Trade-off theory vs. the pecking order hypothesis: Japanese evidence on capital structure under financial constraints

• This empirical research paper presents the biggest study as yet on capital structure in Japan • A horse race is conducted between the trade off theory and the pecking order hypothesis. • This study contributes to the literature by considering the important Japanese case, and testing for the sensitivity of macroeconomic factors, namely the structural shift from a high growth to a low growth economy • This is the first paper to take into consideration the effect of monetary conditions and financial constraints on the performance of these two theories. • The data set used includes 1528 public and 2143 private companies and covers the period of 1980-2007, thus using 60,037 data points. • The trade-off theory works best for companies with low levels of leverage while the pecking order hypothesis performs best for private companies and companies with high levels of leverage. • The findings add to the growing capital structure literature and demonstrate, among other results, that macroeconomic growth as well as credit supply factors should not be neglected. This paper investigates the explanatory power of the two predominant theories in the area of capital structure, the trade-off theory and the pecking order hypothesis, in accounting for financial policy decisions of Japanese corporations. This is achieved through the use of a “horse race” test similar to the one utilized in the seminal papers of Shyam-Sunder and Myers (1999) and Frank and Goyal (2009). This is the first paper to take into consideration the effect of monetary conditions and financial constraints on the performance of these two theories. The data set used includes 1528 public and 2143 private companies and covers the period of 1980-2007, thus using 60,037 data points. Our findings show that economic conditions affect the performance of the two models. The pecking order hypothesis works best during the high growth period of the 1980s while the trade-off theory is the best performer during the stagnant growth period of the 1990s and the subsequent credit crunch. Our results also show that the explanatory power of these two theories varies for different groups of firms. The trade-off theory works best for companies with low levels of leverage while the pecking order hypothesis performs best for private companies and companies with high levels of leverage.