A New Test of Capital Structure

We report results of a new test of the financing of large and indivisible projects – arguably the focus of most capital structure theory. We develop a filter that identifies investment spikes in a large population of firms. Consistent with the pecking-order theory we find that projects are predominantly financed with debt, particularly in large and profitable firms. However, we reject the hypothesis that internal finance plays a major role in funding investment. Consistent with the trade-off theory, firms show a strong tendency to revert back to their initial leverage. This pattern of “pecking order in the short run, trade-off in the long run” is consistent with equity adjustment being postponed until certain thresholds are reached. However, we do not find evidence that equity issues are lumpy or infrequent.