Capital Structure and Financing Choices in Australia

Abstract

We use a modified pecking order framework to analyse financing choices for Australian firms. The traditional pecking order model has been extended to allow a non-linear relationship between a firm’s requirements for external capital (the financial deficit) and the amount of external debt used to meet these requirements. The pecking order theory predicts that firms will follow a defined hierarchy of financing choices with internal funds being used first, followed by external debt and as a last resort the issuance of external equity. Our main finding is that Australian firm’s do not follow the pecking order as closely as in other markets as the model explains less of the variation in debt issuance. Importantly, we find that this is not related to debt capacity constraints, which has been hypothesized by other researchers as a legitimate reason why firms, small firms in particular, would not appear to be following the pecking order theory. We use Altman’s Z-Score, which is a commonly used measure of financial distress, to identify firms that are relatively unconstrained in terms of debt capacity. We also find that while controlling for debt capacity does improve the explanatory power of our model, the improvement is only marginal. We do find evidence against the static trade-off theory of capital structure. In particular firms that are unconstrained in terms of debt capacity and not facing significant capital expenditure do not increase leverage towards an optimal capital structure in the manner predicted by the static trade-off theory.