Empirical Test Of The Pecking Order Theory: Evidence From The U.S. And China

The pecking order theory of Myers and Majluf (1984) has been considered to be one of the most important branches of modern corporate finance theories. It posits that when the firm needs to finance a project, it will be strictly in accordance with the cost of information from low to high, that is, the firm will follow the pecking order: internal funds, debt issue and equity issue. Since 1990s, much empirical research has been done to test the pecking order theory. However, there is no consensus conclusion. In this paper, we have tested the pecking order theory using the data from public traded firms in the U.S. and China. The results show that the pecking order theory does not explain the financing choice in the real world very well. Equity issuing preference is common in both the U.S. and China. The findings also shed light on an empirical puzzle: small firms-although having the highest potential for asymmetric information-do not behave according to the pecking order theory. We provide a solution to the puzzle from the insider trading perspective. As is shown in Gregoire and Huang(2008), issuing new shares increases the liquidity of a stock and more liquidity trades benefit its insiders since it allows them to trade more aggressively without being detected, thus increasing their trading profits. Therefore, insiders or managers of the small firms have the incentive to issue equity for financing. Finally, we discuss the factors, such as firm size, profitability, bankruptcy risk, growth opportunities, non-debt tax shield, as well as the cost of agent, that impact the financing preference of listed companies in China using the multivariate regression model.