Proceedings

investments are "lumpy" and positively serially correlated, and when free cash flow
varies over the business cycle (Shyam-Sunder & Myers, 1999).
Frank and Goyal tested Shyam-Sunder and Myers' time-series specification for the
pecking order on a much larger sample of companies from 1971 to 1998. This
specification worked reasonably well for large companies, particularly in the 1970s
and 1980s. They also find that variables motivated by the trade-off theory help
explain changes in debt financing, even after accounting for changes in companies'
financial deficits. Large companies with tangible assets borrow more, profitable
companies with high market-book ratios borrow less (Frank & Goyal, 2003).
Fama and French test the predictions of both trade-off and pecking-order models on a
large panel of companies from 1965 to 1999. They also consider modified versions of
the pecking order. (Fama & French, 1998) Both theories score some points in Fama
and French's tests, but run into serious difficulties. The trade-off theory struggles to
explain the strong inverse relationship of profitability and leverage. The pecking order
struggles to explain the heavy reliance on equity issues by small growth companies
(Fama & French, 2002).
Baker and Wurgler find that issuing companies seem to "time" the market, issuing
shares when their stock prices are high and turning to internal finance or debt when
prices are low. Consistent pursuit of timing strategies would make debt ratios depend
on paths of past stock prices as well as on requirements for external funds (Baker &
Wurgler, 2002). Ritter calls this the "windows of opportunity" theory. If investors
sometimes overprice issuing companies' shares, so that equity is truly cheap, then
equity can move temporarily to the top of the pecking order. Thus the windows of
opportunity theory could absolve the pecking order of a major empirical shortcoming,
provided that one is willing to assume systematic mispricing of new issues, at least in
"hot" issue periods (Ritter, 2003).
Most research on corporate financing decisions considers the trade-off and peckingorder
theories. There are convincing examples of these theories at work. The
economic problems and incentives that drive the theories taxes, information and costs
of agency and distress show up clearly in financing tactics. Yet none of the theories
gives a general explanation of financing strategy. They are plausible as conditional
theories, but we have only a partial understanding of the conditions under which each
theory, or some combination of the theories, works (Myers, 2003). Zingales says that
we need "new foundations" for corporate finance. The foundations will require a
deeper understanding of the motives and behavior of managers and employees of the
company (Zingales, 2000).
1.4. Confronting theory with practice
How companies make their capital structure decisions has been one of the most
extensively researched areas in corporate finance, yet there is little consensus among
these studies. In a recent paper, Graham and Harvey (2001) examine the theory and
practice of corporate finance by surveying US managers. Bancel and Mittoo (2004) do
the same in the European context, but differ in its scope and focus.
Graham and Harvey (2001) test the implications of different capital structure theories
through a survey of US managers. They find moderate support that companies follow
the tradeoff theory and target their debt ratios. They also find some support for the
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