Professional Documents
Culture Documents
Introduction
reduces the firm's tax liability, but increases the financial risk. The
which the level of debt minimizes the overall cost of capital, maximizes
earnings available to owners and thus maximizes the total value of the firm.
Hence there exists a relation between capital structure and cost of capital.
This relation has been examined by many theorists and researchers. Theories
these two variables and the factors which influence the relationship in selected
valuation and minimum cost of capital is perennial. There are two extreme
views on this. The traditional school, at one extreme, argues that there
that there does not exist an optimal capital structure at any stage and the
as net operating income approach which argues that risk content of the
a matter of fact they redistribute this risk among shareholders. Hence there
which would minimize the cost of capital and maximize the market value
of the firm.
The Net Income and the Net Operating Income Approaches : Net
Income and the Net Operating Income Approaches were developed by David
Durand. 1 The essence of net income approach is that the firm can lower
its cost of capital by using debt. The approach is based on the assumption
1.
Durand, David, "Costs of Debt and Equity Funds for Business : Trends
and Problems of Measurement", in Ezra Solomon (Ed.). The Management
of Corporate Capital, New York : The Free Press, 1959, pp.91-116
202
that the use of debt does not change the risk perception of the investor.
Consequently the interest rate on debt (Ki) and the equity capitalization
overall cost of capital declines and the total value of firm rises. The overall
structure which is reached when the cost of capital is at the lowest. However,
a c r i t i c a l point may be reached beyond which the cost of capital may start
The net operating income approach, on the other hand, contends that
the capital structure does not matter, and that the firm cannot affect its
constant. This results from the fact that as more debt is incurred, equity
their capitalization rate of earnings in such a way as to cancel out the benefit
derived from t h e use of debt, and the average cost remains unchanged. But
it is possible that beyond a high level of leverage the cost of debt may
increase. In such a case, the cost of equity will have to fall to keep the
structure is akin to the Net Operating Income Approach. But, NOI approach
structure. M.M. Thesis does support the NOI approach relating to the
cost of capital and therefore total value of the firm. In other words, the
M.M. approach maintains that the weighted average cost of capital does
premium related to financial risk equal to the debt equity ratio times
/f
the spread between capitalization rate and yield on debt.
2.
Van Home, James. C, Financial Management and Policy, New Delhi :
Prentice Hall of India Pvt. Ltd., 1983, p.248
3.
Modigliani, Franco and Miller, Merton. H., "The Cost of Capital,
Corporation Finance and the Theory of Investment", The American
Economic Review. Vol. XLVIII No.3, June, 1958, p.268
Ibid., p.271
204
3. The cut off point for investment in the firm in all the cases will
(at lower prices) and selling it in another (at a higher price). M.M. contend
that market value of those firms which are identical except for the difference
in the pattern of financing will not vary because arbitrage process will drive
the total values of the two firms together, Rational investors, according
two assets in the same risk class and with same expected returns from selling
at different prices.
through use of leverage, can alter corporate leverage. Tlis argument cannot
5.
Ibid., p.290
6.
Walker, Ernest. W., Essentials of Financial Management, New Delhi :
Prentice Hall of India, 1976, p.99
205
Solomon. The crux of the traditional view relating to leverage and valuation
is that through judicious use of "debt to equity proportions", a firm can
increase its total value and thereby reduce its overall cost of capital. The
in the overall cost of capital and a rise in the market value of the firm.
In the first stage, cost of equity rises as debt is added but does not
increase fast enough to offset the advantage of low cost debt ; cost of
debt remains constant or rises modestly. As a result, the value of the firm
The overall effect of these three stages suggests that the cost of
the effect of leverage on cost of capital and market value of the firm,
structure.
by suggesting that cash flows should be examined under the most adverse
flows with the cash required to meet the firm's fixed charges at each level
to have unused debt capacity. If, however, there is a probability that future
cash flows will not meet the fixed charges during adverse periods, management
must decide, whether it wants to accept the risk involved ; if not, debt
must be reduced.
capital structure. He states that there are six determinants namely borrowing,
reserve, financial insurance, tax, savings and pools of capital which would
serve as a guide in determining the level of debt that a firm can afford.
Although each determinant must be considered, Childs thinks that the first
three are the most important, that is, debt should not be used in an amount
that will (i) destroy the firm's reserve to borrow (ii) eliminate financial
9.
Donoldson, Gordon, "New Framework for Corporate Debt Policy",
Hardward Business Review, March-April 1962, pp.117-32
10.
Childs, John F., Long Term Financing, New York : Prentice Hall Inc.,
1961, pp.7-37
208
the nature of the business and its inherent risks affect the firm's ability
associated with the firm and relate it to the amount of debt that will be
employed.
Thus far, the discussion has touched on the theories of capital structure
the relationship between capital structure and the cost of capital in the
We have seen that cost of debt is higher than the cost of share capital
What is the nature of the relationship between capital structure and the
cost of capital ?
The relationship between the capital structure and the overall cost
of capital in both the cooperative sugar and spinning industries is that the
is less than 15 percent, the overall cost of capital is less than 1.5 percent.
209
But as the proportion of debt increases, the overall cost of capital also starts
rising. (See Tables 6.1 and 6.2)
The results indicate two things. First, the use of debt in capital
structure affects the overall cost of capital and thus the cost of capital
evidence reveals that the overall cost of capital increases as the proportion
of debt or leverage. Thus, the use of debt leads to high cost of capital
This section analyses empirically the factors which have a bearing on capital
which shows that the 'Need for Funds' and the 'Internal Financing' are the
two immediate factors which have influence over the leverage. The 'need
for funds' depends on required initial investment, growth rate and social
influence of 'need for funds' and 'internal financing' and the factors behind
Need for funds : The need for funds is the first factor which has
initial investment depends upon the proposed installed capacity and social
not be able to mobilize adequate equity capital from its members because
for financing its assets. The need for additional funds arises when a firm
it involves a huge capital outlay. This could not entirely be met out of
owned funds. Hence a firm has to resort to debt to meet the additional
investment.
to
-1^
>
215
Apart from this a firm has its social obligations. The cost of welfare
measures such as education, health care facilities for members and employees
and housing for employees, etc. is called social cost. Social cost is un-
productive in nature.
could easily meet and settle its fixed obligations at a quicker pace and could
generate its own internal funds. This would not only help such firms to
reduce the proportion of debt in their capital structure but also, would
anticipates a stable profitability can boldly resort to debt capital _to- finance
its assets, for it may not have any difficulty in honouring its future fixed
internal funds and therefore it can modify its capital structure to its best
sales. But if sales fall, it will suffer a greater loss. Thus the degree of
(See Chapter k)
The extent of the firm's fixed costs in operation also influences the degree
of operating leverage.
increase its production and productivity and this would contribute towards
profitability.
implies the efficiency with which capital employed is rotated in the process
the efficiency in utilising the total assets, fixed assets and inventory.
217
with a fairly higher percentage of gross margin is well on the way to higher
help a firm to achieve a higher gross operating margin. On the other hand,
operating margin. The variability in sales may also affect gross operating
margin. If the sales revenue is fairly stable, then the firm's profit would
be stable. Such a stability paves the way either for going in for a higher
level of debt or for lessening the proportion of debt in the capital structure.
has an influence on the gross operating margin. A sugar mill with higher
percentage of recovery, other things being equal, could bring down the cost
From the foregoing analysis it is clear that the "need for funds" and
the "internal financing" are the two factors which directly influence the
We will begin with 'need for funds' and the factors which influence
depends on the nature of the industry. Firms with low capital intensiveness
may require less amount of funds whereas firms which are of a high capital-
intensive nature may require large funds. Funds required at the time of
to honour social commitments are called social cost. Thus the need for
funds depends on initial investment, growth rate and social cost. (See Page 214)
In this section we will see how these factors affect the 'leverage' in the
selected cooperatives.
intensive mills. The project costs of these mills increase year after year.
The project cost of a cooperative sugar mill with a capacity of 800 to 1000
TCD established in the middle of 50*s was Rs.110 lakhs. The mills
commissioned in 60's, 70's and 80's had to incur very high project cost because
of the sharp escalation in the cost of machinery, building material and land.
13. Data were drawn from the Annual Reports and Working
This increased to Rs.660 lakhs in 1976-77 and shot upto Rs.1020 lakhs in
80's recording around a four-fold increase in the project cost over a period
14
of 20 years. Thus the establishment of the cooperative sugar and spinning
are no reserves. Thus the equity capital is meagre. Hence the mills, at
the time of their establishment, have to rely heavily upon debt. An analysis
of the mode of financing of the sample sugar mill reveals that the proportion
out that the major chunk of the equity contribution comes from the
to 40 percent. Here also the major part of equity is from the government.
14.
Data were compiled f r o m Inaugural Reports and Annual Reports of
the Cooperative Spinning Mills.
220
of the capital cost was financed by debt and the rest by equity. The equity
there would be escalation in cost and the original estimate has to be revised.
For instance, the project cost of the mills with identical capacity established
at the same time was found to have varied by 5 to 10 lakhs in both cases.
The reasons for such variation are shortage of capital resources, longer
from the original estimate will force cooperatives to go in for more debt
capital. Further it would also affect the working of the mills and most
their long-term loans. This in turn would keep the proportion of debt in
17
the capital structure at a higher level.
Growth rate and Leverage : A firm with a stable growth rate calls
for more funds and a greater proportion of these incremental funds may
15.
Cooperative Spinning Mills established after 19S3-'84 do not come
under the purview of the study.
16.
Data were drawn from the project reports of the newly established
Cooperative Spinning Mills.
17.
Kadvekar S.V., Management of Cooperative Spinning Mills in
Maharashtra, New Delhi : Indian Book Gallery, 1980, p.160
221
be derived from debt sources. The growth rate depends on expansion and
the need^for long-term funds would be almost nil. A higher debt component,
other things being equal, comes with an expanding industrial activity and
different authors have used different criteria for measuring the growth.
20
Gupta measured the growth of the firms in terms of annual compounded
21
growth rate in sales. Singh and Whittington have used book value of net
22
assets as a measure of growth rate. Archer and Faerher have used the
18.
Pendse, "Financing New Industrial Ventures : Some Inhibiting Factors",
Economic and Political Weekly, Vol.XII, No.3, July 23, p.1190
19.
Toy N. et.ai., "A Comparative International Study of Growth, Profita-
bility and Risks as Determinants of Corporate Debt Ratios in Manu-
facturing Sector", Journal of Financial and Quantitative Analysis,
Vol.9, Nov. 1974, pp.875-86. They found positive association between
growth rates and debt ratios.
20.
Gupta M.C., "The effect of Size, Growth and Industry on the Financial
Structure of Manufacturing Companies." The Journal of Finance, Vnl.?fc.
No.2, June 1969, p.584
21.
Singh D and Whittington G., Growth, Profitability and _Vs
London : Cambridge University Press, 1968, p.22
22.
Archer S.K. and Faerher H.L., "Firm Size and the Cos
Secured Equity Capital", Journal of Finance, Vol.21, No
p.73
222
23
amount of t o t a l assets as a measure of growth rate. Breen and Lerner
have used the market value of the share outstanding as a measure of a firm's
growth rate. We, in our study use the amount of gross fixed assets as a
basis for measuring the average annual growth rate. The rationale behind
The relationship between average annual growth rate and the leverage
is analysed. It is seen that mills with lower growth rate have lower proportion
of debt in their c a p i t a l structure and the mills with higher growth rate
growth rate of 6 to 7.5 percent was less than 30 percent in many of the
years under review, whreas the proportion of debt in cooperative sugar mills
with an annual growth rate of more than 7.5 percent ranged between 30
23.
Breen W.J. and Lerner E.M., "Corporate Financial Strategies and the
Market Measures of Risk and Return" Journal of Finance, Vol.28,
No.2, May 1973, p.342
24.
See for example, Misra R.K., "Sales Forecasting and Financial Manage-
ment in Sugar Industry", Management Accountant, Vol.20, No.3, March
1985, pp.HU-145
Table 6.*
Relationship between Average Annual Growth Rate of Gross Fixed Assets and Leverage
in Cooperative Sugar Mills
hO
tsj
OJ
KJ
1SJ
-c-
*4
225
But it is insignificant. This means that growth rate and leverage are not
the funds required for expansion of the cooperative sugar mills was met
Tables 6.7 and 6.8) Thus initially, when the cooperatives do not have internal
funds they rely more upon debts. But when they go in for expansion or
funds.
in which they perform their business activities. They have social responsi-
two categories of mills covered under the study, cooperative sugar mills
were found to have bestowed much attention upon social development than
the cooperative spinning mills. In this section we will see some of the social
Table 6.6
Table 6.7
Capital Expenditure for Expansion of Capacity in
Cooperative Sugar Mills : Sources of Finance
(Rupees in Lakhs)
228
Table 6.8
Capital Expenditure for Expansion and Modernization in
Cooperative Spinning Mills ± Source of Finance
(Rupees in Lakhs)
229
school with a student strength of 803 and has spent an amount of Rs.55.94
scheme with a student strength of 180. The mill has constructed buildings
The mill has also proposed to construct a hospital with 50 beds at a cost
cooperative sugar factories are also too well known to need a separate
contributed funds to eye camps, the nutritious noon meal scheme and other
(in the case of cooperative sugar mills) are generally met from net earnings
and from Area Development Fund. Mills with higher profitability were
which have influence over the profitability are capacity utilization, degree
Finally all the five variables are put into multiple correlation and regression
The factors which determine the full capacity utilization in the case
of sugar mills are regular cane supply and avoidance of mechanical breakdown.
mills are uninterrupted power supply, discipline among the labourers and
sales. But if the sales fall, the firm with high degree of operating leverage
This means that degree of operating leverage does not influence profitability.
This may be explained. The percent change in sales should result in a percent
change in profit. This is possible only when there is stability in sales and
sales. Besides this the government policy of control over sugar price and
on release of sugar for sale in the open market greatly influences the price
of sugar and therefore the sales. Similarly government control on the sale
of yarn in the open market affects sales in the cooperative spinning mills.
The stability in operating expenses depends on supply price of raw
material or labour. The supply price of raw material especialy in the case
no say over it. Thus the two important factors namely stability of saies
percentage change in sales does not always lead to percent change in profit.
This would have caused negative and insignificant relationship between the
assets. It can be measured through efficiency ratios like total assets turnover,
fixed assets turnover, and inventory turnover. The influence of these ratios
The total assets turnover ratio indicates the sales generated per rupee
from all its financial resources. As this ratio increases, there is more revenue
assets increase the firm's need for costly financing and the expense of
maintenance and upkeep. Thus the higher the total assets turnover, the
The weak association between these two variables may suggest high level
of under-utilization of assets.
233
The fixed assets turnover ratio measures the efficiency with which
the firm is utilizing its investment in fixed assets. It also indicates the
of fixed assets. Thus fixed assets turnover tends to have a positive association
with profitability.
it can be said that the higher the fixed assets turnover the higher is the
profitability.
increased costs. Thus inventory turnover ratios are likely to have positive
Table 6.9
Simple Correlation of Selected Factors with Profitability
(Cooperative Sugar Mills)
235
Table 6.10
Simple Correlation of Selected Factors with Profitability
(Cooperative Spinning Mills)
236
explanation may be that the cooperative spinning industry might have too
high inventory turnover ratios which in turn might, possibly be the result of
stockout. This might have caused a weak association between the variables.
mills, whereas capacity utilization and fixed assets turnover have positive
were computed.
and fixed assets turnover and is significant at 1 percent level. The association
237
significant at 1 percent level. The negative sign suggests that the higher
tne capacity utilization, the lower is the inventory turnover and vice-versa.
The association of total assets turnover with that of fixed asset turnover
utilization, total assets turnover and inventory turnover. (See Table 6.11)
and total assets are positively associated ; but the association is weak and
insignificant. The association between total assets turnover and fixed assets
of inter -correlations among the variables are mixed and they demonstrate
Table 6.12
Inter-Correlation between Independent Variables in
Cooperative Spinning Mills
240
that three variables namely capacity utilization, fixed assets turnover and
profitability. The first one is significant at 5 percent level and the last
two at 1 percent level. The degree of operating leverage and the total
percent level. This means that all the five variables have a significant
• • 2
Table 6.13
Contribution of Independent Variables to the Total Variance of Profitability
Results of Partial Regression and Multiple Correlation Analysis
(Cooperative Sugar Mills)
tea..
242
the above factors to p r o f i t a b i l i t y was only 7.2 percent. (See Table 6.15)
operating margin. Since gross operating margin has a direct relation with
We have seen that the higher the gross operating margin, the higher
at 1 percent level which shows that gross operating margin is strongly and
Table 6.14
Table 6.15
Contribution of Independent Variables to the Total Variance of Profitability
Results of Partial Regression and Multiple Correlation Analysis
(Cooperative Spinning Mills)
245
Table 6.16
The factors which are identified and are expected to have influence
over the gross operating margin are the rate of recovery, the rate of change
in cost of production, the rate of change in selling price and the variability
in sales. In the case of cooperative spinning mills only two variables, namely,
the rate of change in cost of production and the variability in sales were
studied. The other two factors - recovery of yarn and rate of change in
the gross operating margin is the same as that used to study the factors
influencing profitability.
sugar from sugarcane helps in reducing the cost of production and therefore
246
level. That is, an upward trend in the rate of change in cost of production
results in lower gross operating margin and a downward trend in the rate
(See Table 6.17) The results in cooperative spinning mills show a very
Table 6.18)
247
rise or fall in selling price affects the gross operating margin. A higher
and upward rate of change is likely to increase the gross operating margin,
on sugar price.
operative sugar mills and is significant at 5 percent level. (See Table 6.17)
sugar produced during the f i v e months has to be stored and released in the
market, over the f u l l year. Unless the releases from the factories to the
levy system and control on release of open market sugar. Such a control
248
Table 6.17
Simple Correlation of Selected Factors with Gross Operating Margin
(Cooperative Sugar Mills)
249
Table 6.18
Simple Correlation of Selected Factors with Gross Operating Margin
(Cooperative Spinning Mills)
250
may not cause much variation in sales. This confirms an earlier conclusion
arrived at by Chakraborthy. 25 Hence the negative association.
25.
Chakraborthy S.K., Corporate Capital Structure and Cost of Capital,
Calcutta : Institute of Cost and Works Accountants, 1977, p.84. He
says that •''• when there is an external control on sales, sales value
figure will have different relation with gross operating margin.
251
the cost of production and the variability in sales is negative and significant
at 5 percent level. This means a rise in cost of production affects the sales.
The association among other variables are insignificant. (See Table 6.19)
Table 6.19
Table 6.20
Significant at 1 % level.
case of cooperative sugar mills were put into multiple correlation and
together have a significant relationship - the first one positive and the last
two negative - with gross operating margin. The variables, rate of change
in selling price, did not make any significant contribution to gross operating
margin, when the effects of all other variables were controlled. The value
level. This means that the above four variables together had a significant
2
positive relationship with gross operating margin. The value of R is 0.249.
factors only, a fresh multiple regression equation was fitted with them.
together account for 23.6 percent of the variation in gross operating margin
2
(R = 0.236). This is only about 1.3 percent lower than the total contribution
(24.9 percent) of all the four factors put into multiple regression analysis.
Thus the influence of rate of change in selling price on gross opperating margin
Table 6.21
that the test is significant at 1 percent level. Of the two factors, variability
255
Table 6.22
significant at 1 percent level. This means that the two variabiles together
So far our discussion has centred around the profitability and the
more internal funds. If a firm has a high volume of retained earnings then
correlation technique.
26.
Charleton W.J. and Silberman I.H., "Joint Determination of Rate of
Return and Capital Structure : An Economic Analysis", Journal of
Finance, Vol.32, No.2, June 1977, pp.811-21. The authors are of the
opinion that high profitability will automatically reduce debt ratios
through retentions. Also see, Harold, Peterson, "Risk and the Capital
Structure of the firm" Journal of Finance, Vol.XIX, No.l, March
1964, pp.120-21.
257
Table 6.23
level for both cooperative sugar and spinning mills. (See Table 6.2k) That
is, higher retained earnings lead to low level of leverage and vice-versa.
Table 6.2f
Thus far, we have seen factors affecting leverage given in the model
with empirical evidence. Now we will present two more factors which a r e
not included in the model but have a steady influence on the leverage.
have a large recourse to loans because of the high capital outlay and in-
adequacy of owned funds. An older firm, on the other hand, may have enough
a positive correlation between age and fund availability, because age implies
27
a record of successful operation and solvency. This means, as age increases
all the cooperative spinning mills are long standing ones. The relation between
age and leverage in cooperative sugar mills indicates that debt level is more
than t+5 percent in older cooperatives in many of the years under review
In spite of age, many of them have not been able to bring down the proportion
Table 6.26)
cooperative sugar mills. The indication is that old age cooperatives tend
the higher the age Qf.ih.e:roill,ithe lower may be the level of leverage is proved
result thus runs against the hypothesis. This is due to unsuccessful operations
, 28
ol many of the cooperative spinning mills.
27.
3acoby N.H. and Weston J.F., "Factors Influencing Managerial Decision
in Determining Forms of Business Financing" in Financial Management
Eds., Corrigan F.J. and Ward H.A., New York : Houghton Miffin,
1963, p.75
28.
Chakraborthy S.K., Op.Cit., p.96
260
Table 6.25
Leverage
Age 0-15 15 - 30 30 - 45 45 - 60 60 - 75 75 - 90 Total
261
Table 6.26
Table 6.27
selected for the study were classified into successful and unsuccessful co-
and spinning mills, whereas it was high among the unsuccessful cooperatives.
and the hypothesis relating to this association is proved. That is, a successful
Conclusion
and the factors influencing the relationship for cooperative sugar and spinning
mills were analysed and the analysis leads to the conclusion that the cost
Table 6.28
Table 6.29
Table 6.30
w
267
structure and the cost of capital are the need for funds and the internal
financing.
with leverage. But the association was found to be weak. Social cost is
mainly funded out of net earnings and Area Development Fund and so it
turn, was determined by gross operating margin, fixed assets turnover and
was further carried out to locate the factors affecting gross operating margin.
Age is also found to be related to leverage ; but the results are not