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An Empirical Assessment of the Reality of Pecking Order Theory

Growing Presence of Real Options in Global Financial Markets

ISBN: 978-1-78714-838-3, eISBN: 978-1-78714-837-6

Publication date: 27 November 2017

Abstract

The main objective of this study is to examine whether firms follow the financing hierarchy as suggested by the Pecking Order Theory (POT). The External Funds Needed (EFN) model offers a financing hierarchy that can be used for examining the POT. As far as the EFN considers growth of sales as a driver for changing capital structure, it follows that shall firms plan for a sustainable growth of sales, a sustainable financing can be reached and maintained. This study uses data about the firms listed in two indexes: Dow Jones Industrial Average (DJIA30) and NASDAQ100. The data cover quarterly periods from June 30, 1999, to March 31, 2012. The methodology includes (a) cointegration analysis in order to test for model specification and (b) causality analysis in order to show the generic and mutual associations between the components of EFN. The results conclude that (a) in the majority of the cases, firms plan for an increase in growth sales but not necessarily to approach sustainable rate; (b) in cases of observed and sustainable growth of sales, firms reduce debt financing persistently; (c) firms use equity financing to finance sustainable growth of sales in the long run only, while in the short run, firms use internal financing, that is, retained earnings as a flexible source of financing; and (d) the EFN model is quite useful for examining the hierarchy of financing. This study contributes to the related literature in terms of utilizing the properties of the EFN model in order to examine the practical aspects of the POT. These practical considerations are extended to examine the use of the POT in cases of observed and sustainable growth rates. The findings contribute to the current literature that there is a need to offer an adjustment to the financing order suggested by the POT. Equity financing is the first source of financing current and sustainable growth of sales, followed by retained earnings, and debt financing is the last resort.

Keywords

Citation

Eldomiaty, T.I., Azzam, I., El Din, M.B., Mostafa, W. and Mohamed, Z. (2017), "An Empirical Assessment of the Reality of Pecking Order Theory", Growing Presence of Real Options in Global Financial Markets (Research in Finance, Vol. 33), Emerald Publishing Limited, Leeds, pp. 43-73. https://doi.org/10.1108/S0196-382120170000033004

Publisher

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Emerald Publishing Limited

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