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Traditional theories of capital structure: trade-off versus pecking order

Published on October 7, 2014 Reviewed on December 29, 2016   38 min

A selection of talks on Finance, Accounting & Economics

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0:00
My name is Vidhan Goyal, I am a Professor of Finance, at the Hong Kong University of Science and Technology. And today, I will be talking about "Traditional Theories of Capital Structure: Trade-off versus Pecking Order".
0:13
This talk looks at, how firms make their financing decisions? How do they choose their capital structures? How do they decide between the mix of financing? How much debt and how much equity to have? And the deeper question that we are asking here is, why have firms got into where they are? Whether firms did so because they wanted to save on taxes, avoid showing equity, retain financial flexibility, time the market, etc. So really what we are interested in learning is, why do firms make those choices that they do make? What's driving their financing decisions?
0:48
Let me show you some data. Here is a plot of how leverage looks for US firms over a long period of time. So what we are plotting here is the ratio of debt over debt plus equity for US firms over the 1971-2013 period. Now one thing you would notice from the plot is that the average leverage of US firms appears fairly stationary. The average is about 36%. It doesn't explode, it doesn't go down a lot, it doesn't go up a lot. It stays around close to 35%-36% and that's the average for US firms. The median firm has about 30% debt, 70% equity so they are roughly... you know, using one-third debt financing to finance their assets, and two-thirds equity. So in general, leverage appears to be fairly conservative, roughly two out of every five firms have an average debt to capital ratio of less than 20%. So a lot of US firms appear to be... what some people would say under levered or have little debt and a lot of equity. But in general, firms do use some debt. Most typical firms use a lot of debt, but not nearly enough.

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