Determinants
of Corporate Capital Structure: Evidence from Indian Industries
A.
K. Das Mohapatra
Professor, Dept. of Business
Administration, Sambalpur University, Odisha, India
*Corresponding Author E-mail: akdm.2002@gmail.com
ABSTRACT:
Designing an optimal capital structure depends on a
number of micro and macro economic factors. And searchers in the past have
tried to establish the factors that could be clear determinants of the firm’s
capital structure. Some of them have presented affirmative evidences in respect
of a particular factor or a group of factors as the determinants of corporate
capital structure, whereas others have presented dissenting evidences in
respect of the same factor or factors to be a clear determinant of the
corporate capital structure. Scott (1972) and Scott and Martin (1976) have
presented empirical evidences claiming that industrial class has got influence
on the firm’s financial structure. Scott and Martin (1976) also support the
view that size might shape the firm’s debt-equity mix. Remmers,
Stonehill, Wright and Beekhuisen(1974),
on the other hand, have presented contrary opinion arguing that none of these
two factors - size and industry class - is a clear determinant of the firm’s
use of debt capital. Against this backdrop, the present paper empirically
establishes that both industry size and class have significant bearings on the
corporate capital structure of industries in India.
KEY WORDS: Financial leverage, Profitability, Operating leverage,
External financing, Income gearing, Size of the business.
The economic development of a country depends more on
the availability of development ingredients like finance, labour,
entrepreneurial and managerial skills, and technology. Of these, it is the
finance that is considered most critical a factor for the development as it
enables the firm acquire other ingredients. For the management, effective
utilization of finance is equally important as its availability. The finance
manager, in a view to maximize the value of the firm, faces the real challenge
in procuring the funds from the right source and also seeing their right use.
Financing decision involves the most important and complex areas of functional
management. The financing decision is an intricate and highly complex process
and it requires choice of sources of finance to be made with great care.
This is more so with regard to fixed assets financing
as against current assets financing due to involvement of considerable amount
of long term resources which are non-reversible once invested in fixed assets
(Kumar and Jain, 1989). Industries differ from one another from the view
point of length and technical character of the production process, rate of
technological improvement, degree of vertical integration, durability of
product, income elasticity of demand, custom of trade, time shape of operations
and sales, and customs as to the type of sources used(Singh,1968). The
variations in the nature of industries not only cause differences in the
requirement of gross fixed assets but also in the use of various sources of
long term finance among the industries(Kumar and Jain, 1989). The long-term
financing decision of the firm is more crucial to it than the short-term
financing decision. This is particularly true when the firm has to choose
between debt and equity as a source of finance. The particular combination of
debt and equity achieved by the firm at a given point of time has significant
implications to the management on grounds of solvency and profitability. Debt,
because of its fixed commitment as to income and repayment of principal is
normally thought of as contributing at the same time to the opportunity for
profit and possibility of loss (Donaldson, 1961). Although firms are generally inclined to
taking the income advantage of debt, there ought to be an optimally designed
capital structure for the firm in place, for a poor financial planning will
limit the firm’s ability to succeed in the long run due to high debt service
cost, inadequate liquidity, and inability to raise funds in the capital market.
Designing an optimal capital structure may however be
influenced by a number of micro and macro economic factors. And searchers in
the past have tried to establish the factors that could be clear determinants
of the firm’s capital structure. Some of them have presented affirmative
evidences in respect of a particular factor or a group of factors as the
determinants; others have presented dissenting evidences in respect of the same
factor or factors to be a clear determinant of the capital structure. Scott
(1972) and Scott and Martin (1976) have presented empirical evidences claiming
that industrial class has got influence on the firm’s financial structure.
Scott and Martin (1976) also support the view that size might shape the firm’s
debt-equity mix. Remmers, Stonehill,
Wright and Beekhuisen(1974), on the other hand, have
presented contrary opinion arguing that none of these two factors - size and
industry class - is a clear determinant of the firm’s use of debt capital.
Against this backdrop, the present paper endeavors to empirically establish the
factors that determine the corporate capital structure in India. Attempts have also been made here to measure
the nature and extent to which these factors influence the capital structure of
corporate India.
DATA
AND VARIABLES:
The study is based on financial data collected for 626
non-government and non-financial large public limited companies in India with a
paid up capital Rs one core and above as published by the Reserve Bank of India
in its various issues of monthly bulletins. The study covers a period of 23
years from 1987-88 to 2009-10, divided into two time slots of 10 years and 13
years respectively from 1987-88 to 1996-1997 and from 1997-98 to 2009-10. The
companies included in the study have been clubbed into five groups, called
‘industry class’, as under:
Group –I (coded as G1): Processing and
Manufacture- Foodstuffs, Textiles, Tobacco, Leather and Leather products
thereof.
Group –II (coded as G2): Processing and
Manufacture- Metals, Chemicals and products thereof.
Group –III (coded as G3): Processing and
Manufacture-Not classified under Group-I and II above, and includes companies
such as Cement, Paper and paper products, Rubber and rubber products, Mineral
oils, China earth ware and structural clay products.
Group-IV (coded as G4): Other industries,
i.e., industries not included under Group-I, II, and III above, and includes
companies like Construction, Shipping, Electricity, Hotels and Restaurants,
Land and real estate.
The important techniques used for the analysis of data
are correlation, analysis of variance (ANOVA), F-test and t-test. Similarly,
the variables used are financial leverage (FL), profitability (Profit),
operating leverage (OL), external financing (EF), and income gearing (IG), and
size of the industry (Size). Financial leverage, expressed as the ratio between
total debts to total assets at book value has been taken as the measure of
capital structure in this study in line with Remmers
et al (1975). The average total asset calculated by ‘dividing the net value of
total assets plus depreciation by the number of companies in the industry’ has
been taken as the ‘Size’ of the industry. The profitability has been taken as
the ‘pre-tax return on net assets’. Operating leverage has been taken as the
ratio between ‘percentage change in average earnings before interest and taxes
to the percentage change in average sales’ similar to the one taken by Ferri and Jones (1979).
Further, the ‘ratio of interest to EBIT’, and the ‘sum total of share
capital, borrowings, trade dues, other current liabilities and miscellaneous
noncurrent liabilities’ has been taken as the ‘income gearing’ and ‘external
financing’, respectively.
ANALYSIS
AND FINDINGS:
Discussion on the possible association between a firm’s
financial structure and its size, class, profitability, income gearing,
external financing, and a host of similar factors has gained considerable
importance ever since Modigliani and Miller (1958) initiated the debate ‘Cost
of Capital and Optimal Capital Structure’. Subsequently, Scott (1972) and Scott
and Martin (1976) have presented impressive evidences that industry class
influences the firm’s financial structure, and Remmers
et al( 1975) did not find any association between industry size and class as a
clear determinant of a firm’s financial
structure. Keeping this in view, two distinct hypotheses, such as (i) ‘financial leverage is independent of industry class’
and (ii) ‘financial leverage is independent of industry size’ were formulated
for investigating if industry class and size could be taken as the determinant of corporate capital structure in
India.
Financial leverage and
Industry class
The first hypothesis relates to the possible
association between industry class and financial structure. Firms in the same
industry should experience similar amount of business risk, because they
produce similar products, incur similar costs, rely on similar technology and
operate under similar set of rules, regulations, guidelines and environment.
Business risk, defined as uncertainty of future earnings, should substantially
determine the amount of debt the capital market should provide to the firm.
Since business risk has got relationship with the types of product, and the
products with types of industry, there is reason to believe that a firm’s
financial structure is influenced by its industrial classification. The same
logic should also hold good for inter-industry comparison. Since industries
deal with different products, operate under different environment, rely on
different technology, have different cost structure, their business risks
should essentially be different. As such, their financial structures should
also be different.
To test whether the financial leverage of the four
classes of industry, namely, G1, G2, G3, and G4
differs significantly, an analysis of variance (ANOVA) has been conducted and
the result of displayed in Table 1.1.
It is evident from Table 1.1 that F-Ratio (i.e., 52.76)
is much higher than the table value of F (i.e., 2.70) at 1 percent level of
significance. When compared with the probability F is even significant at less
than 1 percent. This indicates that the means of the financial leverages of G1,
G2, G3, and G4 differ significantly. Thus, the
null hypothesis that financial leverage is independent of industrial class is
rejected leading to the conclusion that financial leverage depends upon
industrial class.
Financial leverage and size
The second hypothesis relates to the association
between size and the financial leverage. Large firms are generally more
diversified, enjoy easier access to capital markets, receive higher credit
ratings, and pay lower rates of interest on borrowed capital. Moreover, as the
level of activity increases with size, more debt is expected in the financial
structure of large corporations. Hence, size of the firm should be positively
related to its financial structure. The same logic should also hold good for
inter-industry variations.
In order to test the validity of the null hypothesis
that financial leverage and industry class are independent, correlation
coefficients between financial leverages and industry size has been calculated
for all the four groups of industries-G1, G2, G3,
and G4 for the period 1987-88 to 1996-1997 and from 1997-98 to
2009-10. To test the significance of the correlation coefficients, t-values
have also been computed. Table 1.2 exhibits details of the empirical results
found in respect of the hypotheses concerning industry size, profitability,
operating leverage, external financing and income gearing.
It is apparent from Table 1.2 that not only there
exists positive correlations between industry size and financial leverages but
also the relations are statistically significant at 5 percent level in period 2
in case of all the industry groups, i.e., G1, G2, G3,
and G4, and at 1 percent level in case of G1, G2,
G3, and G4. As far as period 1 is concerned, the relation
is found to be significant at 5 percent level only in case of G3 and
G4 and at 1 percent level in case of G3. The null
hypothesis that financial leverage is independent of industry size is therefore
rejected and hence we conclude that size has got bearing on financial
structure.
Table
1.1 Analysis of Variance (ANOVA) for financial leverages of G1, G2,
G3, and G4
|
Industry class |
Mean |
No. of items |
|
G1 G2 G3 G4 Grand Mean |
0.298 0.271 0.269 0.396 0.308 |
23 23 23 23 92 |
|
Source of variation |
Sum of squares |
Degree of freedom |
Mean square |
F-Ratio |
Probability |
F-value (at 1%) |
|
Between Within Total |
0.246 0.136 0.382 |
3 88 91 |
0.082 1.5502E-03 |
52.761 |
4.000E-14 |
2.70 approximately |
Table 1.2 Statement showing
Correlation Coefficients(r-values), t-values and level of significance of
different factors
|
Industry Class |
Period |
Correlation
between |
r-value |
t-value |
Table value of t at |
|
|
1% |
5% |
|||||
|
G1 |
Period 1 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.325 0.426 0.180 0.877 0.662 |
1.085 1.476 0.577 5.771 16.210 |
3.169 3.169 3.169 3.169 3.169 |
2.228 2.228 2.228 2.228 2.228 |
|
|
Period 2 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.880 0.366 0.036 0.497 0.376 |
5.547 1.180 0.108 1.717 1.143 |
3.250 3.250 3.250 3.250 3.250 |
2.262 2.262 2.262 2.262 2.262 |
|
G2 |
Period 1 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.481 0.607 0.079 0.963 0.230 |
1.736 2.413 0.251 11.300 0.748 |
3.169 3.169 3.169 3.169 3.169 |
2.228 2.228 2.228 2.228 2.228 |
|
|
Period 2 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.972 0.192 0.341 0.678 0.469 |
12.392 0.587 1.088 2.727 1.590 |
3.250 3.250 3.250 3.250 3.250 |
2.262 2.262 2.262 2.262 2.262 |
|
G3 |
Period 1 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.719 0.432 1.153 0.915 0.736 |
3.271 1.516 0.488 7.159 2.327 |
3.169 3.169 3.169 3.169 3.169 |
2.228 2.228 2.228 2.228 2.228 |
|
|
Period 2 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.628 0.294 0.113 0.171 0.054 |
0.420 0.923 0.342 0.521 0.168 |
3.250 3.250 3.250 3.250 3.250 |
2.262 2.262 2.262 2.262 2.262 |
|
G4 |
Period 1 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.669 0.320 0.610 0.688 0.470 |
2.845 1.068 2.432 2.998 1.685 |
3.169 3.169 3.169 3.169 3.169 |
2.228 2.228 2.228 2.228 2.228 |
|
|
Period 2 |
FL and Size FL and Profit FL and OL FL and EF FL and IG |
0.924 0.613 0.345 0.388 0.423 |
7.251 2.325 1.108 1.263 1.400 |
3.250 3.250 3.250 3.250 3.250 |
2.262 2.262 2.262 2.262 2.262 |
|
FL = Financial leverage,
Profit = Profitability, OL = Operating leverage, EF = External financing , IG
= Income gearing |
||||||
CONCLUSION:
The current study leads to the findings that capital
structure of Indian industries gets significantly influenced by the size of the
industry and also the industry class. Factors like profitability, operating
leverage, external financing and income gearing too have bearings on the
capital structure in Indian industries. Firms depend more and more on debt
financing when they grow in size. Profit earning capacity of the firms, an
indicator of the firms’ ability to serve debt, too determine the firms’ ability
to attract debt capital in the total capital structure.
REFERENCES:
1.
Ferri, Michael G., and
Jones, Wesley H., Determinants of Financial Structure: A New Methodological
Approach, The Journal of Finance, Vol. XXXIV, No.3, June,1979.
2.
Modigliani., and Miller, M.H., ‘ The Cost of Capital,
Corporation Finance and the Theory of Investment’, American Economic Review,
Vol. 48, June,1958
3.
Remmers, L., Stonehill, A., Wright, R. and Beekhuisen,
T., Industry and Size as Debt Ratio determinants in Manufacturing
Internationally, Financial management, summer, 1974, pp.24-32.
4.
Scott, D.F., Jr., Evidence on the Importance of
Financial Structure, Financial Management, Summer, 1972, pp.45-50.
5.
Scott, D.F., Jr. and Martin, J.D., Industry Influence
on Financial Structure, financial Management, Spring, 1976, pp.35-42.
Received on 24.08.2011
Accepted on 24.10.2011
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Asian J. Management 3(1): Jan. – Mar. 2012 page 10-13