Relevance of Pecking Order and Trade-Off Theories in Financial Decision Making: Empirical Evidence in the Sri Lankan Companies

D. M. S. B. Dissanayake

Abstract: This study tests the relevance and the applicability of pecking order theory and trade-off theory in financial decision making using 232 companies and 1624 balanced panel data finance and Non- financial firms for the period of 2011-2017 listed in the Colombo Stock Exchange (CSE). Pecking order theory explains that there is not a well-defined debt equity target, and there two kinds of equity, internal and external, one at the top of the pecking order and one at the bottom. Trade-off theory identifies the optimal debt-to-equity ratio as the level at which the cost of two offset each other. This study uses the pool regression, fixed effect and random effect models. Profitability, Tangibility, Firm size, Growth opportunity and Non-debt tax shield were used as independent variables, while leverage was the dependent variable. The study finds both theories are relevant and pecking order theory is more applicable in Sri Lankan companies.

Keywords: Financial Decisions, Capital structure, Leverage, Trade-off Theory, Pecking Order Theory