Capital structure is defined as mix of debt and equity used by firms to finance their investments. Two most preferred theories explaining the determinants of capital structure are Trade-off theory and Pecking Order theory. Pecking order hypothesizes that there is no target capital structure (unlike Trade-off theory) and the level of leverage is determined by the market conditions and investment opportunities available to firms. As per pecking order theory firms prefer internal sources over external and debt over equity for raising funds to finance their investments.
Trade-off theory on the other hand hypothesizes that there exists a target debt at which the cost of capital for a firm is least. Firms try to minimize the deviations between actual and target debt levels and only tolerate such deviations when it is costly to correct them. However, firms deviate from their targets due to several firm-level, industry-level and macro-economic factors. Existing empirical research on Indian firms evidences support for Trade-off theory over Pecking order theory.
The major drawback with the interpretation of Trade-off or Pecking order theory is that they have been tested rigorously over the last 2 or 3 decades in developed markets only, where firms are less constrained in terms of instrument choice for raising funds and markets are more liquid (I am not undermining the existing work done in emerging markets anyways.) This is an unlikely scenario in many emerging economies including India. The most preferred external source of funds for firms in emerging economies is bank debt either due to its low cost or due to limited access to equity markets…..
Target capital structure of each firm is simple calculated taking industry aggregates which itself may be sub-optimal. Even the better statistical methods using regression equations suffer from the bias since they are derived from the same sample of firms. A better method may be to incorporate a controlling variable for sub-optimal debt for testing the Trade-off and Pecking order theories in emerging economies.