A New Test of Capital Structure Theory

This paper reports a new test of capital structure theories using a filtering technique to identify large investment projects. Contrary to the results of aggregate studies, firms respond to investment spikes by raising la rge amounts of external finance. Large firms raise debt finance and small firms issue new equity. These results run counter to predictions of the pecking order theory. New equity does not come higher up the pecking order either in relation to specific investments or over the life cycle of firms. We also reject a static version of the trade-off theory by which the financing of new investment is determined by invariant characteristics of firms. However, we find support for a dynamic version of the theory in which firms adjust to target levels of leverage both during and after investment projects. We provide evidence that the reason why a dynamic rather than a static version of the theory prevails is that firms face constraints in their choice of finance.