To have a target debt ratio or not: What difference does it make?

The static tradeoff theory of capital structure predicts that firms aim to approach a target debt ratio. The theory provides several firm characteristics that determine this target ratio. In contrast, the pecking order model rejects a target debt ratio, because firms are expected to finance investments subsequently from (internal) equity, debt and (external) equity. A fundamental problem in empirical studies is that having a target debt ratio or not is unobservable from public data. We use survey evidence from 235 Chief Financial Officers (CFOs) to discriminate static tradeoff firms from pecking order firms and relate the responses to public data. For the two sets of firms we estimate standard capital structure models and find that pecking order firms contaminate static tradeoff theory-based estimations.

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