AN EMPIRICAL INVESTIGATION OF THE TRADE-OFF AND PECKING ORDER HYPOTHESES ON ROMANIAN MARKET

Abstract: Starting with the seminal work of Modigliani and Miller (1958, 1963), a growing attention has been given to the manner in which firms adjust their capital structure. When firms adjust their capital structure, they tend to move toward a target debt ratio which is consistent with trade-off theory. According to the trade-off hypothesis profitable firms should have a high level of debt ratio. Contrary to the trade-off hypothesis, the pecking order theory based on information asymmetry predicts a negative correlation be-tween profitability and leverage. We test the aforementioned hypotheses on a sample of non- financial Romanian firms, listed on the Bucharest Stock Exchange from 2005 to 2007. Using a panel data analysis, we found that pecking order theory could be successfully applied to the Romanian market. As the pecking order theory predicts, the Romanian profitable firms with a high proportion of tangible assets have a lower debt ratio.

1. Introduction
In the finance literature there are two main capital structure theories which emerged from reflections on Modigliani and Miller (1958) theorem. Firstly, trade-off theory states that firms select optimal capital structures by trading off various benefits of debt financing against financial distress costs (Kraus & Litzenberger, 1973). The benefits of debt include, for example, the tax deductibility of interest and the reduction of free cash flow problems, while the financial distress costs refer to the costs of bankruptcy or reorganisation, and also to the agency costs that arise because of conflicts between stockholders and bondholders.
Secondly, Myers (1984) developed an alternative theory known as the pecking order theory. This theory is focused on asymmetric information costs and transaction costs associated with new stock issues. Because of these two aforementioned costs, firms finance new investments first with retained earnings, then with safe debt, then with risky debt and finally with equity.
Based on these assumptions, various researchers proposed theoretical models (Jensen and Meckling, 1976; Myers, 1977; DeAngelo and Masulis, 1980; Rajan and Zingales, 1995) in order to explain capital structure decisions across companies and countries and provided empirical support to the application of the models in the real economic world. However, the empirical evidence, especially for European countries, could not keep up with the pace of theoretical developments because of the insufficient data for non-US enterprises and the lack of appropriate econometric methods (Drobetz and Wanzenried, 2006).

We test the prediction of the trade-off theory which state that the large, safe and profitable firms with tangible assets tend to borrow more than small, risky firms with mostly intangible assets and the prediction of the pecking order theory about the negative correlation between leverage and profitability. Our purpose is to determine whether capital structure determinants for Romanian firms support one of the theories of capital structure.
The remainder of the paper is organized as follows. Section 2 summarizes the predictions of trade-off and pecking order theories. Sections 3 and 4 present the variables of the designed model, the data used in order to test the model and the empirical results. Section 5 presents the conclusions of this study.

2. Capital structure theories

Our approach of the trade- off and pecking order theories largely focuses on the determinants of capital structure, more specifically on predictions of how leverage varies with these determinants.

2.1. The trade-off theory

The trade-off theory predicts that firms maintain a target debt-equity ratio that maximizes firm value. The earliest version of this theory was elaborated by Kraus and Litzenberger (1973) and states that the optimal debt-equity ratio balances the corporate tax advantages of debt against the cost disadvantages of bankruptcy. According to Myers (1984), a firm that follows the trade-off theory sets a target debt ratio and then gradually moves towards target. The target debt ratio is determined by balancing debt tax shields against costs of bankruptcy.
The agency models are based on the assumptions of the trade-off theory. According to agency models of Jensen and Meckling (1976) and Jensen (1976), the interests of managers are not aligned with those of security holders, and managers tend to waste free cash flow on perquisites and bad investments. In order to control the agency costs created by free cash flow, firms with more profitable assets in place use a large fraction of their earnings to debt payments. Thus, controlling for investment opportunities, the leverage is positively related to profitability. The underinvestment and asset substitution problems, which arise when debt is risky and the stockholder-bondholder agency problem exists, lead to the prediction that firms with more investments have less leverage (Jensen and Meckling, 1976; Myers, 1977).

In conclusion, the trade-off theory of optimal capital structure has strong commonsense appeal (Myers, 2001). It predicts that large firms with tangible assets tend to borrow more than small, risky firms with mostly intangible assets, and firms with more profitable assets in place, fewer investments, less volatile earnings and net cash-flow have higher leverage.

2.2. Pecking order theory

The pecking order theory of Myers and Majluf (1984) and Myers (1984) is based on the assumption that a firm having assets-in-place and a growth opportunity requires additional equity financing. Myers and Majluf (1984) assumed that a firm is undervalued because managers have, but cannot reveal, information concerning new and existing investment opportunities. Investors are aware of this asymmetric information problem, and they discount the firm's new and existing risky securities when stock issues are announced. On the other side, managers avoid issuing undervalued securities by financing projects with retained earnings and with low -risk debt.

Myers (1984) suggested that the costs of issuing risky debt or equity overwhelm the forces that determine optimal leverage in the trade-off model. The result is the pecking order model, which states that firms finance investments first with retained earnings, then with safe debt, then with risky debt, and finally, with equity. According to pecking order theory, more profitable firms borrow less, because they have more internal financing available and the less profitable firms require external financing, and consequently accumulate debt. 2.3. Testing the pecking order theory vs. the trade-off theory
Some authors found instructive to compare the time-series predictions of the pecking-order and trade-off theories (Shyam-Sunder and Myers, 1999; Hovakimian, Opler and Titman, 2001; Fama and French, 2002).

Shyam-Sunder and Myers (1999) tested the predictions of these two aforementioned theories on a panel of 157 firms from 1971 to 1989. They found that the pecking order theory offers the best explanation of the financing behaviour of the firms in their sample. The authors also established that the target debt ratio, if exists, is followed only by a few managers. Using a large sample of firms from 1979 to 1997, Hovakimian, Opler and Titman (2001) found references for the validity of the trade-off theory because the financing behaviour of the firms included in the sample demonstrates the existence of a target capital structure. The results show that profitable firms have a lower leverage than less profitable firms. In addition, these authors found that the pecking order theory can also explain the short-term financing behaviour of firms.

AN EMPIRICAL INVESTIGATION OF THE TRADE-OFF AND PECKING ORDER HYPOTHESES ON ROMANIAN MARKET

The empirical study of Fama and French (2002) realized on a large panel of firms from 1965 to 1999 reveals support for both theories, but these run also into serious difficulties. Thus, the trade-off theory fails to explain the significant negative correlation between profitability and leverage, while the pecking order fails to explain the heavy reliance on equity issues by small growth firms. The authors found that the pecking order theory works best for dividend-paying firms, which tend to be larger and more conservatively financed.
3. Variables of the model 3.1. The dependent variable
The main differences among leverage proxies concern the use of book values versus market values and total debt versus only long term debt. Because of data limitations, we use the book values rather than market values. Also, because most of the existing studies focus on a single measure of leverage and the

most common measure of debt is total debt, we define the financial leverage D as the ratio between the book value of total debt and the book value of total debt plus the book value of shareholder's equity (Rajan and Zingales, 1995; De Miguel and Pindado, 2001; Nivorozhkin, 2005).

3.2. The explanatory variables

We select the explanatory variables which affect the target leverage of firms based on the assumptions of trade-off and pecking order theories of capital structure and on previous empirical work in this area.
The first explanatory variable is tangibility (TANG) calculated as the ratio between tangible fixed assets and total assets (
TanA

). Tangible assets serve as collateral and the importance of collateral is greater

TA

for newly established businesses with no close ties to creditors. This hypothesis suggests a positive relationship between tangibility and leverage. Indeed, the results for developed countries (Rajan and Zingales, 1995; Titman and Wessels, 1988) confirm this hypothesis. In transitions economies, the importance of tangible assets as collateral is limited by a number of factors (underdeveloped and inefficient legal systems, illiquid secondary market) and a negative relationship between leverage and tangibility has been found in some previous studies (Cornelli et al., 1998; Nivorozhkin, 2002). Based on the aforementioned arguments, we expect to find a negative relationship between leverage and tangibility.

Another determinant of optimal capital structure used in many studies (Titman &Wessels, 1988; Rajan & Zingales, 1995; Nivorozhkin, 2005) is the firm's size. Large firms are more likely to be debt-financed in comparison with smaller firms and that is because of several reasons. One of the reasons is mentioned by Rajan and Zingales (1995) who suggested that larger companies tend to be more diversified and, thus, less prone to bankruptcy. Another reason is stipulated by the pecking order hypothesis which states that larger firms exhibit lower information asymmetry with financial markets and therefore they are able to issue more equity compared to small companies. The positive relationship between the size of a firm and its leverage may be reinforced in transition economies. Larger companies may get a favourable treatment from the creditors and there is also some evidence that banks in most of the transition countries prefer to deal with larger clients. In Romania, the firm size (SIZE) can be measured either through the number of employees or through net sales. Because the net sales are a more appropriate proxy for our goal, we use the natural logarithm of net sales (ln (NS)) and predict a positive relationship between size and debt targets. The theories of capital structure state that market imperfections lead to the relevance of a firm's profitability (PROF) for its choice of leverage. The pecking order theory predicts that more profitable firms will have a lower debt ratio. In contrast to the pecking order theory, the static trade-off theory predicts a positive relationship between leverage and profitability, because higher profitability implies more income to shield. Following Rajan and Zingales (1995) and Nivorozhkin (2005) method, we use the ratio of earnings before interest and taxes to total assets (
EBIT

) for company profitability and expect to

TA

find a negative relationship between leverage and profitability.

Myers (1977) observed that high growth firms may hold more options for future investments than low growth firms. This statement is congruent with the pecking order theory, which argues that high growth firms should use less debt for financing. Furthermore, according to the trade-off theory, firms with great growth opportunities (GROW) tend to borrow less than firms holding more tangible assets, because

growth opportunities cannot serve as tangible assets. Similar to other studies (e.g. Barclay and Smith, 1995; Rajan and Zingales, 1995), we define this proxy as the ratio of book value of total assets minus the book value of equity plus the market value of equity to the book value of total assets.

5. Conclusions
In this paper, we examined the trade-off and pecking order hypotheses using a sample of 31 Romanian listed companies. According to trade-off theory, large firms with tangible assets tend to borrow more than small, risky firms with mostly intangible assets, and firms with more profitable assets in place, fewer investments, less volatile earnings and net cash-flow have higher leverage. The pecking order hypothesis predicts a negative correlation between leverage and profitability of the firms. The empirical findings suggest that there is a difference between capital structure choices for companies in Romania and in developed countries. The negative relationship between leverage and tangibility might be explained by the lack of long -term debt financing and contradicts the predictions of the trade-off theory. More profitable companies had less debt, because these firms use, first of all, internally generated funds and debt as last resort. This result is compatible with the pecking order theory and contradicts the trade-off theory. The relationship between leverage and company size is a positive one and provides some indication about the credit policy in Romania. Thus, banks give more credits to the large firms, because these are more credible. The coefficient for growth opportunities is not statistically significant, which means that either the proxy of this factor was not appropriate or this determinant does not influence the capital structure of the sample of Romanian firms.

Therefore, we can conclude that the pecking order theory is more appropriate to explain the financial decisions of the Romanian floating firms compared to trade-off theory.

114