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Introduction During the late 1980s, the developing countries started liberalizing their financial sectors. Increased emphasis was put on the development of equity markets. India also followed this path. Stock markets grew rapidly in India during the late 1980s and early 1990s. Capital markets have taken a prominent place in the developing countries? financial system during the last decade. Given this backdrop, it is important to assess the impact of stock markets on a country? s economic development. One of the most obvious and direct effect of the stock market is on the corporate sector of a country.

This study intends to find out how the development of stock markets has affected the financing pattern of the Indian corporate sector. This paper is organized in the following way. Section 1 surveys the literature on the subject of stock market development and its impact on the capital structure of the firms in developing countries. This survey will prepare the groundwork for the empirical analysis in section 2. Section 2 empirically investigates how the financing pattern of Indian firms has changed with the development of stock markets in the country.

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The results from this section will then be compared with the results from the earlier studies. Section 3 tries to explain the findings of section 2 in the Indian context. Section 1: Corporate Financing Pattern in Developing Countries ? A Literature Survey. This section reviews the empirical literature on stock market development and firm financing choices in developing countries. This section will not review the theoretical works on corporate finance and capital structures. There are several studies that have reviewed this vast theoretical literature on capital structure.

Some of the most extensive ones are Harris and Raviv (1991) and Samuel (1996)i . This section will report the empirical findings of the capital structure of the developing countries. However, before proceeding further we briefly look at some of the aspects of corporate finance. Theory of Corporate Finance According to the neo-classical irrelevance theorems (Modigilani and Miller, 1958), the financial structure should not matter at all in determining either the valuation of the firm, or more generally, the pattern of investment.

This theory shows that in fully developed capital markets, under neo-classical assumptions of perfect competition, no transactions cost and no taxation, even in a world of uncertainty, the stock market valuation of the firm is independent of its financing decisions and the pattern of investment. This is because in perfectly competitive markets the same product (a firm) will be priced equally in separate markets (debt and equity). Therefore there can be no advantage to firms or their asset holders derived from the firms? capital structure.

Therefore, with taxes favoring debt, firms would tend to choose 100% debt structure. This result was at great variance with the actual behavior of firms. Subsequent studies and models attempted to reconcile this conclusion with reality by relaxing various assumptions of the MM mode and incorporating the concept of imperfect information into the model. It has been recognized that apart from imperfect information, three other factors are important in determining the capital structure: taxes, agency costs, and bankruptcy costs.

However, since then significant progress has been made in the area of imperfect information in financial markets. This has given birth to various new theories of corporate finance which has modified the conclusions of the Modigilani and Miller. The new theories of corporate finance recognize the importance of the capital structure on the real economy. One of the most prominent theories of capital structure, based on asymmetric information is the ? Pecking Order theory of Finance?.

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