In explaining the dynamics of corporate Reserve Debt Capacity (RDC) at its utilization and creation of the high-risk and low-risk RDC by the high-value and low-value firms, the present paper seeks to put forward a new theory in literature. Utilizing the concept of suboptimality at firms’ pecking order track and that of ‘optimality’ at trade-off track, the theory recognizes the presence of ‘separating’ and ‘semi-separating’ equilibrium at the dynamic behaviors of their RDCs and their shifts from one track to the other. The theory conjectures that firms exploit their RDCs if the same are available or they recreate the same before utilization. The study also explores that the Indian firms issue secured as well as unsecured debts in utilization of RDC but these firms show greater reliance on the later sources of debts than the former. They behave differently on their inclusion in the high-value and low-value sub-samples. Both highvalue and low-value firms utilize their internal and external equity for creating their low-risk and high-risk RDC where they show greater reliance on their new issues of equity than their uses of internal equity.

In the literature of corporate finance, the studies of Fama and French (2002 and 2005), Frank and Goyal (2003 and 2008), and the others have showed that neither the Static Trade-Off (STO) theory nor the Pecking Order (PO) theory spells out a persistent picture of firms’ behavior about their capital structure decisions. While the former theory is somewhat biased to firms’ instantaneous adjustments since these ‘static trade-off’ firms try to reach static optimal debt capacity levels, in the latter theory, the ‘pecking order’ firms’ adjustments are purely subject to instantaneous adjustment costs for information asymmetry and transaction costs as well. Both the theories do not offer explicit models on the specific query of what is the role of firms’ reserve debt capacity at equilibrium in an economy. Frank and Goyal (2008) have criticized that these two important classical capital structure theories offer a set of principles towards building of their respective models with a few definite variations and subsequent tests. One of the important principles in the STO framework is that firms’ optimal debt financing is relevant only at the presence of two set-off forces, viz., the interest taxshield benefits and the bankruptcy costs, and the agency control benefits and the agency control costs. Firms’ debt capacity depends on their relevant exogenous forces. In the PO theory, in contrast, Miller and Rock (1985) argue that firms’ information asymmetry costs and their adverse selection problems contribute to the presence of the Reserve Debt Capacity (RDC) at their suboptimal investment situations rather than at any of their static-optimality situations.

In reality, very specific decisions on firms’ external (with the debt or equity issues) and internal (with utilization of accumulated or current profits) financing choices require greater reconciliations. Further, there may be a presence of the optimality (suboptimality) conditions at the lower (higher) levels of firms’ long-term debt ratios. Hence, keeping aside the debate— which firms are STO or PO firms in an empirical dataset and/or time-frame (see, Maji and Ghosh, 2007; and Liang and Bathala, 2009), or which sets of the macroeconomic variables are the dominating factors (see, Sinha and Ghosh, 2010; and Sett and Sarkhel, 2010)— Ghosh and Sinha (2009) have observed that the Indian firms on the one hand are likely to follow the STO (PO)-track at their lower (higher) levels of the long-term debt ratios and on the other, they are likely to revert to the higher debt levels either predominantly or due to the interplay of the effects of different set-off forces.

Applied Finance Journal, Dynamics, Corporate, Reserve, Debt, Capacity.