Debt Capacity And Debt Financing

Abstract

The pecking order theory of capital structure predicts that firms will finance a significant proportion of their financial deficit (investments + dividends – operating cash flows) with debt capital.  I also hypothesize that the amount of debt financing a firm actually uses is also related to its unused debt capacity.  The empirical analysis in this study confirms that firms follow the pecking order theory in financing their financial deficits.  Further, it is shown that firms with more unused debt capacity finance more of their financial deficits with debt than other firms.  Specifically, the data indicates that firms with the most unused debt capacity finance approximately 50% of their financial deficits with debt while firms with less unused debt capacity finance approximately 25% of their financial deficits with debt.  The data also indicate that a failure to adjust for credit availability in an empirical analysis of financial deficit financing will significantly under estimate the degree to which firms follow the pecking order theory.  It is also confirmed that most firms seem to have a target capital structure but the actual firm debt ratio only reverts to the target at a rate of 5-10% per year.  Additionally, the data also shows that a combination of an investment grade credit rating and relatively low debt outstanding is a better proxy for credit availability than the more commonly used total assets.