Testing Trade-Off and Pecking Order Predictions About Dividends and Debt

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The Society for Financial Studies

Testing Trade-Off and Pecking Order Predictions about Dividends and Debt Author(s): Eugene F. Fama and Kenneth R. French Reviewed work(s): Source: The Review of Financial Studies, Vol. 15, No. 1 (Spring, 2002), pp. 1-33 Published by: Oxford University Press. Sponsor: The Society for Financial Studies. Stable URL: http://www.jstor.org/stable/2696797 . Accessed: 16/02/2012 01:28 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

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Testing Trade-Off and Pecking Order Predictions About Dividends and Debt Eugene F. Fama University of Chicago Kenneth R. French Dartmouth College

Confirmingpredictionssharedby the trade-offand pecking ordermodels, more profitable firms and firms with fewer investments have higher dividend payouts. Confirmingthe pecking ordermodel but contradictingthe trade-offmodel, more profitablefirms are less levered. Firms with more investmentshave less marketleverage, which is consistent with the trade-off model and a complex pecking order model. Firms with more investments have lower long-termdividendpayouts,but dividendsdo not vary to accommodateshortterm variationin investment.As the pecking order model predicts, short-termvariation in investmentand earnings is mostly absorbedby debt.

The finance literature offers two competing models of financing decisions. In the trade-off model, firms identify their optimal leverage by weighing the costs and benefits of an additional dollar of debt. The benefits of debt include, for example, the tax deductibility of interest and the reduction of free cash flow problems. The costs of debt include potential bankruptcy costs and agency conflicts between stockholders and bondholders. At the leverage optimum, the benefit of the last dollar of debt just offsets the cost. The tradeoff model makes a similar prediction about dividends. Firms maximize value by selecting the dividend payout that equates the costs and benefits of the last dollar of dividends. Myers (1984) develops an alternative theory known as the pecking order model of financing decisions. The pecking order arises if the costs of issuing new securities overwhelm other costs and benefits of dividends and debt. The financing costs that produce pecking order behavior include the transaction costs associated with new issues and the costs that arise because of management's superior information about the firm's prospects and the value of its risky securities. Because of these costs, firms finance new investments first with retained earnings, then with safe debt, then with risky debt, and finally, under duress, with equity. As a result, variation in a firm's leverage

of and We gratefully the Harvey editor). (the (the acknowledge comments JohnGraham referee) Campbell of 1101East to F. Graduate Schoolof Business, Address University Chicago, correspondenceEugene Fama, IL 58thSt., Chicago, 60637,or e-mail: eugene.fama@gsb.uchicago.edu. The Review of Financial Studies Spring 2002 Vol. 15, No. 1, pp. 1-33

? 2002TheSocietyforFinancial Studies

The Review of Financial Studies / v 15 n 1 2002

is driven not by the trade-off model's costs and benefits of debt, but rather by the firm's net cash flows (cash earnings minus investmentoutlays). We test the dividend and leverage predictions of the trade-off and pecking order models. Our menu is...
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