Academic journal article IUP Journal of Applied Finance

Macroeconomic Variables, Financial Sector Development and Capital Structure of Indian Private Corporate Sector during the Period 1981-2007

Academic journal article IUP Journal of Applied Finance

Macroeconomic Variables, Financial Sector Development and Capital Structure of Indian Private Corporate Sector during the Period 1981-2007

Article excerpt

Introduction

In a perfect and frictionless capital market, the financing decisions of firms have no effect on the shareholders' wealth (Modigliani and Miller, 1958). But the economic world imagined by Modigliani and Miller hardly exists in reality and the capital structure choices do affect the value of the firms. The determinants of capital structure are: firm, industry and country-specific. Even the integration of the economy of a country with the world economy is also expected to affect the factors which ultimately influence the costs of different forms and sources of financing, the value of the firm, and capital structure.

In the initial stage of economic development, agriculture dominates the economy. Since at this stage, agriculture and other economic sectors use simple technologies, information about different economic units can be collected and analyzed very easily. Banks can play an important role in intermediating funds. So, at this stage, firms depend more on funds borrowed from banks and other financial institutions, and so the debt-equity ratio of the firms increases. As the economy progresses further, the share of agriculture in economic activities decreases and the share of industry and services increases. Economic units start using more complex technologies and need more funds which cannot be adequately met by the banking sector alone. The projects use more complex technologies, have long gestation periods and need to be implemented properly. So, for the purpose of evaluating the projects and ensuring the safety of the investments, these projects need continuous monitoring. Instead of a few bankers, a large number of investors who are well dispersed can do this job well. The costs associated with collection and processing of information by market participants may be higher than the costs which may be incurred by a few bankers, but the market, as a whole, is expected to collect information which is relevant and process it more accurately, and so banking sector alone may not be able to ensure efficient allocation of resources. Moreover, as the economy expands, the demand for external funds also increases and the banking sector alone may not be able to meet the entire requirement of funds of the economy. As a consequence, firms are expected to retain more profits or raise funds from new issues market. At the second stage of economic development, stock markets develop relative to banking sector and the debt-equity ratio of firms falls.

As the economy develops further, the share of agriculture in the economy falls further and the informational efficiency of the capital markets increases further relative to banks. Besides stock markets, corporate debt markets also develop. Thus, firms will have opportunities to raise debt from the market and/or borrow from banks. The increasing dominance of market would reflect more in the choice of raising funds from market (both stock and debt) or borrowing from bank than in the amount of financial leverage (Rajan and Zingales, 1995). In a semi-strong form of efficient capital market, firms prefer internal funds; and if external funds are needed, firms issue secured debt first, then they issue convertible securities and equity shares as a last resort (Myers, 2001). So, financially constrained efficient firms having profitable projects raise secured debt first from the market, and the debt-equity ratio of such firms increases. But for efficient firms having sufficient internal funds, debt-equity ratio falls because firms maintain stable dividend payout ratio. In spite of firms' preference for internal funds and secured debt which is raised from the market, economic growth and expansion contribute to the increase in the business for banks. In the third stage of economic development, both stock and debt markets develop relative to banking sector and firms raise funds from capital market (both debt and equity share capital), instead of borrowing from banks.

Financial leverage of firms is expected to depend on firm-specific characteristics too. …

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