Does Liquidity Determine Capital Structure? Evidence from India

Abstract

We explore the relationship between liquidity of a firm’s equity and its capital structure. Firms with more liquid stocks benefit from lower costs of equity issuance. Therefore, it is hypothesized that such firms are likely to have a preference for equity in their capital structure. This article empirically investigates the relationship between liquidity and capital structure decisions on a sample of Indian firms. Contrary to the existing literature, we find no empirical evidence for an inverse relationship between liquidity and leverage among Indian firms. The results are indicative of the fact that due to distinctive features of emerging markets, namely, less sophisticated capital markets, higher information asymmetry, concentrated ownership, constrained access to debt and prevalence of family owned businesses, there are other more significant determinants of capital structure that subsume the explanatory power of liquidity variables.