The
Pecking Order Hypothesis of corporate capital structure Theory is one of the celebrated
theories of corporate finance, formulated by Myers and Majluf (1984). This theory
has been formulated to mitigate the inefficiencies in the firms' investment decisions
that are caused by the information asymmetry. Here, the optimal capital structure
emerges as a solution to the optimal investment decision problem. Myers and Majluf
have argued that if managers have better information about the future investment
opportunity of the firm than the potential investors, they might find it difficult
to get external finance. This is because outsiders ask for a premium in order
to compensate for the possibility of funding a bad firm. If the firm tries to
finance its new projects by issuing equity, then the underpricing may be so severe
that a good firm may find it profitable to reject some of its projects even with
a positive Net Present Value (NPV). Thus, the firm will always try to choose a
security that would minimize this problem, which is called as the `Lemon Problem'.
The internal sources of funds, however, do not suffer from such a problem. Similarly,
debt will be preferred to equity because the possibility of underpricing is much
less here. Thus, capital structure choice will be driven by a hierarchical preference.
First, internal funds are selected; and then, the risky debt; and finally the
equity. This hypothesis, known as `Pecking Order Hypothesis', is valid for the
corporate financing pattern of developed countries, where the internal funds occupy
the first position in the pecking order of funds.
During
the recent years, researchers are working on ways to test the use of Pecking Order
Hypothesis in the financing pattern of firms in developing countries. Although
this line of research is highly developed in other developed countries, the absence
of research in India is noticeable particularly in respect of advanced empirical
modeling to test the Pecking Order Theory. In the period of liberalization, the
Indian financial system in general and the corporate financing practices in particular,
have undergone significant structural and other changes. therefore, it is necessary
to undertake an empirical study of the Pecking Order Theory in India so as to
strengthen our understanding of this issue under the changed circumstances. The
objective of this paper is to make a comprehensive study of the financing pattern
of the Indian corporate sector over a period of five years. The paper constructs
and estimates the latest sophisticated panel data models for testing the Pecking
Order Theory. |
