Factors determining capital structure and corporate performance in India: Studying the business cycle effects

• In a set of panel regression framework, we study the determinants of capital structure and performance of Indian firms.
• We find business cycle and macro policy significantly influence corporate financing decisions and hence performance.
• The endogeneity between capital structure and corporate performance has been resolved using two step GMM panel regression.
• Debt financing has significant influence on firm performance.
• A more efficient firm would be more cost effective in its capital choice and hence more profitable.

This paper empirically investigates the linkage of corporate sector performance with the capital structure and macroeconomic environment. Using a balanced panel data of 1594 Indian corporate firms over 14 years (1998 to 2011), we find empirical evidence to support the hypotheses relating to the relevance of asymmetric information, agency cost, trade off theory, signaling and liquidity aspects in determining firm's capital structure decisions in emerging market economy. It is found that macro economic cycle significantly influences corporate financing decisions and hence performance. The endogeneity between capital structure and corporate performance has also been resolved through a two step dynamic panel generalized method of moments (GMM). The study suggests that the performance of any company hinges around its ability to operate on a capital structure. With the widening of scope of sourcing of capital, the right blend of instruments needs to be meticulously worked out to optimize cost of capital.