Pecking Order or Trade-off Hypothesis

In this paper we test the pecking order and trade-off hypotheses of corporate financing decisions using a cross-section of the largest Chinese listed companies. We build on Allen (1993) and Baskin (1989) to set up three models in which trade-off and pecking order theories give distinctively different predictions: (1) the determinants of leverage, (2) the relationship between leverage and dividends, and (3) the determinants of corporate investment. In model (1), we find a significant negative correlation between leverage and profitability; in model (2) we find a significant positive correlation between current leverage and past dividends. These results broadly support the pecking order hypothesis over trade-off theory. However, model (3) is inconclusive. Overall, the results provide tentative support for the pecking order hypothesis and demonstrate that a conventional model of corporate capital structure can explain the financing behaviour of Chinese companies. Correspondence to: Guanqun Tong, Department of Economics, Loughborough University, Loughborough, Leicestershire, LE11 3TU, United Kingdom Tel: +44 (0) 1509 222718; Fax: +44 (0) 1509 223910; E-mail:[email protected] † This paper is based on and extends Guanqun Tong’s MSc Dissertation at Loughborough University (Tong 2003). We thank participants in the 2004 EEFS Conference in Gdansk for their helpful comments on an earlier draft of this paper. © Guanqun Tong and Christopher J. Green 2004 All Rights Reserved