1. INTRODUCTION:
Optimization of wealth of owners and the financial strength of the corporation has been the major focal point of equity research for the past many years. Moreover, the theoretical relation between corporate leverage and market valuation has been well taught in finance courses at all levels. Theoretical finance has always regarded leverage as one of the basic sources of financial risk. In the real world of finance, capital structure decisions are critical as a shift in leverage could increase or decrease the financial strains on companies. Traditionalists such as Lintner (1956) and Gordon (1959) argue that there exists an optimal leverage ratio that equates the marginal benefits of debt such as tax shields to the marginal costs of debt such as increase in expected bankruptcy costs. Modigliani and Miller (1958), on the other hand, argued rigorously that the value of a firm is independent of its capital structure.
The immediate implication of the leverage value led proposition was that the return on equity capital is an increasing function of leverage. This is because debt increases the riskiness of the stock and hence equity shareholders will demand a higher return on their stocks. Debt and equity are the principal sources of funding for a business. The proportional distribution of these two sources of funding depends on how a firm decides to divide its cash flow between two broad categories: a fixed component to its lending entities and the residue to its equity owners. Therefore a firm’s financial leverage affects the firms value (Sharma, 2006). Many firms consider debt to be an integral part of their growth strategy. The financial leverage employed by the company will depend on the amount of risk the company would like to take. However, financial leverage has an effect on the shareholders return on investment and the market valuation of the companies. It would, therefore, be interesting to evaluate the impact of leverage on market valuation of the firm.
Being the fourth largest Industrial segment of India, FMCG makes significant contribution to the country’s GDP and financial system. Even though this segment is profiled with wider and distinct characteristics ranging from stable production policies to long distribution channels, capital intensity considered more substantial in explaining and determining its financial performance. The firms operating in the sector have to make huge investments in capital assets like physical buildings, plants and equipment and it is logical to expect the effect of capital intensity on the firms’ performance in the form of lower profitability and debt overhangs in liabilities.
This research, therefore, investigates, for Indian FMCG industry, the effect of capital intensity on a firm’s value performance. We propose to link the capital intensity with firms’ profitability and capital gearing practices and ultimately the aim is to examine the effect of capital intensity on market valuation of firms measured by Tobin’s q. The investigation spans 10 years, the most recent time periods covering both recession and resilience phases. The paper next reviews the literature, followed by some descriptions of the data and methodology. Results and discussions conclude the study.
2. REVIEW OF LITERATURE:
The literature explaining the relation between the financial leverage and market valuation is wide and extensive. Adami et al (2010) investigates the effect of firm’s leverage on stock returns, which is an explicit valuation model of Modigliani and Miller (1958). Their research finds that for utilities, returns increase with the leverage. However for the other sectors, the relationship is negative which is similar with the work of Dimitrov and Jain (2005) and Penman (2007). Christie (1982), and George and Hwang (2005) provide empirical evidence based on a sample of large firms for the negative relationship between stock returns and volatility induced by financial leverage. Duffee (1995) argues that such a relationship does not hold when small firms are also included in the sample. Schwartz (1959) shows empirically that financial leverage cannot fully account for the observed variation in market volatility. Aydemir et al (2007) observe that in a benchmark economy with both a constant interest rate and constant price of risk, financial leverage generates little variation in stock return volatility at the market level but significant variation at the individual firm level.
Baker (1973) measures leverage as the ratio of equity to total assets for the leading firms in an industry over a one year period. He finds that at the industry level, leverage raises industry profit rates, and more leverage implying greater risks. Nissim et al (2003) examine the effect of leverage on profitability. They form portfolios sorted by financial leverage, and they find that the portfolios with the lowest financial leverage have higher profitability than portfolios with high financial leverage.
Originally Tobin’s q, a ratio of market value of a firm to replacement cost of invested capital was introduced by Tobin and Brainard (1968). The authors take firm’s market value as a sum of market value of common and preferred shares and long-term debt. Book value of the invested capital is represented by the book value of the same components (Tobin and Brainard, 1977). Assuming that the firm’s market value is defined by discounted future cash flow to firm (Damodaran, 1996) we can highlight the two most important components of market value. These are firm’s ability to generate its cash flows and the cost of capital. Gupta et al (2016) consider Tobin’ qas a good proxy for Market valuation of firms.
Capital intensity cause increase of risk to business that can happen because a business with more fixed assets commits a high level of fixed costs in deriving its profitability and owing to which, the high volume of fixed cost do not vary proportionate with the sales volume and thus bring higher fluctuations in profits (Brealey and Myers, 1984).According to this argument, higher risk deriving from high capital intensity will lead to higher cost of capital that decreases a business’ value or a firm’s value performance. In their empirical studies Martin (1983) and Harris (1986) found a negative effect for capital intensity on firm performance.
On reviewing the literature it is clear that the relations between capital intensity, capital gearing and market valuation are quite mysterious. However, motivated by the previous research in the area we take two hypotheses to investigate the linkage among these three financial factors. We explore the impact of capital intensity on financial leverage or capital gearing at first and the impact of financial leverage on firms’ market value measured by Tobin’s q thereafter.
3. SAMPLE, DATA AND METHODOLOGY:
3.1 SAMPLE:
Sample of the study constitutes 15 NSE listed FMCG firms including in the compilation of the benchmark indices, Nifty and Nifty Junior
3.2 DATA:
Stock prices and selected firms’ financials constitute the base inputs for the study. We have accessed annual reports of firms for financial data and NSE web source for share price information for the period of ten years from 2007 to 2016.
The research computes three primal financial measures- Capital Intensity, Tobin’s q (proxy for market value) and Financial Leverage (represents impact of debt on firms’ profitability) for the core part of analysis. While total asset investments scaled by total revenues measures capital intensity, the ratio of total market value of firms (both value of debt and market value of equity) to book value of assets computes the size of Tobin’s q. Finally the ratio of EBIT to EBT measures the financial leverage.
3.3 Methodology: Panel Regression Models:
Panel estimator approach comes under this research use fixed effects models. Fixed effects models are suitable when one show interest only in analyzing the impact of variables that vary over time. Fixed Effects seek the relationship between predictor and response variables within an entity and each of these entities has distinct features that may or may not impact the predictors.
We predict the relation between capital intensity and market valuation of firms through estimating two regression equations: one is of financial leverage on capital intensity (Equation 1) and second is of market valuation on financial leverage (Equation 2). Finally, we compare the results of these two prediction techniques before we conclude on how the capital intensity of FMCG firms incorporates into the prediction of their valuation at market places.
------- (1)
------- (2)
Where; 
is the financial leverage for firm ‘i’ at
time ‘t’ 
is the market valuefor firm ‘i’ at time
‘t’; 
is the capital intensity of firms; 
is firm specific fixed effects and 
is an idiosyncratic disturbance term.
4. RESULTS AND DISCUSSIONS:
Table 1 summarises the Tobin’s q, Financial Leverage and Capital Intensity conditions of 15 FMCG firms selected for the study. The FMCG sector in India was really receiving market value appreciation during the period of observation. Among the firms observed in this research, market valuation of FMCG giants like Colgate, Britania, HUL and Dabur were really amazing and they got appreciation in their market values on an average 8 to 9 times more than the amount of capital investment they have made. When many other firms gained larger Tobin’s q as per their balance sheet figures, the financial state of the embattled liquor tycoon, Vijay Mallya lead firm, McDowell struggled considerably and lost market value significantly by showing more inclinations to market risk. The debt financing policies of most firms except GSK, HUL and P andG found partially successful in terms of trading on equity and they were somewhat able to provide incremental earnings to shareholders at a rate higher than that of their operating earnings. However, capital gearing policies of two companies both belong to the Mallya group proved most successful in magnifying the earnings available to their owners thorough their leverage financing strategies. Hetero geneity in capital intensity conditions measured by the total assets in scales of revenues was quite visible. The descriptive analysis found the capital intensity of firms like Godrej industries and Tata Global were much higher than that of the remaining firms. Britania, Colgate, HUL and Dabur were moving ahead in generating decent revenues compared to the size of their capital asset investments.
Table 1: Tobin’s q, Financial Leverage and Capital Intensity: Summary Values
|
Company |
Tobin's q |
Financial Leverage |
Capital intensity |
|
Britania |
9.85 |
1.19 |
0.37 |
|
Colgate |
11.21 |
1.19 |
0.46 |
|
Dabur |
8.34 |
1.06 |
0.65 |
|
Emami |
7.08 |
1.13 |
0.87 |
|
Godrej Consumer Care |
6.37 |
1.03 |
0.97 |
|
Godrej Industries |
3.18 |
1.91 |
2.55 |
|
GSK |
4.65 |
1.01 |
0.85 |
|
HUL |
8.74 |
1.00 |
0.49 |
|
ITC |
5.52 |
1.01 |
1.24 |
|
Jubiliant |
7.78 |
1.26 |
0.47 |
|
Marico |
5.71 |
1.07 |
0.67 |
|
McDowell |
0.28 |
1.48 |
1.41 |
|
P and G |
7.08 |
1.00 |
0.84 |
|
Tata Global |
2.00 |
1.17 |
1.83 |
|
United Breweries |
4.33 |
1.34 |
1.03 |
Source: Authors’ Own Compilations
The estimate on the beta parameters in both models is statistically significant (Table 2 and Table 3). The value of beta is positive in panel model 1 and the significance of which shows that the capital intensity of a specific year reflecting the level of asset investments of firms affect positively the firms’ ability to use fixed cost bearing funds in the capital structure to magnify the effect of change in operating efficiency on earnings to shareholders. In that sense capital intensity could be a good predictor of financial leverage practices of firms on a simultaneous basis. Capital intensity rates are able to explain about 50 per cent of variations in financial leverage by FMCG firms at zero lag levels. However, at the increased lag levels (though results are not shown here) the explanatory power of the model is straightly diminishing. Hence, the estimated regression strongly suggests the incremental capital gearing results in Indian FMCG sector under more intensified capital asset investment conditions.