Determinants of Capital Structure in Indian Automobile
Companies – A Case of Tata Motors and Ashok Leyland
Prof. R.M. Indi
Sinhgad Institute of Business Administration & Research, Pune
Abstract:
Firms use different sources of finance
having independent characteristics to fund their
operations and attain the ultimate goal of
creating value for shareholders. Every decision
in business has some connect with finance and
cost of finance. The Indian financial market has
been changing swiftly from banking oriented to
capital market oriented system. A Finance
manager has a variety of alternatives at his
disposal to raise the funds but each one comes
with a set of obligations and specific costs.
Raising funds is not a very tough task in this
liberalized era but the challenge lies in creating
an optimal capital structure that will lead to
wealth creation for shareholders. This paper has
tested the statistical significance of size of
business, profitability, tangibility and growth of
assets as impacting capital structure of Tata
Motors and Ashok Leyland in the auto industry.
The period of the study is 9 years from 2003 to
2011
Key words: Financial Leverage, Capital
Structure, Profitability, Tangibility, Size of
Business
Introduction:
Capital Structure refers to the way in which a
firm finances its assets through long term funds.
A business firm needs long term funds to
finance fixed assets like land, building,
equipment and also permanent working capital.
A firm can make use of different sources of long
term financing, where each source carries a
unique cost of capital. Two of the most
important sources of this financing are:
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1) Owners’s funds – Equity shares, Retained
earnings
2) Debt – Term loans, Debentures, Bonds etc.
While analyzing the importance of the owners
fund and debt, equity as source of finance has
fewer obligations as compared to the latter. Debt
has fixed obligation with fixed rate of interest
and definite tenure. These financial fixed
charges do not vary with the level of EBIT or
sales and they are incurred irrespective of profits
earned. Return to equity holders is affected by
the magnitude of debt in the capital structure of
the firm and its sales revenue.
Corporate finance theory is built on the premises
that the primary goal of a corporation should be
to increase shareholders’ wealth. Earlier
research in Financial Economics also indicates
shareholders’ wealth maximization as the
ultimate goal on which all business decisions
should rest. Shareholders’ wealth maximization
as goal should also be seen in the context of
collective social welfare. Jensen (2001) argues
that a firm’s wealth maximization would lead to
maximization of wealth of the society as well.
Use of fixed cost funds in the form of debt,
generates increased returns for equity
shareholders without additional contributions
from them. The employment of source of funds
for which the firm has to pay a fixed cost or
fixed rate of return may be termed as leverage.
Employment of debt in the capital structure
simultaneously increases the risk associated
with the business and returns available to the
shareholders.
Literature Review
Academic researchers have contributed different
views on capital structure theories.
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1) Net Income Approach: Propounded by
David Durand (1952) the capital structure
decision is relevant to the valuation of the
firm. A higher debt in the capital structure
leads to higher financial leverage and thus
results in a decline in overall weighted
average cost of capital. Consequently, there
is an increase in the value of the firm and
also the value of equity shares.
2) Net Operating Income Approach:
According to this theory, the value of the
firm is independent of its capital structure.
This assumes that increase in the
employment of debt capital increases the
expected rate of return for the stockholders
and the benefit of using the relatively
cheaper debt funds is offset by loss arising
out of the increase in cost of equity. The
market value of the firm depends upon the
net operating profit and the overall cost of
capital. The capital structure is irrelevant
and does not affect the value of the firm.
3) Modigliani and Miller Theory (MM,
1958): According to M&M Approach, the
cost of capital is independent of capital
structure and therefore there is no optimal
value. According to them, under
competitive conditions and perfect markets
the choice between equity financing and
borrowing does not affect a firm’s market
value because individual investors can alter
their investments and the mix of debt and
equity as per their desires. MM argues that
a company’s WACC remains unchanged at
all levels of gearing, implying that no
optimal structure exists for a particular
company. M&M supported their argument
that capital structure was irrelevant in
determining the market value of firm by
using ‘Arbitrage Theory’.
4) Jensen and Meckling (1976): They
developed the capital structure theory based
on agency costs. The firm incurs two types
of agency costs namely: costs associated
with outside equity holders and costs
associated with the presence of debt in the
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capital structure. Total agency cost first
decreases and after a certain level of
outside equity capital it increases.
5) Tariq N. Awan (2011): He analyzed the
impact of size, profitability, tangibility and
growth on the leverage position of sugar
and allied industries in Pakistan. He found
that size and profitability have negative
relationship while tangibility and growth
have a positive relationship with leverage.
6) Tubga Das (2009): He analyzed size,
tangibility and profitability as determinants
of capital structure. Firms with more
tangible assets use higher long-term debt.
As firms grow larger, they become more
diversified and risk of failure is reduced; as
a result they can have higher leverage. In
case of small companies, they have limited
access to debt financing. For a listed firm,
profitability has no effect on leverage
decisions of firms. Hence listed firms do
not take profitability into consideration
while making decisions about debt
financing.
7) Keshar J. Baral (2004): He analyzed the
impact of Corporate Size, Business Risk,
Growth, Earning Rate, Dividend Payout,
Debt Service Capacity and Degree of
Leverage on capital structure. Out of these
seven only three factors, namely size,
growth and earning rate are statistically
significant determinants of leverage. These
variables explain 72% of the variation in
financial leverage. This fact indicates that
corporate size, growth rate and profitability
play a major role in the determination of
financial leverage and business risk, while
dividend payout ratio, debt servicing
capacity and degree of operating leverage
play an insignificant role.
Research methodology
Data Collection: In this study the annual
reports of two major auto companies in India are
referred and the same have been collected from
9
their official websites. Other secondary data is
also collected from Journals and the Internet.
. H03 :- There is no significant relation between
Sample Design: This paper is focused on the
determinants of capital structure in auto industry
and has a case study approach. The companies
considered for study in the paper are Tata
Motors and Ashok Leyland.
Objective of the study: To examine the
determinants of capital structure in the auto
industry.
Scope and Limitations of the study:
1) The study is restricted to only two
companies in the automobile sector.
2) Study Period of 9 years i.e. March 2003
to March 2011 is considered for
analysis.
3) The study is based on four determinants
of a capital structure. (See Table no.01)
H02 :- There is no significant relation between
profitability and financial leverage.
tangibility and financial leverage.
H04 :- There is no significant relation between
growth in asset and financial leverage.
Specification of the model: The following
multiple regression model has been used to test
the theoretical relation between the financial
leverage and characteristics of the firm.
Y = a+b1X1+b2X2+b3X3+b4X4
Where
Y = Financial Leverage
X1:- Size of firm
X2:- Profitability
X3:- Tangibility
X4 :- Growth

Justification of Choice of Companies:

The two companies selected in the analysis

of capital structure have a long standing in the
Indian automobile market. Tata Motors was
established in 1945 while the origin of Ashok
Leyland dates back to 1948. Together they
enjoyed approximately 80% market share in the
Medium and Heavy Commercial Vehicles
(MHCV) sector during the study period. The
period of study from 2002-03 to 2010-11 has
witnessed cyclic fluctuations in the MHCV
sector with demand being sluggish in the initial
years followed by recovery during the middle
years and drop in the volumes during global
meltdown and subsequent recovery towards the
end. Thus analysis of their capital structure can
be representative of the sector.

Hypotheses

The study has tested the following null

hypotheses on relation between the defined
variables and capital structure of auto industry.
H01 :- There is no significant relation between
size and financial leverage.

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3.7 Definition of Variables:

Name of Variable Definition Supported by

Financial Leverage
Size of Business
Long Term Debt/Total Asset
Log of Sales
Rajan and Zingales (1995),Booth et
al(2001),Gracia and Mira (2008), Paulo
F. Pereira Alves(2011)
Keshar J. Balal (2004), Tariq N. Awan
(2011), Fabio Zambuto(2011), Paulo F.
Pereira Alves(2011), Antonios
Antoniou

Profitability Ratio of Net income before tax to Tariq N. Awan (2011), Tugba Bas et al
total asset (2009),S.Franklin John et.al.(2010)
Tangibility Ratio fixed asset to total asset Sarune Sidlauskiene (2009),Tariq N.
Awan (2011), Paulo F. Pereira
Alves(2011), Andre Getzman et
al(2010), Antonios Antoniou

Growth in Asset % change in total asset Tariq N. Awan (2011), Amarjit Gil et.al.
(2009)

Table 01

Use of Statistical Tools in Research:

The following statistical tools were used during the research process:
1) Regression 2) Correlation 3) ANOVA
Analysis of Results:

Descriptive Statistics
Dependent and
Independent Financial Size of the Growth in
Variables Leverage business Profitability Tangibility Asset
Mean 0.354812 25.5744 0.148244 0.588395 16.76641
Median 0.348433 25.46465 0.165054 0.550309 17.22973
Skewness 0.374604 0.021116 -0.2516 0.709661 1.022494
Kurtosis 0.0409 -1.14777 -1.40491 -0.76537 2.714109
Maximum 0.501821 26.97971 0.24077 0.809482 75.05362
Minimum 0.234702 24.14883 0.036637 0.44504 -17.9688

Table 02 – Descriptive Statistics

Table 02 indicates descriptive statistics of Tata Motors and Ashok Leyland between the periods 2003
to 2011.

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Correlation

Sales PBT Tang Growth

Size of the Business 1
Profitability -0.02549 1
Tangibility -0.12065 -0.26011 1

Growth in Asset 0.604198 -0.03769 -0.11703 1

Sales PBT Tang Growth

Size of the Business 1
Profitability -0.02549 1
Tangibility -0.12065 -0.26011 1
Growth in Asset 0.604198 -0.03769 -0.11703 1

Table 03- Correlations among Independent variables (A check for multicollinearity)

Table 03 indicates that the highest correlations value in two variables is 0.60 which mean it is
tolerable, and that a multi-collinearity problem is unlikely in the regression model amongst
independent variables.

Regression and ANOVA Results

Regression Statistics
Multiple R 0.853213
R Square 0.727973
Adjusted R Square 0.644272
Standard Error 0.044882
Observations 18
Table 04- Regression Statistics
Analysis of Variance (Anova)
Significance F
df SS MS F (α= 0.05)

Regression 4 0.07008 0.01752 8.697325 0.001211365

Residual 13 0.026187 0.002014

Total 17 0.096267
Table 05– Analysis of variance

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Regression coefficients
Standard
Coefficients Error t Stat P-value (0.05)
Intercept -0.320905815 0.417607 -0.76844 0.45596
Size of the
business 0.035876095 0.016176 2.217832 0.044998
Profitability -0.806380156 0.161315 -4.9988 0.000243
Tangibility -0.204282451 0.099597 -2.05108 0.060978
Growth in Asset -0.000122375 0.000663 -0.18471 0.856304
Table 06 - Regression Analysis

From Tables no.05, 06, 07 the results of the analysis are as follows:
1) The value of R2 is 72%. It suggests that Size of the Business, Profitability, Tangibility and
Growth in Assets explains 72% variation in the leverage.
2) Significance F at (α =0.05) is 0.001 in ANOVA suggests that overall model is good.
3) Regression analysis shows that of the four independent variables, Size of the Business and
4) Profitability are statistically significant with positive and negative relationship respectively.

Conclusion 1) Andre Getzman, Sebastian Lang, Klaus

Spremann (2010) “Determinants of the
In this paper the author has studied those Target Capital Structure and Adjustment
factors which have significant influence on Speed Evidence from Asian capital
capital structure decisions of the two auto Market”, retrieved from
companies under consideration. For a www.uibk.ac.at/ibf/sonstiges/seminar/ta
regression model, four independent variables rgetcapitalstructureasia.pdf
(Size, Profitability, Tangibility and Growth in 2) Amarjit Gil, Nahum Biger, Chenping
Asset) are considered to predict the dependent Pai, Smita Bhutani (2009), “The
variable, Financial Leverage. Correlation of Determinants of Capital Structure in the
four independent variables has suggested that Service Industry : Evidence from the
there is no problem of multi-collinearity and United States” , The Open Business
ANOVA result shows that the overall model is Journal, pp. 48-53
good at 5% level. Regression analysis shows 3) Fabio Zambuto (2011), “Capital
that Tangibility and Growth in Asset have Structure decisions in
negative relationship, but the results are not Biopharmaceutical industry”, Paper
statistically significant. Due to their presented at International conference on
insignificance it can’t be concluded that Industrial Engineering and Operations
Tangibility and Growth in Asset are positively Management
or negatively related with the financial 4) Keshar J. Baral, Volume I
leverage. As such, the null hypothesis about ‘Determinants of Capital Structure: A
Tangibility and Growth in Assets is accepted. case study of Listed Companies in
Size of the business and profitability are Nepal’ The Journal of Nepalese
statistically significant. Therefore, it is Business Studies, Vol. I No. 1 Dec.
concluded that the size of the business and 2004 pp. 1-13
profitability are the strong determinants of 5) Muhhamad Rafiq, Asif Iqbal,
capital structure of Tata Motors and Ashok Muhhamad Atiq, (2008) “ The
Leyland. Determinants of Capital Structure of the
Chemical Industry in Pakistan” The
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