Internal and external competition has increased the business risk of Indian industries during the last ten years. Since strategies aimed to acquire competitive strength require considerable funding, firms need to adopt appropriate financial policies to mobilize risk capital. An analysis of the firm level data of the Indian industries shows that there is no conscious effort on the part of industries to mobilize internal and external equity to take up such strategies. Indian industries report high level of debt and follow liberal dividend policy despite being exposed to high level of business risk. While the high level of debt reduces the borrowing capacity, the negative growth of return reduces the ability of raising equity finance. A liberal dividend payout policy is also found to be inconsistent in the current situation.

In the last ten years, Indian firms were exposed to internal as well as external competition. The success of a firm depends on its ability to survive competition and grow consistently. In order to grow, firms need to expand and such expansion requires heavy investments in both physical as well as intangible assets. Firms need to continuously invest money in projects that reduce cost or improve quality or increase market share to acquire or sustain competitive strength and improve profitability. In general, investments of a company are determined on the basis of the macro economic environment, the allocation mechanisms through which capital moves from its holders to investment projects and the conditions surrounding specific investment projects (Porter, ME, 1992).

This might cause major impediments for such investments since lenders particularly, the institutional lenders would prevent companies with considerable exposure to institutional funding from expanding its operations to new risky ventures until their dues are settled. Similarly, persistent use of high level of debt increases the fixed cost and in that process, return on equity suffers heavily. It would be difficult to raise equity finance with such poor track record for many companies. In addition to these two reasons, firms, which have allotted shares to institutional investors, face yet another constraint. Institutional investors may also insist the firms to pay liberal dividends and require firms to approach the market for funding new investments.

equity finance with such poor track record for many companies. In addition to these two reasons, firms, which have allotted shares to institutional investors, face yet another constraint. Institutional investors may also insist the firms to pay liberal dividends and require firms to approach the market for funding new investments. Thus, firms need to consider the long-term impact while borrowing capital from financial institutions or issuing equity to certain types of shareholders. Since these capital suppliers can effectively put a block on the freedom of firms to spend capital, capital structure assumes importance for strategies that require large scale funding for implementation.