Capital Structure Adjustment in SMEs: Limits of the Dynamic Trade-Off Model

Abstract

Capital structure theory remains a central concern within corporate finance, despite more than six decades of sustained scholarly inquiry. The seminal contributions of Modigliani and Miller established the analytical foundations from which subsequent frameworks emerged, notably the static trade-off theory and its later evolution into dynamic adjustment models. Although competing theoretical perspectives have advanced the debate, their respective limitations have increasingly encouraged a more integrative understanding of firms’ financing behaviour. This study critically examines the limitations of the dynamic trade-off model in explaining the financing decisions of Portuguese small and medium-sized enterprises (SMEs) during the period 2015–2024. The article contributes to the literature by proposing an original comparative methodological framework and introducing an empirical indicator designed to assess the divergence between the model’s theoretical assumptions and observed financing practices. Using dynamic panel estimations based on the Generalized Method of Moments (GMM), the findings reveal that, although SMEs exhibit partial adjustment behaviour towards target leverage rations, several core determinants predicted by the dynamic trade-off framework lose explanatory power when confronted with observed data. In particular, profitability displays patterns more consistent with pecking order behaviour, while variables traditionally associated with debt optimization and collateral effects become statistically weak or inconsistent. These results suggest that the financing behaviour of Portuguese SMEs cannot be fully explained by a single theoretical framework and is strongly shaped by institutional constraints, internal financing preferences, and contextual factors. The study therefore highlights both the continuing relevance and the empirical limitations of the dynamic trade-off model, while reinforcing the need for more pluralistic approaches to capital structure analysis. From a practical perspective, the findings indicate that SME financing decisions should not be interpreted solely through leverage optimization logic, carrying implications for managers, financial institutions, and policymakers involved in SME financing and fiscal policy design.