Pecking order and trade-off explanations of capital structure and the maturity structure of corporate debt obligations

It is shown i) that the under-investment problem is caused by the debt-equity mix of the financing rather than the investment itself and that a transfer of value (from shareholders to debt-holders) can be reversed by a post-investment adjustment in capital structure that restores the pre-investment gearing ratio. This simple, low-cost solution is preferable to reducing debt maturity (as in Myers (1977)) or gearing; ii) that transfers in value from debt-holders to shareholders to promote over-investment are not sustainable since investors will seek to avoid being disadvantaged by demanding higher returns, greater restrictions on the company or both; and that information asymmetry that restricts the issue of new shares can be managed by using several alternatives such as bridge financing in ways that remove the rationale for the pecking order theory; and iii) that managers have incentives to engage in empire building which is facilitated by a capital structure that reflects the degree of concentration among the other companies in the sector: faced with a low (high) degree of concentration, companies have lower (higher) gearing. The implications of these outcomes are empirically investigated using an extensive sample and robust estimating procedures providing strong support for the hypotheses tested.