Empirical Study of Capital Structure: An Analysis of the Relevance of Pecking Order and Trade-off Theories in Nordic Publicly Listed Companies

Abstract

This study offers an empirical test of two major capital structure theories: the trade-off and pecking order theories. The trade-off theory predicts that companies weigh the benefits of additional debt against the marginal costs, aiming for an optimal, value-maximizing capital structure. In contrast, the pecking order theory rejects the idea of an optimal capital structure and suggests that companies make financing decisions based on a hierarchy of preferences driven by the relative information costs of internal versus external financing. A significant limitation of existing capital structure studies is their focus on firm-specific factors, predominantly using data from American companies. Consequently, there is limited understanding of how these theories apply to firms in Scandinavian economies and how companies in these regions react to macroeconomic and industry-specific factors. This study addresses this gap by employing an unbalanced panel data methodology to test empirical hypotheses on a sample of 913 non-financial listed companies in the Nordic region over the period from 1998 to 2023. Specifically, the study conducts a comprehensive comparative test at both firm and macro levels using the LSDV fixed effects estimator. An Arellano-Bond dynamic estimator is used to examine dynamic capital structure adjustments in line with the trade-off hypothesis, while a Kruskal-Wallis test assesses industry-specific capital structures. The results suggest that firms likely incorporate elements of both the trade-off and pecking order theories in their dynamic capital structure decisions, with varying levels of empirical support for each theory. The findings indicate that industry differences in capital structures, primarily driven by asset tangibility, align with the trade-off theory. Specifically, capital-intensive industries can leverage debt more effectively, supporting the notion that firms optimize their leverage ratios in line with the tradeoff hypothesis. Additionally, companies adjust approximately 20-45% of the gap between their target and actual leverage ratios annually, further supporting the trade-off theory. However, the trade-off theory falls short in explaining why firms reduce their debt ratios as profitability increases, a pattern that aligns with the pecking order theory. Furthermore, it does not account for why some of the largest and most successful companies operate with relatively low levels of debt compared to what the trade-off theory would predict. Overall, these results are robust across different leverage definitions and suggest that both the tradeoff and pecking order theories each seem to play a role in the capital structure decisions of Scandinavian non-financial listed companies.