Determinants Of Capital Structure Studies In India
The value of a firm depends upon its expected earnings stream and the rate used to discount earnings stream is the firm’s required rate of return or the cost of capital.Thus the capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both.Leverage cannot change the total expected earnings of the firm, but it can affect the residual earnings of the shareholders.The effect of leverage on cost of capital is not very clear.Conflicting opinions have been expressed on this issue.In fact, this issue is the most contentious area in the theory of finance, and perhaps more theoretical and empirical work has been done on this subject than any other.
Raising of funds to finances the firm’s investments is an important function of the financial manager. In practice, it is observed that financial managers use different combinations of dedt and equity. A practical question therefore is : What motivates them to do so? More fundamental questions to be answered are: (1)Does use of debit create a value?(2) If so, do firms gravitate towards an optimum mix of debt and equity?
In theory, it is argued that the financing decision is irrelevant under perfect capital markets. When, within the framework of perfect capital markets, taxes and bankruptcy costs are assumed, the financial economists argue that an optimum capital structure, which maximizes the market value of the firm( or minimizes cost of capital), can exist .Firms in developing countries like India, are found following different financing policies-some aggressive and some conservative. One needs to investigate into the causes of this behavior.
We would refer to two Indian studies on the relationship between the cost of capital and the capital structure. Sarma and Rao (1968) following Modigliani and Miller’s (M-M’s) 1966 article, employed a two-stage least square method on the data of 30 Indian engineering firms for three years. In their estimates, the leverage variable had a coefficient greater than the tax rate. Thus, agreeing with the traditional view, they concluded that the cost of capital is affected by debt apart from its tax advantages.
Another study was conducted by Pandey(1981). He attempted to determine the empirical relationship between cost of capital and the capital structure using data of 4 industries viz.,
Cotton(47), chemicals(32), engineering(32), and electricity generation(20).
Some studies have been conducted to ascertain the demerits of financial leverage under the Indian context . Bhatt’s(1980) paper concerned the impact of size, growth, business risk, dividend policy, profitability,debt service capacity and the degree of operating leverage on the leverage ratio of the firm. The study used the multiple regression model to find out the contribution of each characteristic. Business risk (defined as earnings instability),profitability, dividend payout and debt service capacity were found to be significant determinants of the leverage ratio. The study used a sample of 62 companies from engineering industry.
Pandey’s (1984) study about the corporate managers’ attitude towards use of borrowings in India revealed that the practicing managers generally preferred to borrow instead of using other sources of funds because of low cost of debt due to the interest tax deductibility and the complicated procedures for raising the equity capital. In the light of the finding, Pandey (1985) conducted another empirical study examining the industrial trail patterns, trend, and volatilities of leverage and the impact of size, profitability, and growth of leverage. For this purpose, data of 743 companies in 18 industrial groups for the period 1973-74 to 1980-81 were analysed. It was found that about 72 to 80 per cent of assets of sample companies were financed by external debt including current liabilities. Companies trade credit as much as bank borrowings. The level of leverage for all industries showed a noticeable increase after 1973-74. The study also indicated that classifying leverage percentages by the type of industry dies not produce any patterns which may be regarded as systematic and significant. The trends and volatilities associated with the leverage percentages also did not give any support to the belief and the type of industry impact on the degree of leverage. It also revealed that there was some evidence of the tendency of large size companies to concentrate on the higher level of leverage .But it was difficult to say conclusively that size has an impact on the degree of leverage since a large number of small firms were also found employing high level of debt. The study also did not show a definite structural relationship between the degree of leverage, on the one hand and profitability and growth, on the other hand; although over time, profitability and growth have improved and so has the degree of leverage. The majority of the profitability and growth groups of companies were concentrated with narrow bands of leverage.
REFERENCE: FINANCIAL MANAGEMENT,I.M.PANDEY
Chakraborty (1977) has also conducted a study to investigate debt-equity ratio in the private corporate sector of India. He tested the relation of debt-equity ratio with age, total assets, retained earnings, profitability and capital intensity. He found that age, retained earnings and profitability were negatively correlated while total assets and capital intensity were positively correlated to debt-equity ratio. He also provided a glimpse of the regional patterns of debt-equity ratios in different industrial centres in India. He also attempted a prediction equation for debt-equity ratio for each industry. Chakraboty also used a very simple methodology for calculating the cost of capital. He showed calculation of cost of capital for 22 firms. He found that cost of capital increased from 7.36% to 12.36% over years. The average cost of capital for all the consumer good industry taken together was highest while , it was lowest for the intermediate goods firms. One of the reasons for this was attributed to relatively low amount of debt used in the former industry than in the latter. An indirect attempt was also made to test the M-M hypothesis by plotting debt-equity ratios on the X-axis and the cost of capital on the Y-axis for 22 firms. The result showed almost a horizontal line parallel to the X-axis.The study also discussed environmental factors influencing corporate debt-equity ratio and the cost of capital in India.
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