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Capital Structure and Financial Performance: Evidence from India

Prashant Gupta*, Aman Srivastava** and Dinesh Sharma***

Financing decisions are one of the most critical areas for finance managers. It has direct impact on capital structure and financial performance of the companies. It has always been an area for interest for researchers to understand the relationship between capital structure and financial performance of the company. This paper is a moderate attempt to understand the relationship between capital structure and financial performance of the companies. For this purpose, the study used definition of capital structure in scope of book value to market value and measures were assumed for financial performance. In this paper, we applied the data of 100 companies listed on National Stock Exchange (NSE) of India in a 5-year time horizon (2006-2010). Results of our study demonstrated that capital structure influences financial performance. The significance of the influence of capital structure on performance is respectively belonged to measures of adjusted value, market value and book value. _____________________
*Dr. PRASHANT GUPTA, Associate Professor , Gautam Buddha University, Greater Noida, India, prashant@gbu.ac.in, Type V/D-02, Faculty Housing, Gautam Buddha University, Greater Noida, India **Dr. AMAN SRIVASTAVA, Associate Professor, Jaipuria Institute of Management, Noida, India, amansri@hotmail.com, M1/12, Vinayak Apartment , GH-4, Sec-9, Vasundhra, Ghaziabad, India ***Dr. Dinesh Sharma, Assistant Professor , Gautam Buddha University, Greater Noida, India, dinesh@gbu.ac.in, Type V/D-11, Faculty Housing, Gautam Buddha University, Greater Noida, India

this study makes a contribution to the literature in this area because it is an attempt to unfold the capital structure practices of companies operating in a unique environment. This is the . It has direct impact on capital structure and financial performance of the companies. Although there has been a great deal of research on the subject of capital structure. One of the major cornerstones of determining this goal is financial ratios. Primarily. Financial ratios are commonly used to measure firm’s performance. while maximizing shareholder’s wealth. corporations include these in their annual reports to stakeholders. capital structure decisions have great impact on the financial performance of the firm. Much of the theory in corporate sector is based on the assumption that the goal of a firm should be to maximize the wealth of its current shareholders. Introduction Financing decisions are one of the most critical areas for finance managers. It is a topic that continues to keep researchers pondering. it consists of the debt and equity used to finance the firm. as well as will influence how investors perceive the firm. Hence. Investment analysts provide these to investors who are considering the purchase of a firm’s securities. Are firms mostly influenced by the traditional capital structures of their industries or are there other reasons behind their actions? The answers to these questions are very important. Capital structure is directly related with the financing decision of the company. An optimal capital structure is usually defined as one that will minimize a firm's cost of capital. because the actions of managers will affect the performance of the firm. Exactly how firms choose the amount of debt and equity in their capital structures remains an enigma.1. Researchers continue to analyze capital structures and try to determine whether optimal capital structures exist. Generally.

variables. application of these should be in a way that creates an appropriate share of value for both providers and users of resources. a flat corporate tax rate. Providers of resources are related with different levels of risk.environment where there are no personal taxes. Financial leverage refers to the use of debt in a firm's capital structure. Use of debt leads to tax savings but on-time interest payments is a risk–taking way. Thus a capital structure that means a merger of sources of finance minimizes the average costs of capital and leads to good performance is considered optimized one. Section-2 presents the review of literature. hypothesis and data. it would be more appropriate to review the literature available on this subject to see if the results drawn from our analysis are in conformity with the trends in capital structure. before looking into the specifics of these companies. and a financial market system that is not very efficient. Consequently. The objective of this paper is to investigate the impact of financial leverage on the performance of publicly traded Indian companies. . This study provides a unique opportunity to examine the validity of the above statement and whether the financial performance of Indian firms can be explained by Finance theory. However. Section-4 discusses data analysis and results and Section-5 offers findings and conclusions. Therefore. The paper proceeds along the following lines. Survival and growth needs resources but financing of these resources has limitation. On the other hand. Section-3 discusses the research methodology. Most of the research studies on capital structure have used the data from American and European companies. benefit and control. Lack of market efficiency means information flow is not objectively available to all the interested parties. lavishing stock holders wealth increases the value of expected returns of share holders so financing expenses will also be high. their expected returns are not the same.

since total liabilities include such balance sheet items as accounts payable. Also. the ratio of total liabilities to total assets can be considered as a proxy for what is left for shareholders after liquidation. it is useful to keep in mind that the theoretical framework for the relationship between leverage and performance is based on market values of leverage. They suggest that the choice of measure should be based on the objective of the analysis. For instance. thereby underestimating the size of leverage. Since market values of leverage may be difficult to obtain. There is still one issue of concern since the measure contains liabilities that are not related to financing. which are used for transactions purposes rather than for financing. where capital is . pension liabilities. Rajan & Zingales (1995) discuss various accounting based measures of leverage and their informational content. Literature Review In this section. The ratio of total debt to capital. e.g.2.. When choosing a measure of leverage. the reviews of literature are sub-divided into following parts. which are explained respectively as under. it may overstate the amount of leverage.1 Measures of leverage There are various measures of leverage. This measure can be improved by subtracting accounts payable and other liabilities from total assets. market-value measures and quasi-market value measures. which can be classified as accounting based measures. but is not a good indication of the firm’s risk of default in the near future. accounting based measures are often applied as proxies. 2.

One of the problems that cause conflict . Modigliani and Miller (1963) eased the conditions and showed that under capital market imperfection where interest expenses are tax deductible. 1995). bankruptcy costs and agency costs. However. conventional perspective believed that using financial leverage increases company’s value. increasing debt results in an increased probability of bankruptcy. They argued that in efficient markets the debt-equity choice is irrelevant to the value of the firm and benefits of using debts will compensate with decrease of companies stock. there is an optimized capital structure that minimizes capital costs. Agency costs rose from separation of ownership and control and conflicts of interest between categories of agents.2 Different theories about capital structure Since Modigliani and Miller published their seminal paper in 1958. the optimal capital structure represents a level of leverage that balances bankruptcy costs and benefits of debt finance. 2. etc. Hence. In a subsequent paper. firm value will increase with higher financial leverage. 2. suggest that profitable companies should have more debts these firms have more need for tax management in corporation’s profit. Prior to MM theory.1 Static trade – off theory Jensen and Meckling (1976) suggest that the firm’s optimal capital structure will involve the tradeoff among the effects of corporate and personal taxes. Zingales. capital structure has generated great interest among financial researchers.2. is assumed to solve this problem and can be seen as the best accounting based proxy for leverage (Rajan. Models based on impact of tax. In this respect.defined as total debt plus equity.

he states that this decrease will decrease the opportunities of profitable investing. But. The other conflicting problem is that managers may not receive all the benefits of their activities. Song. This is seen when manager’s share in ownership of company is low. have more liquidity. commonly called the “Pecking Order” . Jensen (1976) defined debt as a disciplinary tool to ensure that managers give preference to wealth creation for the equity-holders. yielding the optimal capital structure. Thus. 2. companies with less debt have more opportunities for investment and in comparison with other active firms in industry. Additional costs of debt include potential bankruptcy costs. discussed by Meyers (1984). Myers and Majluf (1984) and Fama & French (2002). 2005). Costs and benefits of alternate financial sources are “traded off” until the marginal cost of equity equals the marginal cost of debt. increasing of debts can be used as a tool of reducing the scope for managers until resources of company may not be waste as a result of their individual purposes.2 Choice – pecking order theory of financing The alternative theory. Stulz (1990) like Jensen believes that debts payment decreases cash flows available for managers. and agency costs associated with the monitoring of investments by bondholders. In this theory. Therefore. this inefficiency decreases. on the other hand. it is appropriate that by increasing debts instead of stock issuance prevent from decreasing of manager’s share of ownership interest (Huang. When the manager’s increase stock is high.2. in the companies that have high cash flow and profitability . Thus. describes a firm’s debt position as the accumulated outcome of past investment and capital decisions.between managers and shareholders is free cash flows. and maximizing the value of the firm.

1987). this conflict demonstrates that high leverage leads to poor performance (Williams J. Consequently asymmetric information is the base of choice – picking order theory of financing. firms with positive net present value investments will finance new investments first using internal funds. they refer to borrowing. then with equity. then risky debt. They argued that if manager have access to private information about becoming worse in future operational performance they will be increase debt. Thus. addition of supervision costs and decrease of investment. Rajan and Zingales (1995) argue that larger firms tend to disclose . Myers and Majluf (1984) believe that this causes that pricing the stock with investors be understate. So. Thus. This hierarchy of preferences suggests that firms finance their investments first using internally available funds. increasing the leverage is a negative sign and demonstrates poor forward performance. companies prefer financing by internal sources to stock issuance and where there is not adequate internal sources. and finally through external equity. Dimitrov and Jain (2003) with operational performance of firms proposed another theory. and in the absence of internal funds will finance them with safe debt. financing investments using internally generated funds may be the cheapest source. The main conclusion drawn from the asymmetric information theories is that there is a hierarchy of firm preferences with respect to the financing of their investments (Myers & Majluf. and the firm’s financial structure is the outcome of past cash flows and investment opportunities.theory. Managers in comparison to investors have more information about operation. The conflict between benefits of share holders and creditors has consequences like increase of interest rate by creditors. 1984). followed by debt. but only if there is no other alternative. In this condition that there is asymmetric information.

Booth et al. 1986. 1998. Zingales. larger firms are often more diversified and have more stable cash flow. 1995). Cai and Zhang (2005) by studying this concept. Ghosh et al. Wald (1999) believed that the link between profitability and debt-asset ratio is positive and significant. 2000. found that in companies with high leverage. But. However. 2001 Ibrahim. Rajan and Zingales confirmed this theory.. 2000. 2000. Findings of Titman and Wessels (1988). larger firms with less asymmetric information problems should tend to have more equity than debt and thus have lower leverage. Some studies (Taub. Profitability was defined in the form of earning before interest and tax (EBIT) (Rajan. Roden and Lewellen. 1995). Janson. Fama and French. Friend and Lang. Champion. Harris and Raviv (1991) and Rajan and Zingales (1995) confirmed the results of Mayers that believed increase of leverage will decrease profitability. Gleason et al. 2009) showed negative or weak/no relationship .more information to outside investors than smaller ones. 1995. 2.3 Relationship between leverage and performance of firms Studies showed contradictory results about the relationship between increased use of debt in capital structure and firms performance.. converse link between leverage changes and return on stock is stronger (Rajan. predicts a positive link between financial leverage and profitability in efficient market and if the market be inefficient. unlike Mayers. The firm’s optimal capital structure will involve the conflicting theoretical arguments. Hadlock and James. Berger and Bonaccorsi di Patti. 1975. Simerly and Li. 2006) showed positive relationship and some (Kester. 2002. In 1988. 1999. 1988. Overall. the probability of bankruptcy for large firms is smaller compared with smaller ones. Zingales.. there will be a negative relationship between them.

Kyereboah-Coleman (2007) found that high leverage is positively related with performance (i. As compared to the developed markets like Europe. it is found by the Eldomiaty (2007) that capital markets are less efficient and suffers . has a weakto-no impact on firm's performance Results of some studies (Myers. A study by Ibrahim El-Sayed Ebaid. whereas Long-term Debt is negatively related with firm's ROE. Eldomiaty.between firms performance and leverage level. Probably this explains the contradictory results of the studies that empirically tested the predictions of relationship between leverage and firm's performance. 2001. 2007) show that capital structure is not the only way to explain financial decisions. In a study of listed firms in Ghana. In a similar study on microfinance institutions in sub-Saharan Africa. Abor (2005) found that Short-term and Total Debt are positively related with firm's ROE. America etc. As explained by Jermias (2008). only the direct effect of financial leverage on performance is examined by prior studies however leverageperformance relationship may be affected by some other factors like competitive intensity and business strategy.e. There is vast literature available that examines relationship of capital structure and performance of firms in developed nations but very less tested empirically for developing and emerging economies. While examining the relationship between capital structure and performance of Jordan firms. in general terms. ROA and ROE) and Abor (2007) on small and medium-sized enterprises in Ghana and South Africa showed that long-term and total debt level is negatively related with performance. (2009) based on a sample of non-financial Egyptian listed firms from 1997 to 2005 reveals that capital structure choice decision. Zeitun and Tian (2007) found that debt level is negatively related with performance.

structure of assets and liabilities that would hinder analysis and inter-company comparisons. Therefore. The starting point of our study is the firms listed at the National Stock Exchange of India. For these firms we collect data for the fiveyear period 2006-2010 from Prowess database of CMIE. Research Methodology. reports and . Archives. 4) There is a significant relation between capital structure and earnings before tax to sale ratio (EBT / S). financial firms were excluded due to the peculiarity in terms of operations. 2) There is a significant relation between capital structure and Return on equity (ROE). Internal secondary data was used in order to estimate the value of the dependent variable as well as the values of the independent explanatory variables. Hypotheses and Data Variables The purpose of this paper is to demonstrate the impact of defining the main variables of capital structure and performance on experimental results.from higher level of asymmetry in terms of information in emerging and developing markets than capital markets in developed countries. So researchers decided to take India as sample of emerging market and evaluate performance of firms against capital structure 3. The 100 respondent firms in National Stock Exchange of India constituted the sample in our empirical test of the theoretical model. the following hypotheses are extracted: 1) There is a significant relation between capital structure and return on investment (ROI). 3) There is a significant relation between capital structure and return on stock (RET). and 5) There is a significant relation between capital structure and operational profit to sale ratio (OPR/S). Moreover.

it is assumed that there is not a link between two variables. Data Analysis and Results Data analysis is done as mentioned above and the results are drawn thereof. Then the variables entered in SPSS software and then correlation between dependent and independent variables were measured by using Pearson correlation coefficient. It is obvious that almost all the correlations (except tow items) are meaningful in level of %1. In H0. S. Table 1 represents the empirical results from correlation matrix between variables. . correlation matrix between capital structure and performance is used. complementary data was collected by using reports available in the library and on the internet. For computing the market value of leverage. Data was processed by descriptive statistics containing Mean. The difference between variables of capital structure is a result of the way of assessing equity in adjusted debt ratios. ANOVA test using Statistical Package for Social Sciences (SPSS). To test the hypotheses. Also to show the meaning fullness of the correlation between variables. they were analyzed by Excel and the variables were calculated. we use market value and the number of issued stock at the end of each term. 4. significance level has been used when significance level is less than %5.D and inferential statistics containing Pearson Correlation. 4.1 Data Analysis After gathering necessary data. H0 (null hypothesis) is rejected. instead of critical value of student’s T test.documents are examples of internal secondary data. average price of selected firms at the end of the terms and average of shares in each of the studying terms has been used. In the case of missing information.

2 Results Tests on coefficient of correlation demonstrated that there is a meaningful link between tree variables of capital structure and five variables of performance except the link between return on stock and book value of capital structure that is not meaningful in significance level of 95%. in the other correlations. This correlation between return on stock and adjusted market value is 95% and among other variables is equal to 99%.AjMV > rPr. rPr.BV 4. The negative relationship is consistent with Myers’ (1984) notion that in general firms prefer internal to external financing sources. Results from tests on correlations and regression revealed that except the link between return on stock (hypothesis 3) in which the correlation between return on stock and market value of capital structure is statistically stronger.MV > rPr.<Insert Table 1> According to obtained results. adjusted value has the strongest relationship with performance measures. AJMV v(adjusted market value). MV (market value) and BV (book value) of capital structure respectively have the most correlation with financial performance measures. <Insert Table 2> . Profits as internal sources reduce the dependency of firms on leverage.

more accurately recorded and not subject to market volatility. if bankruptcy occurs. They suggest that it is possible for a firm to have a negative book value of equity while simultaneously enjoying a positive market value. This is possible because a negative book value reflects previous losses while a positive market value denotes the expected future cash flows of the firm. Those who favor the use of the book value measure present two strong arguments. In practice. the main cost of borrowing is the expected cost of financial distress in the event of bankruptcy. Second. Results of this study demonstrated that market value and adjusted value measures of capital structure in comparison with . book values are more easily accessible. changes in the market value of that debt do not affect the interest tax shield cash savings. Financial distress affects the weighted average cost of capital and consequently the optimal leverage. there is a negative correlation between performance and leverage. 4.Rajan and Zingales (1995) found that if return on stock and investments are fixed in a short term. Unlike market values. Furthermore. and the main way of external financing is debt. those who prefer the market value to book value argue that the market value ultimately determines the real value of a firm. the value of the distressed firm is closer to its book value. In such a situation. Once the debt has been issued. the accurate measure of debt-holders’ liability is the book value of debt and not the market value of debt. both measures of book and market values are often used. previous studies have shown that managers think in terms of book rather than market values. Findings and Conclusions One of main factors subject to intense debate in capital structure studies is whether to use the market value or the book value of debt and equity as the correct measure of leverage. First. On the other hand.

book value measures have stronger link with performance. incensement of financial distress costs has more significance. Why do we regard total liabilities ratio a more appropriate measure for capital structure? We argue that. There are other evidences for this relationship as following: Informational asymmetry and high costs of external resources and inefficiency of the market. Finally. it would be desirable to investigate the determinants of capital structure over a longer period of time and over a number of economic cycles. current debt is a quite steady part of total assets. Many measures of firm performance. firstly. the analysis could be improved by differentiating between types of debt such as long-term and short-term debt. Total liabilities ratio (TL) is used as the main measure of leverage and all the others are employed for robustness checks. such as a firm’s profitability. are negatively correlated with financial leverage. the creditor will consider not only how much the firm’s long-term debt is. Totally. debt level is over than optimized level and in comparison to advantages of tax shield. the conclusion is that company that has high profitability and good performance have less debt. This result can be interpreted in this way that high leverages companies would have less profitability. Rajan and Zingales. These results are consistent with the results of Mayers. Stulz. with respect to observed link between capital structure and performance. The reasons behind using of debts by Indian companies may be constant interest rate in any level of debt and risk. So the portion of other liabilities will affect the debt capacity of a firm. . but also how much the firm’s current debt and total liabilities are. when a firm wants to obtain more debt. This means market value should be taken more into consideration in evaluating capital structure. Second. On the method side. In other words.

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The results from tests on hypothesis .Table 1. The results of correlations Table 2.

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