Trade-off theory of capital structure: Evidence from estimations of non-parametric and semi-parametric panel fixed effect models

Abstract

A firm’s capital structure decisions constitute an essential research topic academically and practically. In this study, the author uses the data of US listed firms to test the traditional trade-off theory of capital structure, which posits that firms should balance the benefit of tax shields and costs of financial distress to purse an optimal debt ratio. Therefore, to determine the complex relationship between firm value and debt ratio and avoid the problem of model misspecification, the author adopts the non-parametric fixed effect model and semi-parametric (partially linear) fixed effect model. Our empirical results reveal that a nonlinear and asymmetric relationship exists between firm value and market debt ratio, thus, considerably supporting tradeoff theory. Moreover, the use of different definitions of key variables and various kernel functions engenders robust results. Overall, the author suggests that firm managers should employ financial leverages appropriately to maximize firm value.