The Cost of Capital: Earnings Retention vs Leverage

Abstract

Firms have three main sources of finance: internal funds, bank loans, and finance raised in the capital market. In India, debt finance represents almost 40% of total finance raised by the largest 100 publicly traded Indian firms (Singh and Hamid, 1992).¹ The choice between debt and equity has always been critical for the overall value of the firm. However, financial economists have rarely hesitated to give advice on capital structure without knowing how firms actually choose their capital structures (Myers, 1984). This chapter addresses part of this problem by examining the determinants and effects of debt financing in Indian firms.