Pecking Order Theory and Trade-Off Theory of Capital Structure: Evidence from Indonesian Stock Exchange

Priska Ralna Eunike Culata · Tri Gunarsih

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Corporate Finance and Governance Financial Analysis and Corporate Governance Working Capital and Financial Performance

Abstract

Numerous empirical studies in the finance field have tested many theories for firms’ capital structure. The pecking order theory and the trade-off theory of capital structure is among the most influential theories of firms’ capital structure. The trade-off theory predicts optimal capital structure, while the pecking order theory does not predict an optimal capital structure. According to pecking order theory, the order of financial sources used is the source of internal funds from profits, short-term securities, debt, preferred stock and common stock last. The main objective of this study is to econometrically test whether the listed companies in Indonesian Stock Exchange follow the pecking order theory or the trade-off theory. Samples in this study are public companies listed during 2009-2010. The research questions are tested by running regression models. The empirical result of this study shows that the pecking order theory is not supported, while the trade-off theory is supported. This suggests that the capital structure of listed companies in Indonesian Stock Exchange is financed based on optimal capital structure, not by the order financial resources.

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1976Theory of the firm: Managerial behavior, agency costs and ownership structure 1984Corporate financing and investment decisions when firms have information that investors do not have 1984The Capital Structure Puzzle 1984Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have 2002Testing Trade-Off and Pecking Order Predictions About Dividends and Debt 2002Testing the pecking order theory of capital structure 2005Partial adjustment toward target capital structures 1999Testing static tradeoff against pecking order models of capital structure1This paper has benefited from comments by seminar participants at Boston College, Boston Unsiversity, Dartmouth College, Massachusetts Institute of Technology, University of Massachusetts, Ohio State University, University of California at Los Angeles and the NBER, especially Eugene Fama and Robert Gertner. The usual disclaimers apply. Funding from MIT and the Tuck School at Dartmouth College is gratefuly acknowledged. We also thank two reviewers, Richard S. Ruback and Clifford W. Smith, Jr., for helpful comments.1

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