Do Companies in Emerging Economies have sub-optimal capital structures?

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.


  1. Comments as on Linkedin India Finance Professional Group

    1. Eric Patel- Analyst
    One clarification that would help facilitate this discussion is what is meant by 'sub-optimal capital structures'. There seems to be a general perception that emerging market economies are either not utilizating their own capital efficiently or do no have meaningful structures in place to deploy foreign invesment initiatives. I am curious to hear whether or not investment professionals in such countries can argue the above case is true and if not, is there is evidence to the contrary (which I have a feeling there is but it hasn't received much coverage either in the mainstream media or the financial press)

    2. Suketu Shah- Independent Finance Professional

    If capital structure is a combination of debt / equity (irrespective of the structure) over long term, I believe it does not matter – whether it is an emerging economy or a developed economy. What is important is the basic principle of cost of capital and return on capital.

    3. Jaspal Kahlon- Corporate planning & Finance professional

    Optimal capital stucture is theoretcially defined as debt ratio where the cost of capital is minimal. In case of companies in emerging economies there are constraints in terms of ineffecient equity and debt markets and obviously other related constraints that impact the debt ratio…

    4. Jaspal Kahlon- Corporate planning & Finance professional

    Hi Suketu,
    Cost of capital is contingent on debt-equity mix in capital structure and the determinants of the same are firm-level, industry level and macro-economic considerations. Key theories pertaining to the same are Trade-off theory, Pecking order theory, agency theory and market timing theory…What I feel is that captial structure does matter in long-term..

    5. Suketu Shah- Independent Finance Professional

    Yes – but that affects your cost of capital. Depending on the cost of capital and return thereon, a company would structure its capital after considering its SWOT and profitability. To co-relate it with emerging economies is believing that companies in emerging economies are not able to get funds at lower cost of capital and hence, have sub optimal structures. What happens to your other cost structures? In case of companies, where there is lower cost of capital, say US or Japan, many companies do not enjoy the PAT margins that Indian companies enjoy. I feel that, in a globalized world, it is not the capital structure – but the inherent SWOT of a company – which would determine its cost of capital and hence, the capital structure.

    6. Jaspal Kahlon- Corporate planning & Finance professional

    Suketu, I totally agree and also understand the complexity of the answer. In fact this is what empirical research on captial structure points out.

    My query was more from the point of questioning the hypothesis of Trade-off theory that says the firms have an optimal capital structure where the debt-tax shields and agency costs balance and hence an appropriate level of debt being maintained. However, several factors lead to deviations and then firms over the long-run try to return to their optimal capital structure.

    In emerging economies macro-economic factors, efficiency of capital markets, industry level and firm level variables impact the optimal level of debt and hence any empirical study conducted in context of emerging economies finding support for Trade-off theory is not valid.

  2. Comments from Linkedin Financial Analysts & Modelers Group

    1. Guilherme Sassi- Economista Pleno at LCA Consultores

    In my opinion, based on my experience with Brazilian companies, a company in emerging economies usually achieves the optimal capital structure. But because spread charged by banks are much higher then their opportunity cost (in some cases this discharges debt as an option), therefore small companies have their cost of debt much larger then their cost of equity. As a result, the companies in emerging economies do achieve their optimal capital structure, but in some cases it is full equity.

    2. Jaspal Kahlon- Corporate planning & Finance professional

    Thanks Guilherme. But how can the companies achieve optimal capital structure even with full equity? As per me there are tax shields that make debt cheaper.. May be you are referring that higher spread on the debt makes it costlier compared to equity.

    3. Guilherme Sassi- Economista Pleno at LCA Consultores

    Exactly, its not uncommon to have, for small companies, Kd > Ke/(1-t), therefore to maximize the company’s value the optimal capital structure is 100% equity.

    4. Jaspal Kahlon- Corporate planning & Finance professional

    I agree 100%. I also found a research paper that empirically tested the existence of a reverse pecking order in the developing countries i.e. leading to preference for equity before debt.

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