424 R.S.Chirinko.A.R.Singha Journal of Financial Economics 58 (2000)417-425 Pecking Order Model based on Eq.(1)are tests of the joint hypothesis of ordering(the financial hierarchy)and proportions(equity issues constitute a low percentage of external financing). Even if one maintains a favorable assumption about the proportion of equity finance,tests based on Eq.(1)are unable to detect situations where the ordering hypothesis is violated.The key empirical prediction of the Pecking Order Model is that equity issues,if they occur at all,are at the bottom of the financial hierarchy.Unfortunately,the ability of Eq.(1)to identify this financing pattern against relevant alternatives is limited.Consider a situation in which equity issues are in the middle of the financial hierarchy;for example,firms rely initially on internal funds,but then issue equity before issuing debt.Such a situation might occur if there are hidden costs to debt or hidden benefits to equity that have not yet been identified by researchers.This convoluted financial hierarchy is depicted in Fig.3,where we again assume that 11%of DEF is met by equity issues.This financing pattern is strongly at odds with the Pecking Order Model, and should be rejected by the test based on Eq.(1).However,the least squares estimate of bpo is 0.99,a result suggesting incorrectly that the Pecking Order Model is valid. Lastly,consider a third case in which debt and equity are always issued in fixed proportions,as might arise if there exists an optimal debt/equity ratio.In this case,each dollar of DEF is financed by $0.89 of debt,and this financing pattern is represented by a straight-line emanating from the origin with a slope of 0.89.Estimating Eq.(1)on this series of debt issues would result in bpo =0.89 and an R2=1.0,thus leading to the incorrect inference that this financing pattern is consistent with the Pecking Order Model. In sum,these three situations highlight serious difficulties with using Eq.(1)to evaluate the Pecking Order Model.Our results,coupled with the power prob- lem with the Static Tradeoff Model documented by Shyam-Sunder and Myers, indicate that their empirical evidence can evaluate neither the Pecking Order nor Static Tradeoff Models.Alternative tests are needed that can identify the determinants of capital structure and can discriminate among competing hypotheses. References Modigliani,F..Miller,M.,1958.The cost of capital,corporation finance and the theory of investment.American Economic Review 48,261-297. Myers,S.C,1977.Determinants of corporate borrowing.Journal of Financial Economics 5. 147-175. Myers,S.C,Majluf,N..1984.Corporate financing and investment decisions when firms have information investors do not have.Journal of Financial Economics 13, 187-221.Pecking Order Model based on Eq. (1) are tests of the joint hypothesis of ordering (the "nancial hierarchy) and proportions (equity issues constitute a low percentage of external "nancing). Even if one maintains a favorable assumption about the proportion of equity "nance, tests based on Eq. (1) are unable to detect situations where the ordering hypothesis is violated. The key empirical prediction of the Pecking Order Model is that equity issues, if they occur at all, are at the bottom of the "nancial hierarchy. Unfortunately, the ability of Eq. (1) to identify this "nancing pattern against relevant alternatives is limited. Consider a situation in which equity issues are in the middle of the "nancial hierarchy; for example, "rms rely initially on internal funds, but then issue equity before issuing debt. Such a situation might occur if there are hidden costs to debt or hidden bene"ts to equity that have not yet been identi"ed by researchers. This convoluted "nancial hierarchy is depicted in Fig. 3, where we again assume that 11% of DEF is met by equity issues. This "nancing pattern is strongly at odds with the Pecking Order Model, and should be rejected by the test based on Eq. (1). However, the least squares estimate of b PO is 0.99, a result suggesting incorrectly that the Pecking Order Model is valid. Lastly, consider a third case in which debt and equity are always issued in "xed proportions, as might arise if there exists an optimal debt/equity ratio. In this case, each dollar of DEF is "nanced by $0.89 of debt, and this "nancing pattern is represented by a straight-line emanating from the origin with a slope of 0.89. Estimating Eq. (1) on this series of debt issues would result in b PO"0.89 and an R2"1.0, thus leading to the incorrect inference that this "nancing pattern is consistent with the Pecking Order Model. In sum, these three situations highlight serious di$culties with using Eq. (1) to evaluate the Pecking Order Model. Our results, coupled with the power prob￾lem with the Static Tradeo! Model documented by Shyam-Sunder and Myers, indicate that their empirical evidence can evaluate neither the Pecking Order nor Static Tradeo! Models. Alternative tests are needed that can identify the determinants of capital structure and can discriminate among competing hypotheses. References Modigliani, F., Miller, M., 1958. The cost of capital, corporation "nance and the theory of investment. American Economic Review 48, 261}297. Myers, S.C., 1977. Determinants of corporate borrowing. Journal of Financial Economics 5, 147}175. Myers, S.C., Majluf, N., 1984. Corporate "nancing and investment decisions when "rms have information investors do not have. Journal of Financial Economics 13, 187}221. 424 R.S. Chirinko, A.R. Singha / Journal of Financial Economics 58 (2000) 417}425