Received: 19 February 2018 Revised: 21 August 2018 Accepted: 9 September 2018

DOI: 10.1002/ijfe.1657

RESEARCH ARTICLE

Examining pecking order versus trade‐off theories of capital

structure: New evidence from Japanese firms

Shaif Jarallah1 | Ali Salman Saleh1 | Ruhul Salim2

1
College of Business and Economics,
Abstract
Qatar University, Doha, Qatar
2
Curtin Business School, Curtin
This study empirically tests the traditional trade‐off model against the pecking
University, Bentley, Australia order model of capital structure using data from the Japanese listed companies
on the Tokyo Stock Exchange. A pooled sample of 1,362 publicly listed nonfi-
Correspondence
Shaif Jarallah, College of Business and nancial companies from 1991 to 2015 is used to establish the relationship
Economics, Qatar University, Doha, between leverage and its determinants by using the generalized methods of
Qatar.
moments econometric framework. The results show that the financing pattern
Email: shaif@qu.edu.qa
of Japanese firms is consistent with the basic pecking order model, which pre-
JEL Classification: G23; G32; C32 dicts external debt financing driven by the internal financial deficit.

KEYWORDS
debt maturity structure, panel data analysis, pecking order theory, trade‐off theory

1 | INTRODUCTION theory and the trade‐off theory to analyse the financing

Research on capital structure has focused on whether cor-
porate financing decisions matters or not. If financing
decisions were completely irrelevant, then actual capital
structures should vary randomly from firm to firm and
industry to industry. Nevertheless, this is not what is
being observed by empirical evidence in the field of cor-
porate finance. The current theory of capital structure
was established by Modigliani and Miller (1958). They
demonstrated that capital structure is irrelevant to the
value of the firm. The logic of the Modigliani and Miller
(1958) analysis is still accepted, despite the contradiction
of their theoretical conclusions with empirical evidence.
The reason is that they developed their theory based on
many assumptions. When these assumptions are relaxed
in order to bring the theory closer to reality, especially
when the taxes and the costs of financial distress are
not ignored, financing decisions do matter. This is why
the conditional capital structures theories came into
existence.
The contributions of this article to the current litera-
ture are as follows. First, this research focuses precisely
on the various predictions implied by the pecking order
behaviour of the Japanese listed companies. This study
develops two empirical models to examine the relevance
of the two competing theories of capital structure by
using a unique large panel data for 1,362 publicly listed
firms on the Tokyo Stock Exchange (TSE) for the period
from 1991 to 2015. This allows for thorough investiga-
tions of the retrospective theories and their validity in
the Japanese market context. This is the first study to
incorporate such a comprehensive and reliable dataset,
the Nikkei Economic Electronic Databank System data-
base. The above period was chosen because it covers
many recent rapid changes in financial policies, regula-
tions, and reforms. It is, therefore, of immense interest
to explore how far this leads to different financial deci-
sions preferred by Japanese companies. Additionally, this
study uses the size of the company, profitability, divi-
dends payout ratio (DPR), and growth opportunities as
the variables to investigate the relative potency and
explanatory power of the pecking order theory and the
trade‐off theory.
The aim of the study is to identify empirically the fac-
tors that determine the optimal debt level in the Japanese
financial market. The finding based on the Japanese

204 © 2018 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/ijfe Int J Fin Econ. 2019;24:204–211.
JARALLAH ET AL.
experience will be interesting because for the last 60 years,
the financial structure of Japanese firms has been domi-
nated by indirect banking, which in turn has led to close
long‐term relationships between the banks and their cli-
ent firms. This main bank relationship has led to a con-
tinuous and large borrowing to the client firms over a
long period. Furthermore, the bank is a key stakeholder
of the company, and the bank conducts numerous bank-
ing and other business transactions with the company.
Even though the bank does not interfere in the manage-
ment of the client company, as long as the company gains
profits, the bank often rescues the trade partner when the
latter faces financial difficulties. However, this structure
of main bank relations and reliance on bank debt went
through a rapid and significant change, because the burst
of the stock market bubble and bad debt problems in the
1990s. Second, the study explores the relevance of the
pecking order and trade‐off theories in the context of
legal and corporate reforms in the post bubble era in
Japan. Third, given the scarcity of studies in the area of
financing behaviour of the Japanese listed companies,
the empirical findings provides beneficial information
for researchers, practitioners, and investors operating in
capital markets for Japanese listed firms.
The rest of the paper is structured as follows. Section 2
discusses the literature review. Section 3 describes the
data and the definitions of the variables, and this is
followed by the econometric methodology in Section 4.
The interpretation of the results is reported in Section 5,
whereas Section 6 discusses the robustness of the results.
A concluding remarks and policy implications are given
in Section 7.
2 | L I T E R A T U R E RE V I E W
The capital structure theories can be categorized in two
broad sets. First, those that argue that there is no clear
target capital structure (pecking order model) or declare
the existence of the optimal capital structure for each
company (static trade‐off theories). The pecking order
theory suggests that there is a lack of optimal capital
structure that increases the market value of the firm.
Hence, financial directors issue debt predominantly with
respect to the cost of capital. Firms favour self‐financing
rather than use exterior funds. When there is financial
distress, companies will choose to borrow instead of issu-
ing equity. However, the static trade‐off theories suggest
that every firm has an optimal capital structure that max-
imizes its market value. The trade‐off arises in numerous
patterns such as a trade‐off between tax shield of debt and
distress cost of capital similar to the case of trade‐off
model. However, the optimal capital structure is attained
205
once the marginal present value of the tax deduction ben-
efits is equal to the marginal present value of the costs of
financial difficulties on further debt. In the case of the
agency theory, the trade‐off between agency costs
demands that the optimal capital structure is accom-
plished when agency costs are diminished. In the case
of signalling theory, the optimal level of debt financing
is achieved by equating the opportunity cost between
the benefits of signalling and the costs of financial diffi-
culties. It indicates that a company chooses debt ratio as
an indication of its type.
There have been debates in the literature about
whether the pecking order model is better than the
trade‐off model in relation to finance structure or vice
versa (Myers & Majluf, 1984). Fama and French (2002)
argue that the two competing models have some similar-
ities with regard to the variables of leverage and divi-
dends. On the one hand, the trade‐off model
outperforms the pecking order theory, and on the other
hand, the pecking order theory (the negative impact of
profitability on leverage) performs better. Prasad, Green,
and Mmurinde (2001) have also concluded that the
empirical results from trade‐off and pecking order theo-
ries remain indecisive. However, the pecking order model
has some advantages over the trade‐off model (Ghosh &
Cai, 1999; Kochhari & Michael, 1998). Nevertheless, some
studies have focused on examining these specific theories
and their empirical relevance. For instance, Kochhari and
Michael (1998) argue that the growth of the firm is made
possible by the pecking order model. This in turn enables
the determination of the capital structure, which is a pos-
itive aspect. In conjunction with that, while applying the
pecking order model, the capital structure can be deter-
mined at any point. In other words, the internal cash flow
of a company can be easily dictated, which suggests that a
company will be able to manage several of its investments
and, hence, avoid many risks. Shyam‐Sunder and Myers
(1994) evaluated the explanatory power of pecking order
theory versus the trade‐off theory. They argue that,
according to the pecking order theory, the estimated coef-
ficient of the financing deficit should be 1. Nevertheless,
this approach and underlying results have been criticized
in some recent studies. For example, Frank and Goyal
(2003) investigated the pecking order theory against the
trade‐off theory using a larger sample and indicated a
minor support for the pecking order theory. Chirinko
and Singha (2000) have also criticized the conclusion
drawn by Shyam‐Sunder and Myers (1994) and argued
that their results may be spurious because the estimated
coefficient is close to 1 even when the pecking order the-
ory is not sustained.
More recently, Miglo (2016) argues that the static
trade‐off model focuses on bankruptcy cost and debt. This
206
aspect, however, provides an advantage that the pecking
order model does not provide. According to the author,
the trade‐off model uses debt to satisfy financial needs,
which is quite profitable, but then firms that apply this
model are more susceptible to financial distress. Sulfia
(2015) argues that an investor might prefer to choose a
firm that uses the pecking model to the one that uses
the static trade‐off model to avoid any financial risk.
She contends that the trade‐off theory is less superior to
the pecking order theory because of the disadvantage of
debt cost. The author also argues that although the
trade‐off theory is quite profitable because the relation-
ship between finance and profit is reasonable, it would
put a company in financial distress because of build‐up
of debt. However, the study concluded that the pecking
order model focuses on internal funding as a good
method of managing capital and other finances; that
way, the firm is able to predict the finance structure at
any time or situation Sulfia (2015).
3 | DATA AND DEFINITION OF
T H E VA R I A B L E S
The optimal capital structure depends on various policy
tools. Meanwhile, many capital structure models have
not clearly specified the leverage measurement for reli-
able aspects. We study the two measures of leverage of
firm as used in most empirical research. The first mea-
sure is defined as the ratio of book value total debt to total
book value of debt and equity (BL). The second measure
is based on the market value and is computed as ratio
of book value of total debt to the book value of debt and
market value of common equity (ML).
However, one should be aware that in the context of
testing the relevant potency of the pecking order theory
and trade‐off theory, the appropriate measure is probably
the book measure of leverage. This is because, in the
agency, conflicts related to debt are mainly influenced
by the financing history of the firm and, therefore, on
the associated claims on firm value possessed by equity
and debt. Moreover, the use of book value can also be
explained on the basis that financial directors emphasize
book value rather than market value of debt when
designing financial structures. Moreover, there is a possi-
bility of a spurious link between the market value dimen-
sion and Tobin's Q ratio (TQ).
In order to test the hypothesis, the capital structure
literature suggests that several variables affect the financ-
ing behaviour of companies, for example, firm size, prof-
itability, growth opportunities, earning volatility, degree
of operating leverage, nondebt tax shield, liquidity, and
ownership. However, in this study, we use the size of
JARALLAH ET AL.
the company, profitability, growth opportunities, and
DPR as the determinants to examine the relative potency
and explanatory power of the pecking order model and
the trade‐off model. Moreover, different proxies for the
independent variables, profitability (PROF), growth
(GROW), and dividend (DPR) are considered in the esti-
mation process.
The firm size is negatively associated with the lever-
age as the information asymmetries are more profound
for bigger firms than for smaller firms. The larger firms
are more sophisticated in their structure and agency
costs; therefore, it is harder for the bigger firms to gener-
ate external equity. Fama and Jensen (1983) show that in
contrast with smaller companies, the bigger companies
have to release more information. Consequently, the
pecking order is emphasized by size and there will be
an inverse correlation between leverage and size. Never-
theless, the common investors are more mindful about
large companies than they are about the smaller ones.
Hence, bigger companies have no difficulties in accessing
funds. They can also have a lower risk portfolio. Warner
(1977) and Ang, Chua, and McConnell (1982) discuss that
there are economies of scale in liquidation, suggesting
that the asymmetric information of debt will be minor
for bigger corporations, and this is established by many
scholars (such as Bradbury & Lloyd, 1994; Michaelas,
Chittenden, & Poutziouris, 1999). Therefore, in reference
with the pecking order theory, a positive correlation
between size and debt may be anticipated. Accordingly,
the trade‐off theory postulates that a positive link
between leverage (BL/ML) and firm size is anticipated.
In this study, we use the natural log of total assets as
the measure of the firms size (SIZE).
The nexus between profit and leverage is varied. The
pecking order model suggests an inverse association
between the variables. For instance, when firms have
retained earnings, they can utilize them for financing
future investment rather than searching for other sources.
Accordingly, there will be an inverse link between lever-
age and profitability (Cassar & Holmes, 2003; Rajan &
Zingales, 1995). Contrarily, there are other methods with
regard to preferences of capital financing of firms provid-
ing signals to investors. In this regard, a higher debt level
is considered as a signal for better performance (Ross,
1977; Leyland & Pyle, 1977). Hence, according to the
trade‐off model of capital structure, it is anticipated that
the profitability and leverage of companies are positively
correlated. In this analysis, we employ two measures for
the profitability interchangeably. We use return on assets
(ROA) as the first measure of the profitability (ROA) and
return on equity as a second measure.
Another influential determinant of leverage is the
growth opportunities available to the firm. The trade‐off
JARALLAH ET AL. 207

theory indicates that a negative association is anticipated
between growth and long‐term debt. That is because the
growth opportunity of the firm is an intangible equity
rather than a tangible one; the liquidity influence of high
leverage could minimize future growth of companies.
This indicates that companies with higher growth pros-
pects may choose a low leverage (Myers, 1977). Con-
trarily, from the viewpoint of the pecking order theory,
growing companies with higher financing demands will
issue equities (short‐term debt) less subject to informa-
tion asymmetries. For instance, if these companies have
a strong bilateral relationship with banks, information
asymmetry problems will be less, and companies will
have easier access to long‐term debt financing. Hence,
this causes a positive relationship, which is in line with
the pecking order model. We consider two growth poten-
tials measure, the TQ and the growth of sale (SG).
Another factor of capital structure is the DPR of the
firm. Dividends are cash outflows from the system; hence,
external funds need to be raised to finance a firm's oper-
ations. Higher dividends lead to an increase in share
prices of the company. According to the equity market
timing theory, managers will prefer equity to debt
because of the higher share price, which further facili-
tates fund raising through the equity market. Similarly,
the trade‐off model shows that the low retentions (divi-
dends payment are high), which is due to low external
financing (containing debt), indicate an inverse associa-
tion between dividends and leverage. Alternatively, the
pecking order model suggests that companies with low
retentions will have less financial distress and higher debt
levels; this is due to higher demand for external funds.
Baskin (1989) and Mazur (2007) suggest a significant pos-
itive link between past dividend payment and current
leverage that endorses the pecking order model. To this
end, in this study, we use two independent dividends
behaviour measures: the DPR and the dividends equity
ratio (DQR).
Table 1 provides a summary of descriptive statistics of
the key variables used in the analysis. An average amount
TABLE 1 Descriptive statistics
of the BL is about 54.104 million U.S. dollars with a
median value of 54.802 million U.S. dollars. The mean
of the ML is approximated to 46.692 million U.S. dollars.
Moreover, on average, a firm has a total capital calculated
at 11.161 million U.S. dollars. The ROA ranges from
59.400 to −74.270 with an average of 4.442 million U.S.
dollars. The TQ, which we calculate as the firm's total
market value over its total asset value, spreads from
168.83 to 0.030 with an average of 0.988. The sample aver-
age of the variable DPR ranges from 0% to 85.45% with a
mean value measured to be 36.947%. The mean value of
the SG variable is calculated to be 0.231 million U.S.
dollars.
The data set contains corporate financial data of 1,362
nonfinancial firms that are publicly listed on the TSE I
and II for the period from 1991 to 2015 (24 years). The
data employed in this research are available from Nikki
Economic Electronic Database Systems database.
4 | ECONOMETRIC
M E T HO DO LO GY
Based on the discussion in the previous section, the fol-
lowing two empirical models are developed to test the rel-
evance of the two competing theories of capital structure
by using panel data for 1,362 listed firms on the TSE for
the period from 1991 to 2015.
BLit ¼ μ þ β1 SIZEit þ β2 PROFit−1 þ β3 GROWit
þ β4 DPRit−1 þ αi þ λt þ ε1;it ; (1)
MLit ¼ μ þ β1 SIZEit þ β2 PROFit−1 þ β3 GROWit
þ β4 DPRit−1 þ αi þ λt þ ε2;it ; (2)
where BL and ML are the book value and market value
measures of leverage, SIZE is the firm size, PROF is the
firm profitability, GROW is the growth opportunities
available to the firm, and DPR is the dividends payout

BL ML SIZE ROA ROE TQ SG DPR DQP

Mean 54.104 46.692 11.161 4.442 1.829 0.988 0.231 35.947 1.636
Median 54.802 46.730 10.965 3.870 3.590 0.762 0.470 31.080 1.540
Maximum 835.426 98.625 16.476 59.400 3786.670 168.826 432.460 85.450 34.070
Minimum 0.187 0.000 5.124 −74.270 −1208.860 0.030 −99.560 0.000 0.000
Std. dev. 21.350 21.495 1.383 4.334 33.664 2.053 15.092 28.943 1.205
Skewness 1.873 0.002 0.629 0.613 44.953 42.779 2.459 0.397 3.549
Kurtosis 72.802 2.191 3.533 15.419 6501.026 2581.431 59.713 1.964 57.296
Obs. 32688 32688 32688 32688 32688 32688 32688 32688 32688
208 JARALLAH ET AL.

ratio of the firm. αi is the individual specific, and λt is TABLE 2 Generalized methods of moment results for the
time specific effect. selected two‐model
In this study, we used the generalized methods of Dependent variable BL ML
moments (GMM), instrumental variable (IV) econometric
BL/ML i,t‐1 0.352** 0.528**
technique. The GMM is applied to overcome the problem
of endogeneity, heteroscedasticity, and autocorrelation (0.010) (0.013)
due to dynamic panel data estimation. In dynamic estima- BL/ML i,t‐2 0.119** 0.045**
tions, the ordinary least squares and generalized least 0.003 0.007
squares estimators will be unreliable because of autocorre-
SIZEi,t 0.955** 0.948**
lation between the autoregressive term (BLi,t‐1/MLi,t‐1)
(0.305) (0.309)
parameters and error term (εit). Pesaran and Smith (1995)
have indicated that autocorrelation can be eliminated by ROAt‐1 −0.595** −1.042**
first difference. Therefore, a dynamic panel data model (0.024) (0.040)
with IVs should offer findings that are more consistent. TQi,t 0.050* 0.207*
There are different IV estimators, but Blundell and (0.024) (0.088)
Bond (1998) used a system GMM estimation method,
DPRi,t‐1 0.087** 0.075**
which incorporates lagged levels of BLit/MLit as instru-
ments besides the lagged differences of BLit/MLit for (0.006) (0.007)
equations in first differences. These added instruments Diagnostic tests
enhance the efficiency of the basic first‐differenced Sargan test 1.629447 1.811584
GMM estimators suggested by Arellano and Bond J stat (p value) 0.157613 0.705928
(1991). The reason is to utilize the orthogonality condi-
Lag 1 Serial Corr. (p value) 0.80028 0.421761
tion that persists between BLit/MLit and the disturbances
εit. An efficient GMM model will utilize various numbers Lag 2 Serial Corr. (p value) 0.141886 0.915736
of instruments in each time period. The GMM cross sec- Note. Standard errors are in parentheses.
tion applies a weighting matrix that is more consistent *Significant at 5% level;
to heteroscedasticity and contemporary correlation of **Significant at 1% level.
unknown form, whereas the GMM time series
heteroscedasticity and autocorrelation consistent estima- The association between leverage and profitability is
tion (HAC) covers this robustness to autocorrelation of negative and statistically significant at the 1% level for
unknown form. The GMM applies added selections of both measures of leverage. The results favour the pecking
difference and orthogonal deviation to deal with cross order theory rather than the static trade‐off models. The
section fixed effects. These selections permit a transfor- inverse relationship can be interpreted from the signifi-
mation procedure for removing the effect from the cant differences in the information cost between internal
arrangement. The difference transformation shows that and external finance. If there is substantial information
the estimation technique would apply first differenced asymmetry between insiders and outsiders, companies
data (Arellano & Bond, 1991), and orthogonal deviations should reply on internal sources before seeking external
(Blundell & Bond, 1998) achieve another technique of finance.
eliminating the individual effects. The Growth variable as measured by TQ has a posi-
tive effect on debt ratio, as the coefficient is positive and
statistically significant at the 99% confidence interval.
5 | DISC USS I ON OF EMPIRICAL The positive relation is in line with pecking order theory
RESULTS and signalling theory of capital structure. This suggests
that when firms pursue growth‐oriented strategies with
The empirical results of the above two models specified in favourable future prospects, they will opt for debt financ-
Equations (1) and (2) are presented in Table 2. ing and will buy back their stocks in order to preclude
The results in Table 2 show that firm size is positively new investor/shareholders from expected future gain.
related to both measures of leverage, that is, book mea- The DPR indicates a positive and statistically signifi-
sure and market measure of leverage. The result is consis- cant relationship with leverage. This supports the pecking
tent with the trade‐off theory and indicates that larger order theory as the firm chooses debt rather than equity
firms can easily tap the debt market, and distress risk financing. Generally, the findings are in line with the
associated with debt financing does not increase as rap- pecking order model. However, the firm size has a posi-
idly as for their smaller counterparts. tive association with the leverage indicating that the scale
JARALLAH ET AL. 209

of the larger companies did not increase the cost of asym- for explanatory variables. Secondly, alternative specifica-
metric information and is not applicable to the pecking tion of the models is estimated in order to check the over-
order theory. Nonetheless, Japanese large economies of all validity of the GMM results. To explicitly address this
scale and market‐oriented companies have a strong and potential concern, Equations (1) and (2) are reestimated
long‐term relationship with financial institutions using the fixed effects generalized least square panel
(Jarallah & Ullah, 2014). This may lead to less conflict regression including lagged dependent variables.
in terms of agency costs and asymmetric information,
which facilitates access to debt and makes it more advan-
tageous to them. Hence, the relationship between size 6 | R E SUL T S RO B U ST N ES S
and debt can be inferred in line with the premises and
the conventions of the pecking order theory. A positive To test whether the results depend on the measures of
connection between leverage and size is detected by explanatory variables, proxies are used for firm profitabil-
many scholars (Kanatani & Yaghoubi, 2017; La Rocca, ity and growth opportunities. Firm performance as was
La Rocca, & Cariola, 2011; Michaelas et al., 1999; Psillaki measured by ROA is replaced by return on equity, growth
& Daskalakis, 2009). potentials measure (TQ) is replaced by SG, and dividends
Lastly, in Tables 2 and 3, the p value of specification behaviour measure (DPR) is replaced by DQR. The
tests for the dynamic panel data models are reported. In results of these alternate measures are shown in Table 3.
all of the four estimations, the Sargan test (J statistic) does Similar to the previous results, the firm size, growth,
not reject the null hypothesis that the overidentifying and dividends behaviour of firm are positively related,
restrictions are valid. Similarly, in most cases, the null whereas profitability is negatively related to the both
hypothesis of no first‐order or second‐order autocorrela- measures of leverage. Thus, it appears that the results of
tion is not rejected. Models 1 and 2 are robust to alternative measures of
To examine the sensitivity of the findings, a number explanatory variables. In the first step, we used the
of robustness tests are conducted. First, it is checked Hausman (1978) specification test to determine the rela-
whether the results depend on the choice of proxies used tionship of cross‐sectional fixed effect with the other
exogenous variables. The procedure is to test if the fixed
TABLE 3 Generalized methods of moment results for the effects model or the random effects model is adequate
selected two‐model (alternate measures) for the estimation of parameters. The computed Chi‐
Dependent variable BL ML squared value is presented in Table 4. The test confirms
that the individual‐specific effects are associated with
BL/ML i,t‐1 0.382** 0.592**
the right hand side variables. The random effects esti-
(0.006) (0.013) mates seem to be biased and significant.
BL/ML i,t‐2 0.100** 0.045** Therefore, the fixed effects models are estimated using
(0.005) (0.007) Equations (1) and (2). The results of the fixed effects spec-
SIZEi,t 2.583** 0.549
ification are reported in Table 5.
The results of fixed effects specification of the both
(0.334) (0.348)
measures of leverage show that estimated effect remains
ROEi,t‐1 −0.066** −0.172** the same in terms of statistical significance and in regard
(0.013) (0.021) to direction of causation; however, there are minor differ-
SGi,t 0.271** 0.116** ences in the coefficients values. As indicated earlier, the
(0.014) (0.021)
fixed effects containing a lagged dependent variable result
in biased estimators. Nevertheless, the model can act as a
DQRi,t‐1 0.931** 1.855**
benchmark, and the estimators are reliable as N or T go
(0.191) (0.311) to infinity and might be applied to confirm the
Diagnostic tests
Sargan test 1.584415 1.918985 TABLE 4 Hausman test
J stat (p value) 0.743132 0.392227 Dependent variable Chi‐sq. statistic Chi‐sq. df Prob.
Lag 1 Serial Corr. (p value) 0.655478 0.171187
Model 1 2693.639 6.000 0.000
Lag 2 Serial Corr. (p value) 0.706046 0.11833
Model 2 4037.594 6.000 0.000
Note. Standard errors are in parentheses.
Note. The table reports the results of the Hausman specification test for BL
*Significant at 5% level; and ML models. Chi‐sq. statistic is the Chi‐squared calculated value, and
**Significant at 1% level. Prob. is the p value of calculated statistic.
210 JARALLAH ET AL.

TABLE 5 Fixed effect model results Japanese firms during the sampled period. It confirms that
Dependent variable BL ML
the pecking order theory can offer a rational clarification
of the capital structure of companies in the Japanese mar-
BL/ML i,t‐1 0.544* 0.576** ket. Nevertheless, the large scale of the firms is positively
(0.24) (0.081) associated with the loan financing and is inconsistent with
BL/ML i,t‐2 0.220* 0.283* the pecking order model. However, the relationship
(0.099) (0.104) between debt and size entails positive or negative sign
and is considered in accordance with the pecking order
SIZEi,t 2.251* 3.298**
theory (Myers & Majluf, 1984; Rajan & Zingales, 1995;
(1.041) (0.637) Serrasqueiro & Caetano, 2015). While studying 1,325 non-
ROAt‐1 −0.328** −0.709** financial Japanese firms between 2002 and 2006, Zhang
(0.075) (0.061) and Kanazaki (2007) found that the traditional static
TQi,t 0.138* 0.742** trade‐off model fails to explain the negative correlation
between profitability and firm leverage, whereas the
(0.086) (0.246)
pecking order model fails to explain the low deficit coeffi-
DPRi,t‐1 0.028** 0.022**
cient. Voutsinas and Werner (2011) show that the two
(0.006) (0.005) events such as asset bubble burst in 1989 and banking cri-
Diagnostic tests ses in 1998 caused extreme credit supply fluctuations in
R‐squared 0.887 0.887 Japan which in turn had a significant impact on Japanese
firms' capital structure. They argued that the pecking order
Adjusted R‐squared 0.88 0.88
model performs well during the high growth period of the
F statistic 124.996 124.996
1980s, whereas the trade‐off model works well during the
Note. Standard errors are in parentheses. stagnant growth period of the 1990s and the subsequent
*Significant at 5% level; credit crunch. However, our findings suggest that the
**Significant at 1% level. pecking order model and trade‐off theory have a signifi-
cant role in the financing activities of companies with the
significance of the GMM outcomes. In summary, one can expansion of Japanese capital markets.
conclude that the results shown in Table 2 are robust and Given that debt financing requires a large amount of
consistent with the alternative measures of the explana- funds in the Japanese capital market, the empirical find-
tory variables and specification of the model. ings indicate that there is a stronger association between
profitability, dividends payments, and the short‐term debt
ratio. The larger and growth oriented firms are more
7 | CONCLUSION AND P OLICY heavily financed through long‐term debt than through
I M P L I C A T IO N S short‐term debt. This suggests that the debt maturity
strategy for Japanese listed companies has incorporated
This study investigates the factors of capital structure and the principle of aligning the assets and liabilities and is
empirically assesses the static trade‐off model and relevant to the trade‐off theory. Overall, the results of
pecking order model of capital structure in Japan. It our study suggest that the pecking order theory enthusi-
reflects on several hypotheses that elaborate on agency astically explains the financing behaviour of the Japanese
theory to explore the behaviour and the financing pattern listed firm, whereas the debt maturity structure is in line
of the Japanese nonfinancial and TSE listed companies with the trade‐off model of Japanese listed companies.
during the period of 1991–2015. Two measures of capital
structure choice (book value and market value measures)
are described by a number of explanatory variables such ORCID
as firm size, profitability, growth, and dividends behav- Shaif Jarallah http://orcid.org/0000-0002-7881-7585
iour. Applying the two firm‐based measures of capital Ali Salman Saleh http://orcid.org/0000-0003-2869-2232
structure (DPR and DQR), our results show that a Ruhul Salim http://orcid.org/0000-0002-8416-1885
company's profitability is negatively associated with loan
financing. In addition, our results also find significant
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How to cite this article: Jarallah S, Saleh AS,
Salim R. Examining pecking order versus trade‐off
theories of capital structure: New evidence from
Japanese firms. Int J Fin Econ. 2019;24:204–211.
https://doi.org/10.1002/ijfe.1657