Chapter 24: Monetary Policy and Corporate Performance in India: “Inside the Black Box Thinking”

The existing literature on the corporate financial structure is ruled by two diverse contentions. The first one is premised on the established Modigliani–Miller (MM) proposition. The same postulates no linkage between capital structure (i.e., finance-mix) and the firm’s cost of capital (Modigliani & Miller, 1958), whereas the second one is grounded on a “peckingorder”¹ in the selection of sources of finance by the firms. The pecking order principle ranks the preferred sources in a specific sequence, whereby firstly firms fully utilize all the existing internal resources (i.e., retained earnings) and only in instances where their financing requirements cannot be met through internal finance, they choose an external finance, including debt and lastly equity (Myers & Majluf, 1984). Information asymmetry lies at the heart of the Myers–Majluf proposition and the asymmetric information prevailing in the financial markets bear serious consequences for corporate finance. The emanating credit market imperfections not only influence bank lending and firms’ financing decisions, but also pertinent to the manner monetary policy affects firms (via the broad credit channel).