Trade Off Theory or Pecking Order Theory: What Explains the Behavior of the Indian Firms?

Abstract

The proposed research is intended to study the financing behavior of the Indian firms. The theory of capital structure is important for firms as they are constantly making investment decisions driven by financing decisions. Corporate decisions on capital structure policy have long been a subject of debate and still remain an unresolved issue. Out of the four major theories: the MM proposition, the Trade off theory, the Pecking order theory and the Agency theories, the present study focuses on the Trade off theory and the Pecking order theory Since the validity of the implications of these theories is mostly an empirical issue, correct model specification is very important. New models for the times series-trade off theory and the cross sectional diagnosis are proposed here. It is important to note that factors that affect these theories are very country specific. It depends on the factors like corporate governance, corporate and personal tax system, law & regulations, development of the capital and debt markets, etc which are highly economy specific (Alves and Ferreira, 2005; La Porta et al., 1997, 1998, 2000; Demirgue-Kunt and Levine, 1999; Demirgue-Kunt and Maksimovic, 1996). Hence it is important to carry out the study for Indian firms and not rely on the results from other economies. The models are tested for a sample dataset and the results are reported. The data consists of firms from ten industries (automobiles, drugs & pharmaceuticals, textile, polymers, electronics, health services, information technology, dairy, tea & coffee and electricity) for the period 1991-2007. The results seem to suggest the existence of the trade off theory in the Indian firms (contrary to the results found by Farhat, Cotei and Abugri, 2006).

Keywords: Trade-off theory, Pecking order theory, capital structure, emerging market

JEL Classification: G32, C23, C33