Abstract for: Testing Pecking Order Theory and Trade-off Theory - A System Dynamics Approach

The fundamental objective of this paper is to present a dynamic framework to test the two competing theories; the Pecking Order Theory (POT) and the Trade-off Theory (TOT); that explain the capital structure behavior of firms. For this purpose we use System Dynamics (SD) method to develop a generic simulation model of a manufacturing firm based on generally accepted accounting principles. We model the capital structure decision conforming to POT and TOT to test the two competing theories, in isolation and in combination. The firms may pursue POT or TOT for their capital structure decision, but it is generally agreed that while doing so their prime objective is to maximize the firm value. Hence we presume that the managers stick to the core objective of firm value maximization. Literature generally suggests the two competing theories as substitutes. We, however, demonstrate the firms following synergy of the two theories would outperform the firms following two theories independently in their pursuit of firm value.