DETERMINANTS OF FIRM’S FINANCIAL LEVERAGE:A CRITICAL REVIEWByRahul KumarAbstractThe purpose of this review paper is to critically investigate the underlying factors that affect firm’s financial leverage from t he perspective of theoretical underpinnings. We reviewed 107 papers published from 1991 to 2005 in the core, non-core and other academic journals. On the basis of critical review, this research has identified a number of determinants of financial leverage based upon logical argume nts identified in the literatures. Major findings show that various frameworks like leverage irrelevance, static trade off, pecking order, asymmetric information signaling framework have partly helped us in understanding the under lying factors determining the firm’s financial leverage, there is no consensus and there is no universal factor determining financial leverage. The paper sets out two challenges for future research: one, how to integrate different factors determining firm’s financial leverage into a common framework and second, what are the explanatory factors determining firm’s financial leverage in a network phenomena Keywords : Capital structure, financial leverage1. IntroductionIn general, companies may raise money from internal and external sources. They can raise money from internal sources by plowing back part of their profits, which would otherwise have been distributed as dividend to shareholders. Or, they can raise money from external sources by an issue of debt or equity. When a company issues shares, shareholders hope to receive dividend on their investment. However, the company is not obliged to pay any dividend. Because dividend is discretionary, it is not considered to be a business expense. When a company borrows money by way of debt, it promises to make regular interest payment and to repay the principal (i.e. the original amount borrowed). If profits rise, the debt holders continue to receive a fixed interest payment, so that all the gains go to the shareholders. On the contrary, when the reverse happens and profits fall, shareholders bear all the pain. If times are sufficiently hard, a company that has borrowed heavily may not be able to repay its debt. The company is then become bankrupt and shareholders loose their entire investment. Because debt increases returns to shareholders in good times and reduces them in bad times, it creates “financial leverage”(leverage). An “unlevered firm2” uses only equity capital whereas a “levered firm” uses a mix of equity and various forms of debt. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The importance of leverage in the capital structure3 of the company is that its efficient use reduces the weighted average cost of capital (WACC) of the company. Lowering the cost of capital increases the net economic returns which, ultimately increases firm value. In sum, the guiding principle of leverage is to choose the course of action that maximizes the firm value and the value of the firm is maximized when the WACC is minimized.The firm’s leverage decision centers on the allocation between debt and equity in financing the company. However, how the leverage of a firm is determined in a world in which cash flows are uncertain and in which capital can be obtained by many different media ranging from pure debt instruments to pure equity instruments is an unsettled issue.A number of researchers have attempted to understand financing choices of the firm and to identify the effect of changes in financial structure on the WACC of the firm and its value. A survey on capital structure theories by Harris and Raviv (1991) provide a summary of determinant of financial leverage of the firm, as identified and discovered by the researchers up to the time. However, in the absence of any review of published papersin the area since then, a need was felt to do this type of review and objective was decided. The literature review is done to understand the progress of research on the subject and to identify the future direction of research. The present study reviews the literatures from January, 1991 to December, 2005, and summarizes various hypotheses determining the leverage of firm as discovered by the researchers. The review work follows from the perspective of theoretical underpinnings developed by the researchers during this time. This paper is organized as follows. In Section 2, we present methodology of review. Section 3 presents classification, discussion, and summary of hypothesis brought forth in the published papers during January, 1991 to December, 2005 from different theoretical underpinnings propounded in the subject area, though the divide line is oblique. Section 4 is the last section devoted to conclusions and future directions of the research.Section: 2For the purpose of our study, we systematically exclude certain topics that, while related to the leverage structure of the firm, but do not keep the determinants of the leverage as its central focus. These include literature dealing with call or conversion of securities, dividend, bond covenants and maturity, bankruptcy law, pricing and method of issuance of new securities, common and preferred stock. Second, we briefly discuss the theories on leverage under various subsection of section 3. Though such theories are undoubtedly of great empirical importance, we found that such theories have extensively been surveyed by Harris and Raviv (1991), Bradley et. al. (1984) and for the purpose of convenience we referred the authors for detailed explanation on the theories.Grouping variables driving leverage allows discussion of the variables in one place and facilitate an examination of the relationship among similar variables. The researchers in the past have looked into the capital structure from various theoretical perspectives and brought forth a number of theories on capital structure. Accordingly, the determination of firm's leverage was postulated to fall under various theoretical model/framework. These are:-1. Irrelevance theory: Research in this area was initiated by Modigliani and Miller (1958);2. Static trade-off theory: Research in this area was initiated by Myers and Majluf (1984);3. Asymmetric information signaling framework : This stream of research began with the work of Ross (1977) and Leland and Pyle (1977);4. Models based on Agency cost :Research in this area was initiated by Jensen and Meckling (1976) building on earlier work of Fama and Miller (1972);5. Pecking order Framework: This stream of research began with the work of Myers and Majluf (1984) and Myers (1984);6. The legal environment Framework of capital structure: Research in this direction was initiated by La Porta et. al.(1997);7. Target leverage Framework (Mean reversion theory): Research in this direction was initiated by Fischer et al. (1989);8. Transaction cost Framework: Research from this perspective was initiated by Williamson (1988).For the purpose of our study, we followed the above distinct categories as have been brought forth by the researchers. Over and above the above theoretical framework wefound that there is some variables not fitting into any of the given categories, which we have put into "others" category. For the purpose of our study, Papers published in the Journals listed in table-1 in the last fifteen years (from 1991 to 2005) are reviewed. Zivney and Reichenstein (1994) categorized academic finance journals as "core" and "noncore." Based on their definition, we categorized the journals into three categories: (i) Core, (ii) Non Core, and (iii) Others. We understand that our sample is the true representative of the population to reflect the state of research in determining the variables affecting the firm’s leverage. We reviewed articles in the journals through the EBSCO research database, Proques t database, Emerald full text database, Elsevie r’s Business management and accounting collection, and JSTOR database.Section 33. Classification, Discussion, and Summary of HypothesisThe researchers have captured a number of factors determining firm’s leverage. In this section, we report the factors identified in the published literature under different theoretical framework propounded over the period by the researchers.。