ABSTRACT
The portfolio theory imparts a natural basis for studying demand for financial assets and liabilities. It is argued that firms’ financing decisions may be better treated by analogy with portfolio decisions, suggesting a system of demand equations (Chowdhury et al. 1994). The system approach is a methodological improvement over the single equation approach, since it forces the investigator to confront the broader implications of any estimated model (Brainard and Tobin 1968). It is also pointed out that the system approach with balance sheet constraints allows us to examine the interdependent nature of decisions about one element of the balance sheet with other elements (Hay and Louri 1991). Following the seminal work of Brainard and Tobin (1968) on a portfolio
balance model, which provided a suitable accounting framework for empirical studies, extensive portfolio literature has been developed for financial institutions. However, the empirical work on the portfolio analysis for corporations is scarce. Notable exceptions are such works as in the following (all for UK firms). In the study of Spies (1974) the components of the capital budget are jointly determined, in which the investment, dividend and financing decisions are tied together by the ‘uses equals sources’ balance sheet identity. Hay and Louri (1989, 1991 and 1996) modelled both assets and liabilities in an attempt to capture the interdependent relationship among the balance sheet items. Taggart (1977) and Chowdhury et al. (1994) focus on modelling financial variables assuming that decisions about real variables are prior. The latter adopts Cuthbertson’s (1985) buffer stock approach by analysing the determinants of short-term financial decisions. This chapter proposes and implements the system approach to firms’ financing
decisions by analysing portfolio behaviour with a balance sheet constraint for Indian non-financial corporations. The empirical focus herewill be given explicitly to sources of financing, assuming that an investment decision is independent of a financing decision. There are a number of contributions in this chapter. First, the balance sheet
is shaped by aggregate flow data (i.e. time series data) of all non-financial companies in India. This is, to the best of our knowledge, the only comprehensive, sector-specific, flow of funds model for corporations of any developing country.
