According to the trade-off theory, optimal capital exists that maximizes firm value. Conversely, in pecking order theory, there is no optimal capital structure. Instead, firms follow a financing hierarchy. Is it logical to test or discover the relation of pecking order theory and trade-off theory in firm value? If it is logical, how do I jointly test the two theories in relation to firm value in one model? Your contribution is welcomed and it will be acknowledged accordingly.
I would suggest running firm value as the dependent variable and debt-equity ratio as the independent variable. Also, I would have included a squared term for the debt-equity ratio to identify any non-linear relationship. The independent variables will at least show what is the optimal debt-equity ratio in your sample.
When it comes to the pecking order, to see if firms only issue equity as a last resort, I would put "amount of debt issued by firms" as the dependent variable and "funds flow deficit" as the independent variable. Here the funds flow deficit, is the funds needed for things like dividend payments, capital expenditure etc. The Pecking order theory states that when internal funds is not available (a fund deficit) firms will use debt, and issue equity as a last resort only. Hence, the coefficient on "funds flow deficit" should equal 1. If this is not the case, the theory does not hold in your sample.
An interesting paper on this topic is "Testing static tradeoff against pecking order models of capital structure" by Shyam-Sunder and Myer, http://pages.stern.nyu.edu/~eofek/PhD/papers/SM_Testing_JFE.pdf
Hope this helps at least a bit..
from my point of view 1) you should study papers regarding the model, 2) I suggest you adding cash flow in the model where debt-equity ratio is independent variable and firm variable is dependent. How do you mesure firm value? Debt-euqity ratio ought to be tested if there is leverage effect or leverage risk, i.e. if costs of financial difficulties have not emerged. In other words if the company (companies) have enough cash flow to be able to pay off all liabilities on time. 3) I advise you test all assumption regarding the model you would use
Thank you Wang and Kravec for your inputs. I find your inputs informative. For this particular research, I intend to use Tobin's Q as a proxy for firm value.
You have to consider another theory: the market timing hypothesis (Wurgler and Baker, 2002,JF). Moreover you have to take into account the leverege target ratio hypothesis (Byoun 2008, JF).
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