The pecking order hypothesis: Australian evidence

This paper investigates the pecking order hypothesis, as previously suggested by Donaldson (1961) and further developed by Myers and Majluf (1984). It utilizes accounting information for a sample of 89 listed Australian industrial and commercial companies drawn from the Australian Graduate School of Management CRIF File for the period 1954–82. The pecking order theory suggests that companies display a hierarchy of preferences with respect to funding sources. This is the result of the existence of asymmetric information. Management is assumed to know more about the firm's value than potential investors. This may cause firms to refuse to issue stock, and they may, therefore, pass up valuable investment opportunities. In these circumstances, companies will prefer to fund by retentions; they will avoid new equity issues and their borrowing will be determined as a residual between desired investment and the supply of retained earnings. To avoid passing up favourable investment opportunities they will maintain spare borrowing capacity and financial slack. A number of cross-sectional regression analyses are used to test hypotheses based on the theory which are consistent with US studies by Baskin (1985, 1989). The pecking order theory suggests that there should be a negative relationship in cross-section between company debt ratios and profitability. This is contrary to static capital structure models. This study finds evidence of a significant negative cross-sectional relationship between measures of leverage and previous measures of profitability taken at various intervals. Care is taken to avoid picking up balance sheet relationships in the specification of the regression equations. The above, and further results, are broadly consistent with the pecking order theory and are largely parallel to that of Baskin.