Pecking Order as a Dynamic Leverage Theory

This paper and its sequel (Financial Leverage Strategy with Transaction Costs, Applied Mathematical Finance 3, 1996, 191-208) pick up the pecking order leverage theory where it was left in 1984 by Stewart Myers (JF v.39) and his joint paper with Nicolas Majluf (JFE v.13). Static tradeoff theories, which do not explicitly treat the impact of transaction costs, do not explain the asymmetry between frequent small debt transactions and infrequent large equity transactions. Nor do they explain why the debt ratio is allowed to wander a considerable distance from its alleged static optimum, or how much of a distance should be tolerated. We offer a class of diffusion models that mimic this behavior in a stochastic-dynamic framework and are designed to optimize a financing strategy in combination with various static tradeoff theories. The models developed reveal the determinants of the size and frequency of equity transactions and the range of values over which leverage variations should be tolerated in four generic scenarios. They also yield a new formulation of the cost of capital that recognizes stochastic transaction costs and a penalty for deviation from any static-optimal leverage. These models augment the pecking order theory by providing a flexible quantitative framework for its implementation as a decision tool, and by facilitating the formulation of additional hypotheses for its empirical validation. Moreover, results presented have important implications for the role played by static tradeoff theories in a stochastic-dynamic framework. One implication is that the static-optimal leverage has no immediate effect on the firm's leverage policy: The target leverage for refinancing transactions is different from the static-optimal leverage and the mean leverage is generally different from both. As a consequence, the latter cannot be used to estimate the former. Another implication is that, even when the mean leverage equals the static optimum, mean reversion is not an optimal behavior and therefore not a legitimate test for the existence of a static tradeoff in a dynamic context. Still another implication is that wide variations in leverage ratios cannot be interpreted as evidence of leverage indifference