Pecking order in the sources of corporate borrowing: Evidence from new debt issues

Vassil Tontchev Mihov, Purdue University

Abstract

This study investigates empirically the factors that determine whether firms borrow from banks and other finance companies versus issuing bonds for sale to the public. I analyze 1,560 new borrowings from banks, non-bank private lenders, and the public debt market by 1,480 U.S. public firms over the period 1995–1996. Using an incremental approach that focuses on new financing decisions, I find that the probability of issuing public debt, relative to both bank debt and non-bank private debt, is positively related to firm size, the ratio of fixed assets to total assets, credit rating and profitability. I interpret these results as consistent with the pecking order theory of corporate financing. According to this theory, a firm facing problems of information asymmetry uses primarily internal funds, and when those are not available issues the security whose value changes least when inside information is revealed to the market—first debt, and only as a last resort, equity. I extend the pecking order hypothesis to the choice between private and public debt: I argue that because private debt is more informed through monitoring and screening, and is usually senior and collateralized, firms with problems of information asymmetry will first borrow privately before issuing public debt. The findings support this prediction. I further extend the literature by distinguishing empirically between bank debt and other private debt. I document that the firms that borrow from private, non-bank sources tend to be poorer performers, have lower credit rating, and higher ex-ante probability of default than bank borrowers. This study also examines the effect of managerial discretion on the borrowing decision. I hypothesize that, when borrowing, managers with low stock ownership will issue public debt to avoid the pressures that private lenders exert on them. Consistent with the hypothesis, firms with lower managerial ownership tend to issue public debt, even after controlling for firm size. Overall, my findings are consistent with the pecking order theory and other theories of debt choice based on monitoring, borrower's reputation, and efficient renegotiation.

Degree

Ph.D.

Advisors

McConnell, Purdue University.

Subject Area

Finance|Banking

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