IMPACT OF CAPITAL STRUCTURE ON PROFITABILITY: EMPITRICAL EVIDENCE FROM CEMENT INDUSTRY IN INDIA

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1 IMPACT OF CAPITAL STRUCTURE ON PROFITABILITY: EMPITRICAL EVIDENCE FROM CEMENT INDUSTRY IN INDIA Abstract * M. John Jacob ** Dr. Jothi Jayakrishnan The paper examines the relationship between the capital structure on profitability of cement companies in India for a period from 2007 to 2014 studied. The purposive sampling technique is used to decide the selection of the cement companies. The companies were chosen for net profit criteria based. The present study used secondary data for the analysis. It is found that the debt ratio, debt / equity ratio, short term debt ratio, long term debt ratio and GDP are influenced the profitability. Keyword: profitability, debts, GDP, Government Intervention and Size Introduction Modigliani and Miller (1958) in their pioneer work on capital structure theory concluded that debt is irrelevant to the value of the firm. For this theory to hold water, the tax advantage and the risk of using debt must cancel out exactly. This also means if the tax advantage is nil, then the risk disadvantage must also be nil for the theory to hold. The argument MM were making is that, no matter the mix of debt and equity in the firm s capital structure, there is no effect on the firm s market value, profitability and cost of capital. By extension, the capital structure of the firm is irrelevant in making shareholders richer or poorer. According to Ross (1977) a firm capital structure decision as the choice of how much debt a firm should have relative to equity. Sarkar and Zapatero (2003) found that a positive relationship between leverage and profitability. Myers and Majluf (1984) found that firms are profitable and generate high earnings are expected to use less debt capital comparing with equity than those that do not generate high earnings. If more leverage is used it can act as a tax protection shield and gives best capital structure for firm, Brigham and Gapenski, (1996). *M. John Jacob Ph.D Research Scholar Dept. of Business Administration Annamalai University johnjacob751@gmail.com **Dr. Jothi Jayakrishnan Associate Professor Dept. of Business Administration Annamalai University jjaisubi2003@rediffmail.com

2 The dynamic trade-off theory (DTOT) tries a compromise between TOT and POT, Fischer, Liu J. and Pang, D. (2009). Although, due to information asymmetries, market imperfections and transaction costs, many companies allow their leverage ratios to drift away from their targets for a time, when the distance becomes large enough, managers take steps to move their companies back toward the targets. While the POT explains short-run deviation from the target, the traditional trade-off theory holds in the long run. Empirically, many studies have proved that profitability and capital structure were negatively correlated. The cause may mostly be coming from the present value of financial distress costs exceeding the tax savings. Abor and Biekpe (2007). Abor, (2005) concluded that capital structure has a negative relationship with the profitability in Ghana. Fama & French (2002) within their work on taxes, financing decisions and value, concluded that there is a negative correlation between debt, value and profitability. Amarjit et al. (2009) concluded that, leverage is negatively correlated with profitability. Amsavani and Gomathi (2011) suggested that the negative correlation between profitability and Capital structure in pharmaceutical companies in India by opined that firms who finance their investment activities with retained earnings are more profitable than those who finance with debt capital. The found to be profitability is significantly negative related to bank debt ratio Proxy for the amount of effortor interventionmade to increase the use of long-term debt, Government intervention is measured by the index of government, which captures the size of the government in economy.this index which isgathered from the National Economic Research Institute (NERI) is available by province and consists of three components fiscal revenues as percentage of GDP, public financial burden on farmers and government control. Fan and Wang obtained the data about government control through a survey on how much time business executives have to spend on dealing with the government in order to keep business going. The lower index means the larger size of the government in the provincial economy, and more intervention and effort made in subsidizing long-term financing or decreasing the cost of debt to increase the use of long-term debt in the province. Statement of problem Capital structure is refers to the several mix of debt, equity and other source of fund that the firm uses in its financial operation. They argued that capital structure is a reflection of a firm s borrowing policy. Managers should choose the capital structure that they believe will have the highest firm value, because this capital structure will be most beneficial to the firm s shareholders. Titman and Wessel (1988) contend that firms with high profit levels, all thing

3 being equal, would maintain relatively lower debt levels since they can realize such fund form internal source. Today firms financial objective is profit maximization and minimize the cost of capital and increase the shareholder values. Generally most of the firms keep their attention almost with the short term financing sources and specially concern about their short term activities. So, the firm will sick other long term source and equity financing. Hence, this study focuses on profitability and capital structure in cement industry in India. Objective of study To examines the profitability earned by cement companies To evaluates the relationship between the capital structure on profitability To find out the factors influence the capital structure on profitability. Variable measurement Variable Measurement Profitability EBIT / Total Assets Debt ratio Total Debt = Total Debt / Total Assets Debt / equity ratio Debt / equity Short term debt ratio Short term debt ratio/ Total Assets Long term debt ratio Long term debt ratio / Total Assets GDP Gross domestic product Government Intervention Dummy Variable Size log of assets Methodology This study uses the descriptive research methods and empirical nature to identify capital structure and profitability of the selected cement companies in India. Descriptive research specifies the objective and the techniques for collecting the information from the balance sheets, profit and loss account cash flow statement. The data collected is processed and

4 analyzed in order to the result. The purposive sampling technique is used to decide the selection of the cement companies. Top fifteen companies were chosen for net profit criteria based. The present study used secondary data for the analysis. The study made the relationship between capital structure practices and its effects on profitability of fifteen cement companies in India for a period of seven years from will be studied. Analysis and discussion Table-1 Level of capital structure and profitability Variables Mean Std. Deviation Profitability Debt ratio Debt / equity ratio Short term debt ratio Long term debt ratio GDP Government Intervention Size Source: secondary data computed Explain the table indicate the profitability is measures by EBIT to Total assets. Profitability value is 0.19, it is found to be 19 percent of total assets. Debt ratio is measure by total debt to total assets. Debt ratio value is 0.44, it is found to be 44 percent of total assets. Debt / equity ratio value is Short term debt ratio defined as the ratio of Short term debt ratio to total assets. Short term debt ratio is found to be 0.32, it is noted that the 0.32 percent of total assets. Long term debt is defined as long term debt to total assets. It found to be 0.60, it is indicate that 60 percent of consist in total assets. GDP is found to be 0.62 it noted that 62 level of GDP. Government Intervention is dummy variable is found to be 1.00 and size of firm is found to be Table-2 Relationship between capital structure on profitability

5 Variable Profitability r-value p-value Debt ratio (NS) Debt / equity ratio (NS) Short term debt ratio ** Long term debt ratio * GDP (NS) Government Intervention * Size (NS) Source: Secondary data computed: *. Correlation is significant at one percent level, **. Correlation is significant at five percent level. (NS) non-significant Ho: There is no relationship between capital structure and profitability In order to examine the above stated hypothesis, Pearson correlation is executed. From the above table noted that long term debt is having positively correlated with profitability. But, short term debt ratio is having negatively correlated with profitability Therefore, the hypothesis is rejected. Hence, the results are supportive of the pecking order theory suggested that the profitable company may prefer internal financing.

6 Table-3 Effect of profitability on capital structure Model Variable B Std. Error Beta t-value p-value (Constant) Debt ratio * 2 RR value= Adjusted RR2= F-value= P=value=0.001 Debt / equity ratio ** Short term debt ratio * Long term debt ratio * GDP * Government Intervention * Size Source: Secondary data computed: *. Correlation is significant at one percent level, **. Correlation is significant at five percent level. Ho: There is no relationship between the capital structure on profitability Further, regression analysis is applied to know the effect of independent variable on the dependent variable. It is inferred that the independent variable are influenced at levels. It found to be 83.7 percent influence the independent variable such as debt ratio, debt / equity ratio, short term debt ratio, long term debt ratio, GDP, Government Intervention and size are significantly influence the profitability. Hence, the stated above hypothesis is rejected. The unstandarized co-efficient beta value indicate that the strongest relationship between dependent and independent variable. It is found that the debt ratio, debt / equity ratio, short term debt ratio, long term debt ratio, GDP and Government Intervention are significantly influence the profitability. Chisti et, al., (2013) Debt to Equity ratio is negatively correlated to

7 profitability ratios which imply that if the debt content is increased aggressively it will adversely impact the profitability. Moreover the companies are exposing themselves to more risk and they can lose control if they do it. Mohammad and Jaafer (2012) reveal significantly negative relation between debt and profitability. This suggests that profitable firms depend more on equity as their main financing option. Nuri Baltac and Hasan Ayaydin (2014) this finding is consistent with the trade-off theory that large firms face lower financial distress and agency costs and, thus, are able to borrow more than small firms. Zeeshan et, al. (2014) there is a negative weak relationship between profitability and Return on equity. Mehdi Mohammadzadeha (2013) Results showed that there was significant negative relationship between the profitability and the capital structure which means that the pharmaceutical companies have established a Pecking Order Theory and the internal financing has led to more profitability. Conclusion and Recommendation This study examines the capital structure and profitability of selected cement companies in India. The study covered fifteen listed cement companies in India over the period of It is found that the debt ratio, debt / equity ratio, short term debt ratio long term debt ratio and GDP are significantly influence the profitability. Recommendation of this study, total debt ratio 30 to 40 percent is best mix of financing. Hence, the cement companies will follow and also getting low level financing distress. If the company maintain the satisfied level then companies surly increase the profitability, shareholder values and appropriate capital structure.

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