The dynamic specification of the modified pecking order theory: Its relevance to Italy

Abstract.

This paper proposes an empirical model for the modified pecking order theory (MPO) in which both trade-off (TO) and pecking order (PO) models are nested. The MPO model is specified as an error-correction mechanism and applied to a vast panel data-set. Unlike previously estimated financial models, it avoids a number of problems: the mis-specification of dynamics, the approximation of the target leverage using the historical mean, the constrained estimation of the free cash flow components in a unique parameter. The MPO model is particularly good at explaining “hybrid” systems (neither market-based nor bank-based) such as the Italian one, in which companies are a mixture of two types: TO-type firms with a long-term optimal debt ratio towards which they converge; PO-type firms for whom the short-term availability of internal funds for investment may interfere with the process of adjustment towards the target leverage. Finally, the MPO model enables us to separately test the individual relevance of each of the restricted (“pure”) TO and PO models: results confirm their mis-specification and clearly point towards the excellent empirical performance of the MPO model.