Determinants of Capital Structure in Indian Automobile Companies A Case of Tata Motors and Ashok Leyland

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1 Determinants of Capital Structure in Indian Automobile Companies A Case of Tata Motors and Ashok Leyland Prof. R.M. Indi Sinhgad Institute of Business Administration & Research, Pune Abstract: Firms use different sources of finance having independent characteristics to fund their operations and attain the ultimate goal of creating value for shareholders. Every decision in business has some connect with finance and cost of finance. The Indian financial market has been changing swiftly from banking oriented to capital market oriented system. A Finance manager has a variety of alternatives at his disposal to raise the funds but each one comes with a set of obligations and specific costs. Raising funds is not a very tough task in this liberalized era but the challenge lies in creating an optimal capital structure that will lead to wealth creation for shareholders. This paper has tested the statistical significance of size of business, profitability, tangibility and growth of assets as impacting capital structure of Tata Motors and Ashok Leyland in the auto industry. The period of the study is 9 years from 2003 to 2011 Key words: Financial Leverage, Capital Structure, Profitability, Tangibility, Size of Business Introduction: Capital Structure refers to the way in which a firm finances its assets through long term funds. A business firm needs long term funds to finance fixed assets like land, building, equipment and also permanent working capital. A firm can make use of different sources of long term financing, where each source carries a unique cost of capital. Two of the most important sources of this financing are: 1) Owners s funds Equity shares, Retained earnings 2) Debt Term loans, Debentures, Bonds etc. While analyzing the importance of the owners fund and debt, equity as source of finance has fewer obligations as compared to the latter. Debt has fixed obligation with fixed rate of interest and definite tenure. These financial fixed charges do not vary with the level of EBIT or sales and they are incurred irrespective of profits earned. Return to equity holders is affected by the magnitude of debt in the capital structure of the firm and its sales revenue. Corporate finance theory is built on the premises that the primary goal of a corporation should be to increase shareholders wealth. Earlier research in Financial Economics also indicates shareholders wealth maximization as the ultimate goal on which all business decisions should rest. Shareholders wealth maximization as goal should also be seen in the context of collective social welfare. Jensen (2001) argues that a firm s wealth maximization would lead to maximization of wealth of the society as well. Use of fixed cost funds in the form of debt, generates increased returns for equity shareholders without additional contributions from them. The employment of source of funds for which the firm has to pay a fixed cost or fixed rate of return may be termed as leverage. Employment of debt in the capital structure simultaneously increases the risk associated with the business and returns available to the shareholders. Literature Review Academic researchers have contributed different views on capital structure theories. ISSN DAWN Journal for Contemporary Research in Management July

2 1) Net Income Approach: Propounded by David Durand (1952) the capital structure decision is relevant to the valuation of the firm. A higher debt in the capital structure leads to higher financial leverage and thus results in a decline in overall weighted average cost of capital. Consequently, there is an increase in the value of the firm and also the value of equity shares. 2) Net Operating Income Approach: According to this theory, the value of the firm is independent of its capital structure. This assumes that increase in the employment of debt capital increases the expected rate of return for the stockholders and the benefit of using the relatively cheaper debt funds is offset by loss arising out of the increase in cost of equity. The market value of the firm depends upon the net operating profit and the overall cost of capital. The capital structure is irrelevant and does not affect the value of the firm. 3) Modigliani and Miller Theory (MM, 1958): According to M&M Approach, the cost of capital is independent of capital structure and therefore there is no optimal value. According to them, under competitive conditions and perfect markets the choice between equity financing and borrowing does not affect a firm s market value because individual investors can alter their investments and the mix of debt and equity as per their desires. MM argues that a company s WACC remains unchanged at all levels of gearing, implying that no optimal structure exists for a particular company. M&M supported their argument that capital structure was irrelevant in determining the market value of firm by using Arbitrage Theory. 4) Jensen and Meckling (1976): They developed the capital structure theory based on agency costs. The firm incurs two types of agency costs namely: costs associated with outside equity holders and costs associated with the presence of debt in the capital structure. Total agency cost first decreases and after a certain level of outside equity capital it increases. 5) Tariq N. Awan (2011): He analyzed the impact of size, profitability, tangibility and growth on the leverage position of sugar and allied industries in Pakistan. He found that size and profitability have negative relationship while tangibility and growth have a positive relationship with leverage. 6) Tubga Das (2009) : He analyzed size, tangibility and profitability as determinants of capital structure. Firms with more tangible assets use higher long-term debt. As firms grow larger, they become more diversified and risk of failure is reduced; as a result they can have higher leverage. In case of small companies, they have limited access to debt financing. For a listed firm, profitability has no effect on leverage decisions of firms. Hence listed firms do not take profitability into consideration while making decisions about debt financing. 7) Keshar J. Baral (2004 ): He analyzed the impact of Corporate Size, Business Risk, Growth, Earning Rate, Dividend Payout, Debt Service Capacity and Degree of Leverage on capital structure. Out of these seven only three factors, namely size, growth and earning rate are statistically significant determinants of leverage. These variables explain 72% of the variation in financial leverage. This fact indicates that corporate size, growth rate and profitability play a major role in the determination of financial leverage and business risk, while dividend payout ratio, debt servicing capacity and degree of operating leverage play an insignificant role. Research methodology Data Collection: In this study the annual reports of two major auto companies in India are referred and the same have been collected from ISSN DAWN Journal for Contemporary Research in Management July

3 their official websites. Other secondary data is also collected from Journals and the Internet.. Sample Design: This paper is focused on the determinants of capital structure in auto industry and has a case study approach. The companies considered for study in the paper are Tata Motors and Ashok Leyland. Objective of the study: To examine the determinants of capital structure in the auto industry. Scope and Limitations of the study: 1) The study is restricted to only two companies in the automobile sector. 2) Study Period of 9 years i.e. March 2003 to March 2011 is considered for analysis. 3) The study is based on four determinants of a capital structure. (See Table no.01) H 02 :- There is no significant relation between profitability and financial leverage. H 03 :- There is no significant relation between tangibility and financial leverage. H 04 :- There is no significant relation between growth in asset and financial leverage. Specification of the model: The following multiple regression model has been used to test the theoretical relation between the financial leverage and characteristics of the firm. Y = a+b 1 X 1 +b 2 X 2 +b 3 X 3 +b 4 X 4 Where Y = Financial Leverage X 1 :- Size of firm X 2 :- Profitability X 3:- Tangibility X 4 :- Growth Justification of Choice of Companies: The two companies selected in the analysis of capital structure have a long standing in the Indian automobile market. Tata Motors was established in 1945 while the origin of Ashok Leyland dates back to Together they enjoyed approximately 80% market share in the Medium and Heavy Commercial Vehicles (MHCV) sector during the study period. The period of study from to has witnessed cyclic fluctuations in the MHCV sector with demand being sluggish in the initial years followed by recovery during the middle years and drop in the volumes during global meltdown and subsequent recovery towards the end. Thus analysis of their capital structure can be representative of the sector. Hypotheses The study has tested the following null hypotheses on relation between the defined variables and capital structure of auto industry. H 01 :- There is no significant relation between size and financial leverage. ISSN DAWN Journal for Contemporary Research in Management July

4 3.7 Definition of Variables: Name of Variable Definition Supported by Financial Leverage Long Term Debt/Total Asset Rajan and Zingales (1995),Booth et al(2001),gracia and Mira (2008), Paulo F. Pereira Alves(2011) Size of Business Log of Sales Keshar J. Balal (2004), Tariq N. Awan (2011), Fabio Zambuto(2011), Paulo F. Pereira Alves(2011), Antonios Antoniou Profitability Ratio of Net income before tax to total asset Tariq N. Awan (2011), Tugba Bas et al (2009),S.Franklin John et.al.(2010) Tangibility Ratio fixed asset to total asset Sarune Sidlauskiene (2009),Tariq N. Awan (2011), Paulo F. Pereira Alves(2011), Andre Getzman et al(2010), Antonios Antoniou Growth in Asset % change in total asset Tariq N. Awan (2011), Amarjit Gil et.al. (2009) Table 01 Use of Statistical Tools in Research: The following statistical tools were used during the research process: 1) Regression 2) Correlation 3) ANOVA Analysis of Results: Descriptive Statistics Dependent and Independent Financial Variables Leverage Size of the business Profitability Tangibility Growth in Asset Mean Median Skewness Kurtosis Maximum Minimum Table 02 Descriptive Statistics Table 02 indicates descriptive statistics of Tata Motors and Ashok Leyland between the periods 2003 to ISSN DAWN Journal for Contemporary Research in Management July

5 Correlation Sales PBT Tang Growth Size of the Business 1 Profitability Tangibility Growth in Asset Sales PBT Tang Growth Size of the Business 1 Profitability Tangibility Growth in Asset Table 03- Correlations among Independent variables (A check for multicollinearity) Table 03 indicates that the highest correlations value in two variables is 0.60 which mean it is tolerable, and that a multi-collinearity problem is unlikely in the regression model amongst independent variables. Regression and ANOVA Results Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 18 Table 04- Regression Statistics Analysis of Variance (Anova) df SS MS F Significance F (α= 0.05) Regression Residual Total Table 05 Analysis of variance ISSN DAWN Journal for Contemporary Research in Management July

6 Regression coefficients Coefficients Standard Error t Stat P-value (0.05) Intercept Size of the business Profitability Tangibility Growth in Asset Table 06 - Regression Analysis From Tables no.05, 06, 07 the results of the analysis are as follows: 1) The value of R 2 is 72%. It suggests that Size of the Business, Profitability, Tangibility and Growth in Assets explains 72% variation in the leverage. 2) Significance F at (α =0.05) is in ANOVA suggests that overall model is good. 3) Regression analysis shows that of the four independent variables, Size of the Business and 4) Profitability are statistically significant with positive and negative relationship respectively. Conclusion In this paper the author has studied those factors which have significant influence on capital structure decisions of the two auto companies under consideration. For a regression model, four independent variables (Size, Profitability, Tangibility and Growth in Asset) are considered to predict the dependent variable, Financial Leverage. Correlation of four independent variables has suggested that there is no problem of multi-collinearity and ANOVA result shows that the overall model is good at 5% level. Regression analysis shows that Tangibility and Growth in Asset have negative relationship, but the results are not statistically significant. Due to their insignificance it can t be concluded that Tangibility and Growth in Asset are positively or negatively related with the financial leverage. As such, the null hypothesis about Tangibility and Growth in Assets is accepted. Size of the business and profitability are statistically significant. Therefore, it is concluded that the size of the business and profitability are the strong determinants of capital structure of Tata Motors and Ashok Leyland. Bibliography:- 1) Andre Getzman, Sebastian Lang, Klaus Spremann (2010) Determinants of the Target Capital Structure and Adjustment Speed Evidence from Asian capital Market, retrieved from rgetcapitalstructureasia.pdf 2) Amarjit Gil, Nahum Biger, Chenping Pai, Smita Bhutani (2009), The Determinants of Capital Structure in the Service Industry : Evidence from the United States, The Open Business Journal, pp ) Fabio Zambuto (2011), Capit al Structure decisions in Biopharmaceutical industry, Paper presented at International conference on Industrial Engineering and Operations Management 4) Keshar J. Baral, Volume I Determinants of Capital Structure: A case study of Listed Companies in Nepal The Journal of Nepalese Business Studies, Vol. I No. 1 Dec pp ) Muhhamad Rafiq, Asif Iqbal, Muhhamad Atiq, (2008) The Determinants of Capital Structure of the Chemical Industry in Pakistan The ISSN DAWN Journal for Contemporary Research in Management July

7 Lahore Journal of Economics pp ) Paulo F. Pereira Alves, Miguel A. Ferreria, Capital Structure and Law around the World, Journal of Multinational Financial Management, pp ) Raghuram R. Rajan, Luigi Zingales (1995) What do we know about Capital Structure? Some Evidence from International Data The Journal of Finance, Vol. 1, No. 5. 8) V. Sivarama Krishnan, Stakeholders, Shareholders and Wealth Maximization, retrieved from, an.pdf, pp.1 9) Khan M.Y., Financial Management: Text, Problems and Cases, 5 th Edition (2008), Tata McGraw-Hill Education, pp.18.3,18.4 ISSN DAWN Journal for Contemporary Research in Management July