Empirical Analysis of the Borrowing Behavior of Indian Firms on the Backdrop of the Pecking Order Model

Abstract

The determination of an optimal capital structure has been one of the most debatable issues in the finance literature since the introduction of the groundbreaking work by Modigliani and Miller on the capital structure irrelevance in 1958. Following the work of Modigliani and Miller (1958), two conflicting theories of capital structure came to the limelight, namely the static trade-off theory, and the pecking order theory. The paper starts with a very succinct description of these two theories followed by rigorous analysis of different facets of the latter one. The static trade-off theory of capital structure states that optimal capital structure is obtained where the tax advantage of debt financing balances leverage-related costs such as financial distress and bankruptcy. According to this theory, issuing equity means a diversion from the optimum position and should , therefore, be treated by the external stakeholders as bad news. The theory also states that firms attempt to set a target debt to equity ratio by trading off the tax advantage of debt with the cost of financial distress, which maximizes the firm value by keeping the WACC at the minimum. Once the target structure has been set, all the strategic and financial decisions are aligned toward achieving the same. On the practical ground, such setting of the optimal capital structure is difficult as the parameter- cost of financial distress is hard to define. On the other hand, Pecking order theory proposed by Myers states that firms prefer to finance new investment, first internally with retained earnings, then with debt, and finally with an issue of new equity. Myers argues that an optimal capital structure is difficult to define, as equity appears at the top and the bottom of the pecking order. Internal funds incur no flotation cost, asymmetric information costs, and no cost of financial disclosure and thereby, they are given the highest priority for financing deficit. On the other hand, when the managers go for equity issue, the investors, who normally have less information about the firm's value relative to the managers, anticipate that the shares are overpriced. This results in the fall in share price post such announcements. This asymmetric information cost of equity issue is high enough to motivate the management to keep the equity issue only as a last option. Thus, it can be generalized that firms issue securities that carry the smallest adverse selection cost, i.e. that are least likely to be mispriced by inaccurately informed outside investors. This intuition reduces to the pecking order, i.e. firms prefer to issue debt, only when the adverse selection cost of debt is negligible. Halov and Heider (2004) argued that the standard pecking order is only a special case of the adverse selection argument of external financing and that, as soon as the outside investors are imperfectly informed about the risk, debt can be mispriced, and firms may prefer to issue equity. Asymmetric information cost of debt arises because the outside investors are not aware of the risk of the projects where they are investing. As there is a tendency of the management to siphon borrowed funds into high risk projects, the providers of the debt are concerned about not knowing the risk of the projects, and they normally set a premium on the debt price. This results in the mispricing of debt. The adverse selection of cost of debt is higher if the past asset volatility of the firm is high. The reason being that, high asset volatility hints toward high riskiness of the firm, which compels the risk caring investors to set a premium. This paper empirically studied these observations in the Indian context.