Assuming that firms operate in a perfect and frictionless capital market, Modigliani and Miller (1958) argue that the value of a firm is independent of its capital structure. But other researchers argue that financial leverage depends on firm, industry and country-specific factors. As an economy transforms itself from an agro-based one to an industry and services-based one, the orientation of its financial system may also change. The orientation of the financial system and macroeconomic variables are expected to affect the sources of finance and the costs and benefits associated with different forms of financing. This paper examines the effect of the financial system and macroeconomic variables on the financial leverage of the Indian non-financial private corporate sector during the period 1981-2007. It is found that financial leverage is negatively related to stock market development and positively related to banking sector development, rate of inflation and effective rate of corporate tax.

In a perfect and frictionless capital market, the financing decisions of firms have no effect on the shareholders' wealth (Modigliani and Miller, 1958). But the economic world imagined by Modigliani and Miller hardly exists in reality and the capital structure choices do affect the value of the firms. The determinants of capital structure are: firm, industry and country-specific. Even the integration of the economy of a country with the world economy is also expected to affect the factors which ultimately influence the costs of different forms and sources of financing, the value of the firm, and capital structure.

In the initial stage of economic development, agriculture dominates the economy. Since at this stage, agriculture and other economic sectors use simple technologies, information about different economic units can be collected and analyzed very easily. Banks can play an important role in intermediating funds. So, at this stage, firms depend more on funds borrowed from banks and other financial institutions, and so the debt-equity ratio of the firms increases. As the economy progresses further, the share of agriculture in economic activities decreases and the share of industry and services increases. Economic units start using more complex technologies and need more funds which cannot be adequately met by the banking sector alone. The projects use more complex technologies, have long gestation periods and need to be implemented properly. So, for the purpose of evaluating the projects and ensuring the safety of the investments, these projects need continuous monitoring. Instead of a few bankers, a large number of investors who are well dispersed can do this job well. The costs associated with collection and processing of information by market participants may be higher than the costs which may be incurred by a few bankers, but the market, as a whole, is expected to collect information which is relevant and process it more accurately, and so banking sector alone may not be able to ensure efficient allocation of resources. Moreover, as the economy expands, the demand for external funds also increases and the banking sector alone may not be able to meet the entire requirement of funds of the economy. As a consequence, firms are expected to retain more profits or raise funds from new issues market. At the second stage of economic development, stock markets develop relative to banking sector and the debt-equity ratio of firms falls.

Applied Finance Journal, Macroeconomic Variables, Financial Sector Development, Corporate Sectors, Capital Markets, Stock Market Development, Financial System, Economic Development, Economic Units, Banking Sector Development, Financial Leverage.