little serial correlationin
borrowingbehavior?One pointis thatthe directionof
effect is not a priori obvious.If corporationsclosely
adhereto some staticoptimalcapitalstructure,and if
the exogenousenvironmentremainsstable, then one
shouldobservea veryhigh positiveserialcorrelation.
This is clearlycounterfactual.
Alternatively,if firmshave similardesireddebt ra-
tios whicharerarelyattaineddue to continuousshocks
from buffetingcash flows, then firmswith high debt
ought to striveto borrowless in subsequentperiods.
The evidenceprovidessome supportfor this view but
it appearsas if recurringfunding pressuresinhibits
adjustment.Note that high-debtfirmsmust not only
fund dividendsand investmentbut also substantial
interestpayments,andwithoutcountervailingincreas-
ing costs of debt finance,theywoulddesireto borrow
more than similarfirmswith lowerleverage.Analogy
maybe made todayto certainSouth Americancoun-
trieswhose excessivedebtscontinueto mount.
V. Effectof Past Dividendson Investment
A. Past Controversyand Theoretical
Importance
The empiricalevidencesuggeststhatthe availability
of internallygeneratedequity greatlymatters.Debt
policy appearscompromisedrelative to a static op-
timum so as to accommodatethe desiredinvestment
with relativelyfixed retainedearnings.Unless the in-
vestmentis completelyinelastic,however,it also must
rationallyadjustto reflectthe availabilityof funds.In
pecking order models the incrementalsource of fi-
nance consistsprimarilyof debt. Additionalretained
earningacts to lower the level of debt, which in turn
diminishesthe likelihoodof bankruptcy. As distressbe-
comesmoreremote,theincremental implicitbankruptcy
costs of debt financedecreases,and so does the effec-
tive marginalcost of funds.Thisshouldrationallyraise
the level of investment.
Consistentwith this prediction,it has been quite
generallyobservedthatgreaterprofitsdo indeedresult
in more investment.However,there has been a long
andfiercedebateas to whetherthe responsiblemecha-
nism derivesfromfundingconsiderationsor expected
futurerents.Thisambiguitycanbe largelyovercomeby
examiningthe effect of past dividendson subsequent
investment.A high ratio of dividendsto equityought
to indicatea liberalpolicywhichceterisparibusshould
rationallyresultin lowercapitalspending.This is con-
sistentwithLintner'sconvictionstatedin the firstpar-
agraphof his 1956paperthat"dividendsrepresentthe
FINANCIAL 1989
MANAGEMENT/SPRING
primaryand active decisionvariable. . . savingsin a
given period are largelya by-productof dividendac-
tion."
Apparently inconsistentevidence(thatiswidelycited)
is providedby Fama [19], who finds no interaction
betweendividendsandinvestmentin fixedcapitalwhen
using annualtime seriesfor individualfirms.A simple
explanation,though,is that dividendsare sticky,while
capitalspendingvariesoverthe businesscycle.A more
sophisticatedcritiqueis that Fama'sregressionspeci-
fications are biased againstdiscerningthe effects of
fundingfactors.Profitabilityand valuationare inex-
plicablyexcludedfromhis regressionequations,which
gives rise to possiblyprofoundmissingvariablebias.
For example,when investmentis the dependentvari-
able, and dividendsproxiesfor the excludedvariables,
an increase in dividendsmay accompanyadditional
capital spendingmerelybecauseboth reflect greater
expectedfutureearnings.The misspecificationis par-
ticularlydamagingas the empiricallyvalidatedLintner
model predictsthat time seriesvariationin dividends
will primarilyarise fromchangingprofits.Fama'sre-
ported insignificantpositive coefficientsof dividends
in his regressionof investmentare thus not surprising
and establisheslittle.
B. EmpiricalFindings
This motivatesExhibit4, wherethe pastbook value
dividendyield is includedin a cross-sectionalinvest-
mentequationwith sufficientcontrolsfor profitability
and valuation.Investmentis operationalizedby the
ratio of 1972to 1965investedcapital(the book value
of all debt and equitysecurities)and so includesnot
only fixed assets but also-as theoreticallycorrect-
the net workingcapitalneededto makethemproduc-
tive. ROA is as beforethe ratio of operatingearnings
to investedcapital;Q is the ratio of marketto book
value equity.To be conservative,other controls that
mayinfluenceinvestmentare also includedin the re-
gression equations. Size is the naturallogarithmof
investedcapitalin 1965(in millions),andcontrolsfor
the observedtendencyfor largesurvivingfirmsto grow
moreslowly.15As size is positivelycorrelatedabout0.1
withdividends,its exclusionwouldslightlymagnifythe
negativecoefficientof dividends.16 The specialization
ratio is the percentageof the firm'ssales in its largest
four-digitSICindustryin 1972,andcontrolsfor diver-
15Other studies with similar findings include Caves, et al. [14]. A
possible explanation is Penrose-type effects [42] causing difficulties
in enlarging already large bureaucracies.
BASKIN/THEPECKINGORDERHYPOTHESIS 33

Exhibit4. Regressionof the Growthof Invested standardized(beta) coefficientof DIVEQ65 is 32%,

Capitalfrom 1965to 1972* and thusabout 10%of the variancein investmentmay
Equation(4) Equation(5) Equation(6) be therebydirectlyattributedto dividendpolicy.Econo-
(Nobs = 356) (Nobs = 356) (Nobs = 356) metricinvestmentequationshave notoriouslylow R2
and 10%variancewouldseemmaterialin an equation
ROA65 2.57 2.20 3.34
that explainsless than 30%.These findingsconstitute
(t-Stat) (2.4) (1.9) (2.7)
ROA70 2.16 2.06 1.95 evidenceof the sensitivityof investmentto internally
(2.3) (2.1) (2.0) generatedfunds,andtheyareconsistentwithasymmet-
ROA72 -0.285 -0.577 -0.121 ric informationacting to partiallyisolate firmsfrom
(0.3) (0.7) (0.1) financialmarkets,as in the peckingorderhypothesis.
Size -0.189 -0.244 -0.231
(3.7) (4.5) (4.3)
Q65 0.118 0.112 0.121 VI.Conclusion
(2.5) (2.2) (2.3) The accumulatedevidencein favorof the pecking
Specialization -0.0074 -0.0082 -0.0086 order hypothesisis now substantial.The alternative
(3.3) (3.5) (3.7)
DIVEQ60 -8.06 -6.21 theory of static optimal capital structureappearsto
(4.2) (3.2) - have little power in explainingcorporatebehavior.
DIVEQ65 - - -10.6 Whilethis findingmaybe startling,as the lattertheory
- - (4.0) has been widely accepted,perhapsit is not entirely
DAR65 0.834 0.639 0.710
(1.9) (1.5) (1.7) unexpected.The pecking order hypothesisoriginally
Industry arose as a descriptionof corporatepractice.On the
Dummies - F(19,328)=3.7 F(19,328)=3.5 other hand,the theoryof static optimalcapitalstruc-
R2 0.199 0.330 0.341
0.180 0.274 0.287
ture is deductivelyderivedfrombasicaxioms,whichin
Adj.R2
particularignorethe materialrole of asymmetricinfor-
mation. Now it is possible to providepecking order
F(19,328) = 1.95is the 0.01 significancelevel. behaviorwith a rational theoreticalbasis, and there
*Constantis includedbut not reported. seems no longer any reason to ignore the manifest
t-statisticsin parenthesis.
empiricalevidence.
The evidencepresentedhere as well as in all other
publishedstatisticalstudies show that debt leverage
sifyinggrowthwhich may have been accompaniedby varies positivelywith past growthand inverselywith
new equityissues.17Two-digitSIC dummiesbased in past profits.In addition,it is found that firmswhich
1972are includedto controlfor industry-wideoppor- paidhigherdividendsin the pasttend to borrowmore.
tunities, which unsurprisinglyhave a potent, highly The regressionshavehighR2 and appearto be able to
significanteffect.DAR is the grossdebt to assetsratio explainmost of the cross-sectionalvariationin capital
and controls for possible fundinglimitationsarising structure.The importanceof fundingconsiderationis
from high leverage.None is observed,consistentwith demonstratedby the fact that once these are control-
passivedebt policy. led, borrowingbehaviorappearsseriallyuncorrelated;
The conclusion appears unambiguous:past divi- there is little indicationof any adjustmenttowards
dendshavea highlysignificantsizableeffectupon sub- staticoptimalcapital.
sequentinvestment.For example,in Equation(6) the The basic idea of the peckingorder hypothesisis
remarkablysimple. Firms borrowbecause they need
funds.Onceasymmetricinformationplaceslimitations
16To be exact,the effect of omittinga controlis determinedby its on equityfinance,debt tends to become the primary
partialcorrelationwith the variableof interest,in the direction incrementalsource of funding.Bankruptcycosts do
orthogonalto the otherincludedcontrols(see e.g.,Malinvaud[33]).
Usually,though,the distinctionbetweensimpleandpartialcorrela-
restrictborrowing,but it appearsthat the supplyof
tion is not materialin thiscontext. debtfundsis moreelasticthanthatof equityamongour
sampleof largematurecorporations.The evidenceis
17Theperiodincludestheconglomeratemergerwave.It appearsthat consistentwithasymmetricinformationproducingsub-
acquisitionsmayoffer an opportunityfor firmsto issue additional
equitywithoutconveyingundesiredsignals.Note thatthe specializa- stantiallygreaterproblemswiththose securitieswhose
tionratiois not significantly
correlatedwithDIVEQandits omission value is most dependentupon publicallyunknownfu-
wouldhavelittleeffect. tureprospects.Capitalstructurein practiceappearsto
34
be somewhatpassivelydeterminedin responseto the
need to fund investmentwith an imperfectlyelastic
supplyof equityfromretainedearnings.
Corporatebehaviorappearsto be often limitedby
the availabilityof funds.This findinghurlsus into the
midst of one of the majordebatesin economics:the
affectof internallygeneratedfundson investment.Evi-
dence presentedprovidesnew support that funding
matters. Many further implicationsof funding con-
straintslikelyremainunexploredandfertilegroundfor
futureresearch.
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