Most of the previous studies have analyzed the validity of Tradeoff and Pecking Order in the context of firms that are financially sound, not under financial distress. This study departs from that approach and analyzes the firms in financial distress to find empirical evidence on the issue as to whether the firms in financial distress follow a target debt ratio model or pecking order in adjusting their debt ratios. The findings show a weak support for the target adjustment model. Specifically, the firms in financial distress are found to be making a downward adjustment to the debt ratios, apparently due to potential increase in bankruptcy costs. Further, the study finds that transaction costs and bankruptcy costs influence the speed of adjustment towards the optimal debt ratio as well as the financing behavior of the firms in financial distress. The results are also supportive of the pecking order approach to capital structure adjustments by firms in financial distress.

Extant empirical literature provides evidence in support of both static and dynamic capital structure models that have been developed by relaxing the utopian assumptions of Modigliani and Miller (MM) models (1958 and 1963). Overtime, studies expanded to include agency problems, information asymmetry, and pecking order considerations and brought out a wealth of empirical implications for capital structure decisions. According to the tradeoff literature, use of debt financing involves various costs and benefits and the managements' objective is to pursue an optimal debt level that is consistent with the maximization of firm value or shareholder wealth. The information asymmetry arguments take the view that the firms' managers use debt policy and related announcements to `signal' to the market about the firm's quality and future prospects. An offshoot of this line of research is the pecking order hypothesis which views raising capital (debt versus equity) for funding needs in a hierarchical sequence—use of debt, internal equity, and finally external equity. Most studies, however, examined the capital structure policies of firms without regard to whether the findings and inferences apply to firms that are operationally or financially distressed.

This study makes an attempt to fill the void by focusing on firms in distress conditions. Specifically, it addresses the question: Which of the two capital structure policies—tradeoff or pecking order—do financially distressed firms follow? This study follows Shyam-Sunder and Myers (1999) in methodology and analysis. The findings reveal that firms in financial distress do not follow either tradeoff or pecking order approach with respect to capital structure. The results imply that, as argued by Gilson (1997), firms in distress are burdened with high transaction costs, making it difficult for them to make capital structure adjustments in their pursuit of achieving optimal debt ratios. Further, analysis carried out in this study does suggest interesting differences between the two criteria used for classifying financially distressed firms.

Applied Finance Journal, Financial Distress, Empirical Evidence, Empirical Literature, Capital Structure, Debt Restructuring, Financial Policies, Information Technology, IT, Empirical Implications, Gross Debt, GD, Net Debt, ND, Corporate Finance, Regression Analysis.