DETERMINANTS OF THE CAPITAL STRUCTURE AND FINANCIAL LEVERAGE: EVIDENCE OF SELECTED INDIAN COMPANIES. Chette Srinivas Yadav

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1 ISSN: , EISSN DETERMINANTS OF THE CAPITAL STRUCTURE AND FINANCIAL LEVERAGE: EVIDENCE OF SELECTED INDIAN COMPANIES. Chette Srinivas Yadav Assistant Professor, Department of Commerce Sri Sathya Sai Institute of Higher Learning, Brindavan Campus, Bangalore, India ABSTRACT This study investigates the relationship between financial leverage and determinants of capital structure of 50 companies listed on the national stock exchange, NIFTY Index during the period In relation to the study determinants are considered are profitability, collateral value of assets, growth, size, debt service capacity, tax rate, non debt tax shields, liquidity, uniqueness, and business risk. The study uses correlations and multiple regression analysis, to find the relationship between financial leverage (i.e., Dependent variable) and determinants of capital structure (independent variables), that the firm faces agency cost, asymmetric information, taxes and bankruptcy cost, among others, are important determinants of capital structure choice of firm. Key words: Capital structure, financial leverage, Asymmetric information, Agency cost, Bankruptcy cost. INTRODUCTION Finance is life blood of business organizations. Financial management functions are investment decision, financing decision and dividend decision to achieve objectives of financial management i.e., wealth maximization and creating value to the shareholder Capital structure theories contributed well known financial economist. David Durand proposed for the first time in 1952 stating that the capital structure is influences value of the firm (is at highest) and the overall cost of capital( is the lowest) in Net Income Method. He further suggested through Net Operating Income approach that is quite opposite to that of the Net Income Approach i.e., optimum capital structure is not affected the firms value. Solomon developed the immediate approach to the capital structure in This theory implication of the traditional position is that the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. The seminal work of Modigliani miller (1958, MM in short) is considered to be the basis of the modern corporate finance upon which the tradeoff theory and perking order theory were latter developed. The Page 121

2 ISSN: , EISSN MM (1958) paper showed that subject to some condition (existence of perfect capital market) financing decision and the value of the firm. Thereafter, the literature on capital structure has expanded by adding many theoretical and empirical theories. The restrictive assumption made by the MM theory, have been relaxed in the subsequent models by taking into account corporate taxes (MM,1963),bankruptcy costs (Baxter1967, Stiglitz,1972 Titman,1984),agency costs(jensen and Meckling,1976), and information asymmetric (Myers and Majluf,1984) as the potential determinants of capital structure of corporate firm Recognizing the presence of asymmetric information, Myers (1984) (Myers and Majluf 1984) developed the perking order theory of finance. Perking order theory is based on the propositions that investors (outsiders or principal) are less well informed than current firm insiders (managers or agents) about the value of the firm s assets. in such situation manager tend to maximizes the associated in raising finance for investment by following a perking order of finance which postulates that firm first choose internal source which is cheaper and secondly firm goes for external source, debt in the form of debenture or long term loan which comparatively cheaper than other sources. Given that internal source of finance are limited, firm often have to look beyond their internal resource to credit and equity markets to pay the premium attached to these external sources (Malik, 2004). Review of literature: The determinants of capital structure of firm are a dubious issue which has engaged academic for decades. Several empirical studies in area after the land mark study by Modigliani and Miller (1958). Maji and Gosh (2007) they have analyses that capital structure theories i.e., static trade theory and perking order theory frame work from the Indian corporate. The study used four determinants of capital structure such as tangibility, size, dividend and profitability its impact on leverage of the firms. The study considered a sample size of 160 companies of six manufacturing sector by using ordinary least square regression model. The results showed the positive relationship between tangibility and leverage, firm size and leverage are positively related and dividend and leverage are negatively related. They neither support perking order theory nor does static trade off theory thus fail to arrive at the conclusive evidence on the issue. Pathak (1997) studied related to various determinants of capital structure impact on leverage of the firm; the working paper consider 135 listed companies in Bombay stock exchange ( India) for the period of ten years ( ),taking six determinants such as profitability, liquidity, tangibility, growth, size and business risk. The study found that there is a significant relationship between leverage and capital structure determinants. Pahuja and sahi (2012) examined connection between determinants of capital structure and debt equity ratio of Indian firms by considering Bombay stock exchange stocks i.e., 30 organization listed during The study considers five factors affecting capital structure such as growth, profitability, liquidity, tangibility and size. The study used ordinary least square regression model to arrive at a conclusion that growth and liquidity showed positively significant with the leverage supporting perking order theory. Seetanah, Padachi and Ronoowah (2007) have done empirical research on capital structure of the stock exchange of Mauritius for the period of 10 years ( ). The study extracted samples 38 firms from six industries and seven determinants are used (such as profitability, size, tangibility, growth opportunities, business risk, tax shield effects and liquidity) to find relationship with the leverage. Results showed that profitability, size, tangibility, and liquidity are positive whereas business risk, Page 122

3 ISSN: , EISSN growth, nondebt tax shield does not impact on capital structure. The study concludes saying that it partially satisfies perking order theory and trade off theory. riyazahmed.k (2012) studied determinants of capital structure considering a case of Indian auto manufacturing which is listed in Auto Index of National Stock exchange of India with sample size of 15 firms, seven determinants such as size, earning rate, business risk, growth, dividend payout, debt service capacity and degree of operating leverage. The study showed relationship between determinants and financial leverage found that debt service capacity, operating leverage, dividend payout and business showed statically significant & size, earning rate and growth showed statically insignificant. mallikarjunappa and goveas(2007) studied determinants of capital structure influencing leverage of pharmaceutical companies in India, for the study they considered ten determinants of capital structure such as profitability, collateral value of assets, growth, size, debt service capacity, tax rate, nondebt tax shield, liquidity, uniqueness and business risk. They considered data for ten years ( ) with sample size of 71 firms by using multiple regression. They concluded that debt service capacity, liquidity and business risk are statically significant and others showed insignificant. Chandra shekar mishra (2011) studied the relationship between determinants of capital structure and leverage from the public sectors manufacturing units in India post liberalization for five year ( ) he considered 9 variables (such as asset tangibility, growth, size, earnings volatility, profitability, nondebt tax shield, tax, age and uniqueness) and 48 sample size. The results were identified with help of regression method and found five variables are negatively related such as profitability, growth, earning capacity, nondebt tax shield and uniqueness where other showed positively related are tax, tangibility, size and age. Yuanxin Liu & Jing Ren(2009) they have studied relationship between determinants of capital structure and leverage of IT companies listed in the china stock exchange for four years i.e., with a sample size of 92 firms and six variables such as size, profitability, tangibility, liquidity, growth rate and growth opportunity, with help of multiple regression found that growth rate is more significant in IT companies in china. Egle Krasauskaite(2011) he has studied in the determinants of capital structure and leverage of Small Medium sized enterprises by considering seven variables such as tax rate, size, growth, growth opportunity, age, liquidity and profitability with sample size of 4679 firms for three years data 2008 to 2010 using multiple regression and found that growth opportunity and liquidity is statically significant. Keshar J. Baral(2004) he examined the determinants of capital structure and leverage considering 40 listed companies of Nepal stock exchange limited for 5 years data taken, with seven variables such as size, business risk, growth, earning rate, dividend payout, debt service ratio and operating leverage and finally concluded that size, growth and earning rate are statically significant with help of the regression method. Wanrapee Banchuenvijit(2009) investigated the relationship between leverage and determinants of capital structure for five during of 81companies on the Stock Exchange of Thailand as the sample size by considering profitability, size, tangibility, growth and volatility. The study considered cross sectional time series regression model and found that profitability, tangibility and size are statically significant. Page 123

4 ISSN: , EISSN Noulas and G. Genimakis (2011) they have done analysis on determinants of capital structure and leverage from the Athens stock exchange, using multi regression analysis and parametric test for 259 firms over nine years from 1998 to2006 with help of These determinants consist of the age of the firm, size, profitability, profit volatility, tangibility of assets, depreciation, growth rate, credit rating, economic activity classification, sector classification, ownership and stock market Categorization. It provides evidence of significant positive correlations among firm s leverage and sales, growth rate, tangibility of assets, depreciation, profit volatility and credit rating. Respectively, profitability and firm s age are significantly inversely associated with leverage, whereas the number of workers as a measure of firm size does not have an effect on leverage. The second part is a deeper examination of the financing decision, providing tentative support that capital structure varies significantly across economic activity classification. In contrast to the previous empirical studies, the implementation of nonparametric tests suggests that both ownership and stock market categorization do not affect the capital structure choice. In particular, the framework presented here supports the pecking order hypothesis in the context of growth and profitability, whereas the static tradeoff theory is solely supported in size context. Abdulkader M.A. Abdullah(2002) studied the determinants of capital structure and debt maturity measured using 56 companies listed in Saudi stock market for the period of six years between , determinants were used are short term debt ratio, long term debt ratio, liquidity, profitability, growth opportunity, size maturity and age. He thus concluded that Saudi companies are with high long term debt ratio, is positively significant. The regression analysis shows that total debt is positively and significantly related to growth opportunities and negatively and significantly related to both liquidity and asset structure. Arvin gosh et.al.(2000) analysis of determinants of capital structure on leverage. Those determinants which are considered are asset size, growth of the assets, nondebt tax shield, fixed asset ratio, profit margin, research and development expense advertisement expenditure, selling expense, and business risk. Sample of 319 firms from 19 industries, for ten years between are studied by using ordinary least square method and arrived at a conclusion that four determinants are statistically significant i.e., growth of assets, fixed asset ratio, R&D expenditure and advertisement expenditure. Titman and Wessel (1988) have examined various debt ratios are related to a firms growth rate, volatility, nondebt tax shields, profitability, the collateral value of assets, industry classification, size of the firm and uniqueness of the firm. The data analyses over 8 years (1974 to 1982), the sample size of 105 manufacturing firms, used factor analytical technique. Thus concluded that uniqueness of the firm is negatively related, liquidity of firm has low debt ratio, debt ratio is negatively related to size, other facors not significant. Davis(1987) studied he has extended the study of Deanglo and masulis(1980) hypothetical study on corporate tax and level of debt used the analysis done for Canadian firms during 1966 to 1982 with 115 firms, using cross sectional analysis. He has concluded that there is a positive relationship between nondebt tax shield and leverage. Thus the existing literature suggests that the firm faces agency cost, asymmetric information, taxes and bankruptcy cost, among others, are important determinants of capital structure choice of firm. These factors individually or together exert their influence on firm specific factors which ultimately determine Page 124

5 ISSN: , EISSN the capital structure or financing choice of the firm. The determinants of capital structure based on the various factors: Hypotheses (Statement of specific research questions): Variables Description Expected sign profitability EBIT to total assets Negative Collateral Value of Assets net fixed assets to total assets Positive Growth proxy s growth by five year Negative average of sales growth size Natural logarithm of sales Positive Debt service capacity profit before depreciation, Positive interest and tax to total interest Tax Rate tax provision to profit before Positive tax NonDebt Tax Shields deprecation plus amortization Negative to total assets Liquidity current assets by current Negative liabilities. Uniqueness selling and distribution Negative expenses to total assets Business risk the coefficient of variation of EBIT Negative Objectives of the study: 1. To study determinants of the capital structure of the selected listed companies in National Stock Exchange of India 2. To study relationship between financial leverage and collateral value of assets, profitability, growth opportunity, size of firm, liquidity, debt service capacity, business risk, tax shield and nondebt tax shield. Data Description: The samples are selected at from Nifty fifty companies of The National Stock Exchange of India (NSE) in official directory. The financial data for the study for ten years The data for the study: The data for the study has been collected from NSE India website and Capital Line web site, magazines, journals, and annual reports. Tools of analysis: Various statistical tools used for the analysis are Mean, Standard Deviation, Variance, Coefficient of Variance and Multiple regressions for testing hypothesis. Page 125

6 ISSN: , EISSN Data analysis Model: Identify the relationship between financial leverage and determinants of capital structure. Debt equity ratios are regressed on determinants of capital structure. Leverage = f( profitability, collateral value of assets, growth, size, debt service capacity, tax rate, nondebt tax shield, liquidity, uniqueness, business risk) The following regression model is used for testing the hypothesis: Leverage=α+β 1 PROF+β 2 COVA+β 3 GROW+β 4 SIZ+β 5 DSC+β 6 TAXR+β 7 NDTS+β 8 LIQ+β 9 UNIQ+β 10 BRISK+Error Table showing regression statistics: Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 36 ANOVA df SS MS F Significance F Regression E06 Residual Total Standard Intercept Coefficients Error t Stat Pvalue PROF COV SIZ GROW DSC E06 TAXR NDTS LIQ UNIQ BRISK Page 126

7 ISSN: , EISSN Table showing correlation between the variables D/E PROF COV SIZ GROW DSC TAXR NDTS LIQ UNIQ D/E 1 PROF COV SIZ GRO W DSC TAXR NDTS LIQ UNIQ BRISK BRIS K Hypothesis Testing: The present study shows the statistical significance value for the intercept. Regression using F statics are highly significant, R 2 is 77.68%, and thus goodness of fitness this model does not suffer from serious limitation so as to describe the relation between the variables (explanatory and independent). 1. Profitability: According to static trade off theory, firms with higher profit employ higher amount of debt to gain tax benefits. On the contrary, pecking order hypothesis postulates negative association between profitability and leverage because firms prefer to finance internally rather than going to external. Profitability does not affect capital structure of an organization. It showed no relationship between profitability and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 2. Collateral Value of Assets (COVA): From the perspective of pecking order theory proposes that the firm with tangible assets will tend to accumulate more debt over the time due to the asymmetric information problem. In contrast to the static trade off trade theory predicts positive association between them, tangible assets generally serve collateral. Tangibility doesn t affect the capital structure of an organization. it is argued in the literature that tangibility assets can be an important factor in deciding capital structure as they can used as collateral. Therefore, higher the tangibility lower the risk of a creditor and increase the value. Thus a positive relationship between tangibility and leverage, it showed no relationship beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 3. Growth (GROW) Growth in total assets is used to measure a firm s growth opportunity. The growth is positively associated with leverage; this is inconsistence with agency cost hypotheses. However these results indicate growth opportunities Page 127

8 ISSN: , EISSN add value to the firm and increase its long term debt taking capacity. More over growing firms needs more long term debt in order meet their requirement; Growth does not affect capital structure of an organization. It showed no relationship between Growth and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 4. Size (SIZ) Firm size to raise funds usually small firms have less capacity raise funds where as large firms has higher capacity to raise funds. Since the study under taken is large firms they have higher capacity, Firm size will have a positive relationship to leverage. It showed no relationship between size of the firm and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 5. Debt service capacity (DSC) The higher the debt coverage, the greater the like hood of a firms having a higher debt components in its financial structure. The capacity of firm to borrow will be directly proportionately to its ability to discharge its fixed payment obligations. Hence, higher the capacity of the company to service debt, the grater is likelihood of the debt ratio being higher. The study proxies for debt with ratio between profit before depreciation, interest and tax to total interest, there significance between the debt service capacity and leverage, It showed relationship between debt service and leverage beta coefficient is , correlation is Though null hypothesis is rejected, accept alternative hypotheses. 6. Tax Rate (TAXR) Firm s effective tax rates will have a positive relationship to leverage. It showed no relationship between tax rate and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 7. NonDebt Tax Shields (NDTS) Firm s nondebt tax shield will have a negative relationship to leverage. It showed no relationship between non debt tax shields and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 8. Liquidity (LIQ) Firm s liquidity will have a negative relationship to leverage. It showed no relationship between non debt tax shields and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 9. Uniqueness (UNIQ) Firm s uniqueness will have a negative relationship to leverage. It showed no relationship between uniqueness and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company. 10. Business risk (BRISK) Firm s business risk will have negative relationship to leverage. It showed no relationship between business risk and leverage beta coefficient is , correlation is Though null hypothesis is accepted doesn t affect capital structure of a company Page 128

9 ISSN: , EISSN Conclusion: The conclusions are based on the study The theories on capital structure have been designed based on the studies done on the capital structure determinants. These studies have been conducted by choosing ten independent variables and a dependent variable. The samples are drawn from Nifty index stocks. The study used independent variables as profitability, collateral assets, growth, size, debt service capacity, tax rate, non debt tax shields, liquidity, uniqueness and business risk, dependent variables as debt equity ratio. The study observed the values of all the independent variables and dependent variables using the data of fifty companies, of which 36 companies were selected them based on availability of debt in the capital structure and banking & financial institution were rejected because of different the parameters are used. The study uses ten years ( ) data, accessed through Capital Line database. The study uses Multiple Regression and Correlation to identify relationship between the variables, on regression the data the standard error is the regression was found to be significant with ANOVA(F= ,P= E06). These indicate that all the independent variables together have a significant on the financial leverage. The coefficient of beta showed as profitability(positive), collateral value of assets(positive), growth(positive), size(positive), debt service capacity(positive), tax rate(negative), non debt tax shields(negative), liquidity(positive), uniqueness(negative), and business risk(negative); but the individual are not significant except debt service capacity but null hypothesis is rejected because same sign as the null hypothesis. Other variables have any significance individually but as total there is significance. The correlation between various independent variables with dependent are as follows, profitability is negatively correlated to debt equity ratio, collateral value of asset is negatively positively to debt equity ratio, size is negatively correlated to debt equity ratio, growth is positively correlated to debt equity ratio, debt service coverage is positively correlated to debt equity ratio, Tax rate is negatively correlated to debt equity ratio, non debt tax is negatively correlated to debt equity ratio, liquidity is positively correlated to debt equity ratio, Uniqueness is negatively correlated to debt equity ratio and Business Risk is negatively correlated to debt equity ratio. Bibliography: 1. Anurag Phuja and Anu Sahi (2012), Determinants of Capital Structure: A case of Automobile Manufacturing Companies listed in NSE, International Journal of Marketing, Financial services & Management research, Vol.No.3,pp Bahram and Nagendra babu(2008), the effect of ownership structure on firm performance: evidence from iran, Icfai journal of applied finance, Vol.14,No.3,pp: Deanglo,H.and Masulis,R.(1980), optimal capital structure under corporate and personal taxation,journal of financial economics,8(1): Durand David(1952), Cost of debt and equity funds for business trends and problems of measurement, in conference on research in business finance. National bureau for economic research, new York 5. Harris M and Raviv A(1991), The theory of capital structure, journal of finance, vol.46,pp Jensen M(1986), Agency costs of free cash flow, corporate finance and take over, journal of finance, vol.23, pp Kester carl(1986), Capital and owenership structure: a comparision of united states and japaneses manufacturing corporations, financial management, vol.15,pp Mallikarjunappa and Carmelita Goveas(2007), Factors Determining the capital structure of pharmaceutical companies in India, Icfai journal of applied finance, Vol.13,No.11,pp: Marsh Paul (1982), The choice between debt equity: an evidence study, journal of finance, Vol.37,pp Mittal and single(1992), Determinants of debtequity mix, finance India, vol.37,pp Page 129

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