Impact of Capital Structure & Cost of Capital on Shareholders Wealth Maximization- A Study of BSE Listed Companies in India

Transcription

1 Chanakya International Journal of Business Research, Vol 1(1), 28 36, March 2015 ISSN (Online) : Applied for Impact of Capital Structure & Cost of Capital on Shareholders Wealth Maximization- A Study of BSE Listed Companies in India Vinod K. Bhatnagar * [Ph.D.], Manju Kumari and Nikku Sharma Department of Management, Prestige Institute of Management, Gwalior, MP, India; dr.vinodbhatnagar@gmail.com Abstract This paper aims to evaluate the optimum capital structure, cost of capital and to analyze the impact of capital structure and cost of capital on shareholders wealth maximization. The study is empirical in nature. For the purpose of the study we have selected 12 highest net worth companies listed on BSE stock exchange. This study is based on secondary data and data have been collected from B.S.E (website) and Money Control.Com (website). Arithmetical formulae have been applied for calculating capital structure, cost of capital and shareholder s wealth. Regression Analysis has been used to construct a mathematical model to determine the impact of one variable on others. We found that value of R square is 0.8% which indicates that independent variables (capital structure and cost of capital) explain only 0.8% variance in dependent variable (shareholders wealth maximization). F value is which is significant at 78.4% significant level. Result of the study shows that there is linearity between cost of capital and shareholder s wealth maximization while there is no relationship or linearity between shareholders wealth maximization and capital structure. Keywords: Capital Structure, Cost of Capital, Shareholder Wealth Maximization 1. Introduction Capital Structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm s capital structure is then the composition or structure of its liabilities. The Modigliani- Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company s value is affected by the capital structure it employs. Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. 2. Structural Corporate Finance An active area of research in finance is that which tries to translate the models above as well as others into decision theoretic setups that are time-consistent and that have a dynamic structure similar to the one that can be observed *Author for correspondence

2 Vinod K. Bhatnagar, Manju Kumari and Nikku Sharma in the real world. Managerial contracts, debt contracts, equity contracts, investment decisions, all have long lived, multi-period implications. Therefore it is hard to think through what the implications of the basic models above are for the real world if they are not embedded in a dynamic structure that approximates reality. A similar type of research is performed under the guise of Credit Risk research in which the modeling of the likelihood of default and its pricing is undertaken under different assumptions about investors and about the incentives of management, shareholders and debt holders. 3. Cost of Capital The cost of capital is a term used in the field of financial investment to refer to the cost of a company s funds (both debt and equity), or, from an investor s point of view the shareholder s required return on a portfolio of all the company s existing securities. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk. If a project is of similar risk to a company s average business activities it is reasonable to use the company s average cost of capital as a basis for the evaluation. A company s securities typically include both debt and equity, one must therefore calculate both the cost of debt and the cost of equity to determine a company s cost of capital. However, a rate of return larger than the cost of capital is usually required. The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company can be modeled as the risk-free rate plus a risk component (risk premium), which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous (not linked to the company s activities). 4. Shareholder Wealth Maximization When companies maximized shareholder stocks, it only shows that the company is in progress and supports a positive environment to people/employees who works in finance, marketing, production administration. Shareholder wealth is the market value of the firm s common stock. Shareholder wealth is calculated as the number of common shares outstanding times the market price per share. The goal of shareholder wealth maximization is a long-term goal. Shareholder wealth is a function of all the future returns to the shareholders. Hence, in making decisions that maximize shareholder wealth, management must consider the long-run impact on the firm and not just focus on short-run (i.e., current period) effects. 5. Review of Literature La Porta, et al. (2000) argued that a legal environment provides strong protection to shareholders enables them to force companies to disgorge cash. The implication is that effective monitoring by shareholders in UK, where legal protection rather limited show that there is a negative relationship between inside ownership Iyer and Agarwal(2007) identified that optimal capital structure constrained by industry dynamics with a single objective of increasing the value of the firm. Strebuleav 12 (2007) also identified that higher business risk, bankruptcy cost and lower tax advantage all reduce optimal leverage. Asquith and Mullin (1986); Baker and Wurgler (2002); Jung, Kim and Stulz (1996); Mickelson and Partch 9 (1989); and Marsh (1982) identified that firms have preference to issue equity rather than debt when stock prices are high. Dasgupta and Hilary (2006) focused on credit ratings and analyst follows up as the influencing factors determining capital structure adjustment which contributed to cost and ultimately the value of the firm. Singal and Mittal 11 (1993) found that asset composition, business risk, growth rate, earning rate, industry class, debt services capacity and corporate size are the important determinants of shareholders wealth maximization. Boodho 1 (2009) identified that there have always been controversies among finance scholars when it comes to the subject of capital structure. So far, researchers have not yet reached a consensus on the optimal capital structure of firms by simultaneously dealing with the agency problem. This paper provides a brief review of literature and evidence on the relationship between capital structure and ownership structure. His study also Chanakya International Journal of Business Research 29

3 Impact of Capital Structure & Cost of Capital on Shareholders Wealth Maximization- A Study of BSE Listed Companies in India provides theoretical support to the factor (determinants) which affects the capital structure. Mehmet & Eda (2009) tested whether average leverages level of sector and leverages level of sector leader are effective on capital structure decision of selected firms and sector listed of ISE. We depend on the approach of behavioral finance to this manner as a supplementary approach of traditional finance to capital structure. Joshua 4 (2008) compared the capital structure of publicly quoted firms, large unquoted firms small and medium enterprises (SMEs) in Ghana.The result did not show significant difference between the capital structures of publicly quoted firms and large unquoted firms. The result revealed that short-term debt constitutes a relatively high proportion or total debt of all sample groups. The regression result indicate that age of the firms,size of the firms, asset structure, profitability, risk and managerial ownership are important in influencing the capital structure decision of Ghanaian firms. For the SME sample of the entrepreneur, export status, industry, location of the firms and form of business are also important in explaining the capital structure choice. Fakher et al. (2005) provided further evidence of the capital structure theories pertaining to a developing country and examined the impact of the lack of a secondary capital market by analyzing a capital structure question with reference to the Libyan business enviorment. The cross-sectional OLS regression shows that both the static trade-off theory and the agency-cost theory are pertinent theories to the Libyan companies capital structure where as there was little evidence to support the asymmetric information theory. The lack of secondary market may have an impact on agency costs, as shareholders who are unable to offload theirs shares might exert pressure on management to act in their best interest. Keshar & Baral 6 (2004) examined the determinants of capital structure-size,business risk, growth rate, dividend payout, debt services capacity, and degree of operating leverage-of the companies listed to Nepal stock exchange Ltd. Eight variables multiple regression models has been used to access the influence of defined explanatory variables on capital structure.in the preliminary analysis, manufacturing companies, commercial bank, insurance companies, and finance companies were included.however, due to the unusual sign problem in the constant term or the model, manufacturing companies were excluded in final analysis. This study shows that size, growth rate and earning rate statistically significant determinants of capital structure of the listed companies. Venkatesan (1983) investigated the determinants of financial leverage by analyzing the relationship between seven different variables and the financial structure of the firm s.the variables included industry categorization, size, operating leverage, debt coverage, cash flow coverage, business risk, and growth rate. Industry influence has been examined on the grouping of firms in various leverages classes and he found a statistical relationship between industry class and leverage, but the relationship could not be significant and conclusive. The impact of the remaining independent variables on the dependent variable was examined in two samples classification, viz. Intra-industry through multiple regression analysis.in summation, only debt coverage ratio was found to be the important variable significantly affecting the financial structure of the firms. Asideu Elizabeth (2005) suggested that macroeconomic instability, investment restriction, corruption and political instability have a negative impact on foreign direct investment in Africa. However, the relationship between FDI and these country characteristics has not been studied. These paper uses panel data for 22 Countries over the period to examine the impact of natural resources, market size,government policies, political instability and the quality of the host country institution on FDI. Fama Eugene F (1998) argued that two internal rates of return for the non financial corporate sector (1) the return on the initial market values of the securities issued by firm (2) the return on the cost of their investment. The return on the cost delivered by the firm on the investment outlays. The return on the value is an the overall cost of capital, that is,the return o the investment required by the capital market. The estimate of the corporate cost of capital for the is Hutchinson Robert W (1995) argued that a greater emphasis might usefully be placed on the cost of capital dimension in the future research into small business financing. He has also suggested that where the objective of an owner manager is to control the firm, the interdependent investment and financing strategies may be chosen to control the small firms cost of capital. Singh Kulwinder (2005)also argued that the concept of Foreign Direct Investment is now a part of India s economic future but the term remains vague to many, despite the profound effects on the Despite the extensive studies on 30 Chanakya International Journal of Business Research

4 Vinod K. Bhatnagar, Manju Kumari and Nikku Sharma FDI, there has been little illumination forthcoming and it remains a contentious topic. The paper explores the uneven beginnings of FDI, in India and examines the developments (economic and political) relating to the trends in two sectors: Industry and Infrastructure and sub sector Telecom. Spencer Barbra (2005) cited international outsourcing to lower cost countries such as China and India can best be understood through the enrichment of trade models to include concepts from industrial organization and contract theory that explain the vertical organizational of production. The combination of trade with the choice of the organization of production.the combination of the trade with the choice of organization form represent an important new area for both theoretical and empirical research.this survey paper provides a perspective on this new literature so as to gain insights into the for driving international outsourcing. This paper focuses on the relationship specific investment incomplete contracts and also search and matching, as fundamental concept that explain outsourcing decision. 6. Rationale of Study Many empirical studies have been conducted and focused mainly on relationship between capital structure and wealth maximization in developed countries. Our study looks at the issue of emerging markets like India and focusing exclusively on 12 High Net worth Companies Listed on Bombay Stock Exchange (BSE) in India. The major objective of this research is to empirically examine the impact of capital structure and cost of capital on Shareholders wealth maximization. In Indian context few studies analyzed the impact of cost of capital and capital structure on shareholders wealth maximization, therefore present study will contribute a lot to understand the impact. 7. Objectives of the Study Following are the main objectives of the study: To calculate Capital Structure. To calculate Cost of Capital. To calculate shareholder s wealth maximization. To analyze the impact of capital structure on shareholder s wealth maximization. To analyze the impact of cost of capital on shareholder s wealth maximization. 8. Research Design 8.1 The Study This study is empirical research in nature. 8.2 Population Companies Listed on Bombay Stock Exchange (BSE). 8.3 Sample Size B.S.E (Index Listed) 12 Companies on the basis Highest Net Worth. 8.4 Tools Used for Data Collection This study is based on secondary data and such data have been collected from B.S.E (website) and Money Control. Com (website). 8.5 Tools Used for Data Analysis 1. Arithmetical formulae have been applied for calculating capital structure, cost of capital and shareholder s wealth. 2. Regression Analysis has been used to construct a mathematical model to determine one variable by another variable (s). 9. Results and Discussion The value of R square is 0.8% that indicates that independent variables i.e. capital structure and cost of capital explains only 0.8% variance in shareholders wealth. It indicates that other factors also contribute in shareholders wealth maximization. 1. The beta value is positive in case of cost of capital; it indicates that there is positive relationship between shareholders wealth maximization and cost of capital. The b regression coefficient, representing the amount of dependent variable y changes when the corresponding independent variable changes by 1 unit. 2. Beta tells us the number of standard deviation that the outcome with a change as a result of standard deviation changes in the predictor. Here the beta value is This means that the one unit S.D. changes in capital structure ratio will lead to unit change in shareholder s wealth which is not significant. Chanakya International Journal of Business Research 31

5 Impact of Capital Structure & Cost of Capital on Shareholders Wealth Maximization- A Study of BSE Listed Companies in India Table 1. Showing rate of cost of capital S. No. Company s Name ONGC RELIANCE IND COAL INDIA ITC MAHINDRA &MAHINDRA NTPC LARSEN &TOURBO WIPRO RELIANCE COMMUNICATION DLF GRASIM INDUSTRIES BAJAJ AUTO Source: Annual Report, Financial Year to Table 2. Showing ratio of capital structure S. No. Company s Name ONGC RELIANCE IND COAL INDIA ITC MAHINDRA &MAHINDRA NTPC LARSEN &TOURBO WIPRO RELIANCE COMMUNICATION DLF GRASIM INDUSTRIES BAJAJ AUTO Source: Annual Report, Financial Year to Here F value is.244 which is significant at 78.4% significant level. 10. Findings 1. From table 1 we found that the highest rate of cost of capital among sample companies incurred by ITC followed by ONGC during the Table 2 revealed ratios of capital structure and ITC showed the highest ratio i.e % followed by Coal India during the Table 3 showed shareholders wealth of all sample companies. Reliance Industries showed the highest net worth of Rs Crores in We found that value of R square is 0.8% that indicates that independent variables i.e. capital structure and cost of capital explains only 0.8% variance in shareholders wealth. 5. We found that the beta value is This means that the one unit S.D. changes in cost of capital will lead to.093 unit change in shareholder s wealth which is significant. 32 Chanakya International Journal of Business Research

6 Vinod K. Bhatnagar, Manju Kumari and Nikku Sharma Table 3. Showing shareholders wealth (Rs. In Crores) S. No. Company s Name ONGC RELIANCE INDUSTRIES COAL INDIA ITC MAHINDRA &MAHINDRA NTPC LARSEN &TOURBO WIPRO RELIANCE COMMUNICATION DLF GRASIM INDUSTRIES BAJAJ AUTO Source: Annual Report, Financial Year to Table 4. Showing linear regression analysis of shareholder s wealth as dependent variable and cost of capital and capital structure ratio as independent variables Model Summary Model R R Square Adjusted R Square Std. Error of the Estimate Predictors: (Constant), capital structure, cost of capital Dependent Variable: Shareholder s Wealth Model Coefficients Unstandardized Coefficients Standardized Coefficients B Std. Error Beta 1 (Constant) t Sig. cost.of.capital a. Dependent Variable: SW CS ANOVA b Model Sum of Squares Df Mean Square F Sig. 1 Regression a Residual Total a. Predictors: (Constant), CS, cost of capital b. Dependent Variable: SW Chanakya International Journal of Business Research 33

7 Impact of Capital Structure & Cost of Capital on Shareholders Wealth Maximization- A Study of BSE Listed Companies in India 6. We also found the beta value is This means that the one unit S.D. changes in capital structure ratio will lead to unit change in shareholder s wealth which is not significant. 7. F value is.244 which is significant at 78.4% significant level. 11. Suggestions 1. In the study, 12 Companies on the basis of High net worth have been taken as sample but sample can be increased. 2. The analysis has been done on three variables i.e. Capital Structure, Cost of Capital and Shareholder s wealth, as soon as we consider some more variables, results may vary. 3. ITC must try to reduce its debt so that cost of borrowing can be reduced and wealth can be maximized. 4. ONGC has also been incurring high cost of capital therefore its wealth is comparatively less than sample companies wealth. 12. Conclusion Shareholders wealth is a function of all the future returns to the shareholders. The goal of shareholder wealth maximization is a long-term goal. Hence, in making decisions that maximize shareholder wealth, management must consider the long-run impact on the firm and must consider all those factors which are responsible of shareholders wealth maximization. In this study we have used regression approach to find out the impact of cost of capital and capital structure on shareholders wealth maximization where we have used shareholders wealth maximization as dependent variable and cost of capital & capital structure ratio as independents variables. On the basis of networth we can conclude that Reliance Industries had highest net worth followed by coal India Ltd. In We found that there is linearity in case of cost of capital and shareholder s wealth maximization but on the other hands we found that there is no relationship or linearity between shareholders wealth maximization and capital structure. 13. References 1. Boodhoo and Roshan. Capital Structure and Ownership Structure: A Review Literature. The Journal of Online Education, 2009.New York. 2. M. Jenson and W. Meckling. Theory of the firm: managerial behavior agency cost, and ownership structure. Journal of financial economic, Vol. 3, , M. C. Jenson. Agency coasts of free cash flow, corporate finance and take over. American economic review, Vol. 76, , J. Abor. Determinants of the capital structure of Ghanaian firms. Department of Finance University of Ghana business school legion K. M. Kale and R. A. Walking. The impact of industry classification on financial research. Journal of financial and quantitative analysis, Vol. 31, , K. J. Baral. Determinants of capital structure: A case study of listed companies of Nepal. The journal of Nepalese business studies, B. Lev. On the association between operating leverage and risk. Journal of financial quantities analysis, , R. W. Masulias. The impact of capital structure change on firm value: some estimates: Journal of finance, Vol. 38, , W. Mickelson and M. Patrch. Managers voting rights and corporate control. Journal of Financial Economics. Vol. 25, , M. A. Peterson and R. G. Rajan. The benefits of lending relationship: Evidence from small business data. The Journal of finance, Vol. 49(1), 3 38, R. K. Singal and R. K. Mittal. Determinants of capital structure a survey. Finance India, Vol. 7(4), , Dec A. Stebuleavilya. Do test of capital structure theory mean what they say,? Journal of finance, Vol. 62, , Internet: Internet: 34 Chanakya International Journal of Business Research

8 Vinod K. Bhatnagar, Manju Kumari and Nikku Sharma ANNEXURE 1. Residuals Statistics Minimum Maximum Mean Std. Deviation N Predicted Value Std. Predicted Value Standard Error of Predicted Value Adjusted Predicted Value Residual Std. Residual Stud. Residual Deleted Residual Stud. Deleted Residual Mahal. Distance Cook s Distance Centered Leverage Value a. Dependent Variable: SW Histrogram. Chanakya International Journal of Business Research 35

9 Impact of Capital Structure & Cost of Capital on Shareholders Wealth Maximization- A Study of BSE Listed Companies in India Normal P-P Plot of Regression Standardized Residual. Scatterplot. 36 Chanakya International Journal of Business Research