Role of financial hierarchy and trade-off therories in capital structure decisions: An empirical analysis of BIST companies

The aim of this study is to determine the validity of Financial Hierarchy theory in determining the capital structures of companies in Turkey, employing a panel of companies listed in the BİST throughout 1994-2015, and compare the findings with the implications of Trade-off theory. Financial Hierarchy theory predicts that firms will follow a pecking order in their financing preferences, based on the level of information asymmetry inherent in these financial sources; hence internal financing is preferred over external financing. If needed, firms issue debt securities first, then equity, as a last resort. A three-step analysis is carried out employing one of the dynamic panel estimator methods, generalized method of moments' system version (System GMM). System GMM is believed to help overcome endogeneity and heterogeneity problems of panel data via a more direct method. First, the implied positive relationship between debt level and financial deficit, which is the inadequacy of internal funds for investments and dividend commitments, is tested. The coefficient of the financial deficit is found positive and 0.4, at 1% significance level. Next, when separate effects of financial deficit and surplus on borrowing decisions are allowed for, the positive coefficient of the financial deficit increases (0.7). However, contrary to the predicaments of Financial Hierarchy theory, Turkish firms do not pay down debt when they have a surplus of internal funds. Finally, based on reliably important factors that determine the level of borrowing, the effects of firm characteristics and industry leverage ratios on firms' debt levels were analyzed. Profitability and firm size negatively affect debt levels, while growth opportunities have a positive effect, as predicted by the Financial Hierarchy theory. Tangibility was not significant. Keywords: Capital Structure, Financial Hierarchy, Trade-off