Capital Structure Dynamics and Financing Imbalance: Evidence from an Emerging Economy

This paper considers the trade-off and pecking order theory in a unified framework and examines the influence of adverse selection costs on target adjustment process by investigating the relationship between firms’ financing imbalance and their target adjustment speed. Using a large dataset of 2718 non-financial and non-utility listed firms over a period of 2004–2005 to 2015–2016, the study observes that Indian firms adjust toward target leverage with a moderate adjustment speed of 32–36 percent. Moreover, firms with above-target debt make faster adjustment than firms with below-target debt, and firms with financing deficit make faster adjustment than firms with financing surplus. The extensions of target adjustment model by considering financing imbalance and direction of deviation together, and also by incorporating extent of deviation further reveal that firms try to avoid equity and prefer to deal in debt while making adjustments toward the target. In fact, firms deal in equity only when they are highly deviated from target leverage. All these findings suggest that adverse selection costs play significant role in the adjustment process. Therefore, though capital structure decisions of Indian firms are guided by trade-off theory, significance of pecking order arguments cannot be negated. This study makes important contributions to the existing literature as prior studies on impact of financing imbalance on adjustment speed are based on US which is very much different from emerging economies, particularly India.