The impact of debt capacity on recent tests of competing theories of capital structure
is examined. Controlling for debt capacity, the pecking order appears to be a good
description of the financing policies of a large sample of firms. The main results
are first, that internally generated funds appear to be the preferred source of financing.
Second, if external funds are required, in the absence of debt capacity concerns,
debt appears to be preferred to equity and, when possible, debt capacity is "stockpiled."
Demonstration of this preference also provides evidence directly contradictory to
the tradeoff theory. Finally, we present evidence consistent with the hypothesis
that asymmetric information and its attendant costs are the basis for the observed
pecking order of financing choice.