This study explores the relationship between financial fragility and corporate risk-taking, drawing on prospect theory, which suggests that financially vulnerable firms may engage in heightened risk-taking to avert losses under financial pressure.
The analysis utilizes 11,705 firm-year observations from 1,243 Indian firms, spanning the period from 2005 to 2024 and employs OLS regressions with industry and year fixed effects. Robustness and endogeneity are addressed using alternative variable specifications, instrumental variable regression and PSM.
The results indicate that financially fragile firms exhibit higher levels of corporate risk-taking. Transition analysis reveals that firms transitioning from a safe to a fragile status exhibit stronger changes in risk-taking than those moving in the opposite direction. Additionally, firm size and industry dynamism significantly moderate the relationship between fragility and risk. Business group affiliation buffers fragile firms by reducing external capital dependence and dampening risk incentives.
The findings suggest that understanding the nuanced behavior of fragile firms can help managers and policymakers design more targeted financial strategies that strike a balance between risk and stability.
The study contributes to corporate finance by showing how firm-specific and contextual factors shape risk-taking under financial fragility. The findings extend Prospect Theory to firm-level decision-making in the context of persistent financial fragility, especially in emerging markets.
