The static trade off theory attempts to explain the optimal capital structure in terms of the balancing act between the benefits of debt (tax shield from interest deduction) and the disadvantage of debt (from the increased expected bankruptcy costs). The tax shield benefit is the corporate income tax rate multiplied by the market value of debt and the expected bankruptcy costs are the probability of bankruptcy multiplied by the estimated bankruptcy costs. The pecking order theory is the preferred, and empirically observed, sequence of financing type to raise capital. That is, firms first tap retained earnings (internal equity) finance, second source is debt and the last source is issuing new common stock shares (external equity). The empirical evidence of non-financial firm debt ratios coupled with the decision making process of top management and the board of directors point to greater adherence to the pecking order theory.

Based on empirical findings around the world, both the static trade-off and the pecking order theories are evident in capital structure decision making. However, dynamic trade-off and market timing theories are also evident in some capital structure decision making. It is possible that one single theory cannot explain capital structure decision making.

It really depends on the economy (firms) you are analyzing. There is really no definitive answer. In addition, this is why different researchers use different variables in explaining the capital structure decision of firms within and across countries.

It's a little complicated to pinpoint with great precision. There is evidence in the recent capital structure literature raving about  non-mutual exclusiveness between these theories, The trade-off and information based theories. I further suspect it all depends in a lot of firm specific and institutional factors reflecting macro level conditions in the economy. The choice whether firms follow trade off or information based theories depends on the quality of the stock market firms operate in and of course firm unique condition such as creditworthiness,type of assets held,size of tangible and quantity and quality of intangible assets just to mention a few. Oftentimes ,in high growth prospect , semi-efficient and inefficient capital markets information based theories tend to outclass trade-off theories. Not to mention,there is no definite proxy for such theory tests.

HI,

You could add to the list  the "market timing " theory of Baker and Wurgler (2002) JF and have a look at this paper:

G S Chauhan, F Huseynov, "Corporate financing and target behavior: New tests and evidence", Journal of Corporate Finance, 2017 Forthcoming.

Best regards.

Dear Marlon,

I find your question very interesting.

I agree with all previous comments. Both theories (PoT and ToT) have found empirical support (Fama and French, 2002). 

I also suggest to read: Chang, X., and Dasgupta, S. (2009). Target behavior and financing: how conclusive is the evidence?. The Journal of Finance, Volume 64, Issue 4, pp. 1767–1796; and Frank, M.Z., and Goyal, V.K. (2009). Capital Structure Decisions: Which Factors Are Reliably Important?, Financial Management, Volume 38, Issue 1, pp. 1-37.   

Greetings,

Fabrizio

HI,

We can also speak about pecking order for equities only!

A pecking order of shareholder structure

Journal of Corporate Finance,  June 2017, Pages 1-14

Fuxiu Jiang, Kenneth A. Kim, John R. Nofsinger, Bing Zhu

Best regards