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This paper contrasts the "static tradeoff" and "pecking order" theories of capital structure choice by corporations. In the static tradeoff theory, optimal capital structure is reached when the tax advantage to borrowing is balanced, at the margin, by costs of financial distress. In the pecking order theory, firms prefer internal to external funds, and debt to equity if external funds are needed. Thus the debt ratio reflects the cumulative requirement for external financing. Pecking order behavior follows from simple asyninetric information models. The paper closes with a review of empirical evidence relevant to the two theories.

This paper tests traditional capital structure models against the alternative of a pecking order model of corporate fmancing. The basic pecking order model, which predicts external debt fmancing driven by the internal fmanciai deficit, has much greater explanatory power than a static trade-off model which predicts that each firm adjusts toward an optimal debt ratio. We show that the power of some usual tests of the trade-off model is virtually nil. We question whether the available empirical evidence supports the notion of an optimal debt ratio.