Market Imperfections and Optimal Capital Structure: Evidence from Indian Panel Data

Abstract

This article is an attempt to answer the question: whether corporate firms in India have a tendency to adjust their financial structure to a targeted level? For this, we have focused on the partial adjustment process of long-term debt and equity. The results show evidence in favour of adjustment process towards optimal level of long-term debt and equity, but it is very slow in both the cases, especially in case of equity. Adjustment speed for long-term debt in India is similar to the speed of adjustment of developed countries, the United States (US) and the United Kingdom (UK). This finding does not support the view that economies characterized by private lending adjust faster than market-dominated economies as transaction cost of private lending is less in comparison to public lending. This study contributes to the existing literature by considering capital market regulation as one of the determinants of capital structure. It has been observed that stringency of capital market regulation exerts a negative impact on equity and debt. As the stringency of capital market regulation increases, it reduces the problem of ‘asset substitution’, and at the same time, raises the transaction cost of fund raising from the public domain. Moreover, the interaction between real and financial decisions has also been observed as the labour demand and leverage is inversely related. The impact of labour demand on leverage is transitory in nature.

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