Yet another paper on the pecking order! This one is by Agca and Mozumdar. You will definitely want to read it!
There is a large debate in the financial world as to whether Myers' and Majluf's pecking order holds. Their famous hypothesis states that firms want to use internally generated funds first, and then if they still have to issue new securities, they will issue safer (debt) first and only use equity as a last resort. However, the evidence on this has been mixed to say the least with some saying the Pecking order is alive and well, while others suggesting it is dead. In this paper Agca and Mozumdar report in on the "it's ALIVE!" side.
From their abstract:
"conflicting nature of the existing evidence on the pecking order theory is due to the difference between financing practices of large and small firms, and the skewness of the firm size distribution. The theory performs poorly for small firms because they have low debt capacities that are quickly exhausted, forcing them to issue equity. The pecking order theory performs satisfactorily for large firms, firms with rated debt, and when the impact of debt capacity is accounted for"The authors explain that some of the difficulty in previous studies has been brought about by the treatment of firm size.
For instance, in possibly the most well known of the pecking order studies "Frank and Goyal (2003) normalize all variables by firm size and then use equally weighted averages. This increases the importance of small firms whose financing mix conforms poorly with the pecking order...." (here is a 2001 version of the Frank and Goyal paper)
In their current paper Agca and Mozumdar break the firms into deciles based on size and then examine firm financing behavior. The conclusion?
"We find that working with nonnormalized numbers yields results that are in line with the conventional notions about corporate financing practices. Furthermore, sorting firms into size deciles, we find that the debt-deficit sensitivity coefficients and R2 values are low for small firms, as in Frank and Goyal (2003), while they are high for large firms, as in Shyam-Sunder and Myers(1999)."So size does matters. Or as the authors state:
"Why does the pecking order theory perform so differently for large and small firms? Our analysis shows that this is due to different factors assuming primacy in the two cases. How much a firm borrows depends on how much it can borrow (its debt capacity), as well as how much it wants to borrow. The observed debt level is the lower of the two. The pecking order theory focuses on the latter, and largely ignores the former."Or in the vernacular: the pecking order works when there are not other constraints (such as debt capacity) in the way.
An I^3 paper for sure!
Agca, Senay and Mozumdar, Abon, "Firm Size, Debt Capacity, and Corporate Financing Choices" (December 2004). http://ssrn.com/abstract=687369