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Testing Tradeoff and Pecking Order Predictions about Dividends and Debt.

Confirming predictions shared by the tradeoff and pecking order models, more profitable firms and firms with fewer investments have higher dividend payouts. Confirming the pecking order model but contradicting the tradeoff model, more profitable firms are less levered. Firms with more investments have less market leverage, which is consistent with the tradeoff model and a complex pecking order model. Firms with more investments have lower long-term dividend payouts, but dividends do not vary to accommodate short-term variation in investment. As the pecking order model predicts, short-term variation in investment and earnings is mostly absorbed by debt. The finance literature offers two competing models of financing decisions. In the tradeoff model, firms identify their optimal leverage by weighing the costs and benefits of an additional dollar of debt. The benefits of debt include, for example, the tax deductibility of interest and the reduction of free cash flow problems. The costs of debt include potential bankruptcy costs and agency conflicts between stockholders and bondholders. At the leverage optimum, the benefit of the last dollar of debt just offsets the cost. The tradeoff model makes a similar prediction about dividends. Firms maximize value by selecting the dividend payout that equates the costs and benefits of the last dollar of dividends. Myers (1984) develops an alternative theory known as the pecking order model of financing decisions. The pecking order arises if the costs of issuing new securities overwhelm other costs and benefits of dividends and debt. The financing costs that produce pecking order behavior include the transaction costs associated with new issues and the costs that arise because of management’s superior information about the firm’s prospects and the value of its risky securities. Because of these costs, firms finance new investments first with retained earnings, then with safe debt, then with risky debt, and finally, under duress, with equity. As a result, variation in a firm’s leverage is driven not by the tradeoff model’s costs and benefits of debt, but rather by the firm’s net cash flows (cash earnings minus investment outlays). We test the dividend and leverage predictions of the tradeoff and pecking order models. Our menu is ambitious. We examine predictions about how long-term leverage and the dividend payout ratio vary across firms with the main driving variables proposed by the two models – profitability and investment opportunities. Moreover, to test predictions about the interdependence of long-term leverage and the dividend payout, we model dividends and leverage jointly. We test the tradeoff model’s prediction that leverage is mean-reverting. And we test pecking order predictions about how financing decisions respond to short-term variation in earnings and investment. To our knowledge, we are the first to test tradeoff and pecking order predictions about the dividend payout ratio, and we are the first to jointly model and test the interaction between the payout ratio and leverage. But one can argue that many of our leverage results just confirm previous evidence.