Trade-Off and Pecking Order Theories of Debt

This chapter reviews the theories of taxes, bankruptcy costs, transactions costs, adverse selection, and agency conflicts and the related evidence and identifies a number of important empirical stylized facts. The empirical literature supports a number of generalizations that appear to be robust and particularly important for an understanding of actual leverage. To draw attention to these key facts, this chapter highlights these generalizations using the label "stylized fact." To understand the evidence, it is important to recognize the differences among private firms, small public firms, and large public firms. Private firms use retained earnings and bank debt heavily; small public firms make active use of equity financing; and large public firms primarily use retained earnings and corporate bonds. The available evidence can be interpreted in several ways. Direct transaction costs and indirect bankruptcy costs appear to play important roles in a firm's choice of debt. The relative importance of the other factors remains open to debate. No currently available model appears capable of simultaneously accounting for all of the stylized facts.