Determinants of Capital Structure of Indian Companies: Pecking Order or Trade-off Hypothesis - Santi Gopal Maji Lecturer in Commerce

, Gushkara Mahavidyalaya, Burdwan, West Bengal, India. E-mail: sani_2india@yahoo.co.in - Santanu Kumar Ghosh Reader, Department of Commerce, University of Burdwan, Burdwan, West Bengal, India. This paper investigates whether the Static Trade-off or Pecking order theories explain the capital structure of Indian companies. The analysis is based on 160 Indian companies selected from nine manufacturing sectors for a period of 14 years from 1990-91 to 2003-04. The results indicate that neither the Trade-off nor the Pecking order theory fully explains capital structure²though evidence provides support in favor of the Trade-off theory. Introduction `Factors influencing capital structure of a firm' is a debatable issue which has engaged academicians for decades. Several theories have been put forward on this subject, after the landmark studies of Modigliani and Miller (1958, 1963) that established capital structure irrelevance and tax shield advantages. Amongst the several theories advanced to explain capital structure of firms, the Static Trade-off Theory (STT) and Pecking Order Theory (POT) are the most influential theories on corporate leverage. The STT presumes that firms set up a target debt ratio and try to achieve it. This target would be a trade-off between the cost and the benefit of debt, that is, bankruptcy cost against tax benefits. This theory also recognizes that target debt ratio may vary from firm to firm depending on size, growth, risk and profitability. A strong challenger of the trade-off model has emerged in the form of the Pecking order theory put forward by Myers (1984) and Myers and Majluf (1984). According to this theory, firms prefer a sequencing of financing due to: i) incongruity of information between company insiders and outsiders and ii) existence of transaction cost. The existence of asymmetric information between a company's insiders and outsiders affect the choice between internal and external finance, and between new issue of debt and equity. The outcome of this theory is that firms prefer internal sources to external financing of any sort, debt or equity. If external financing is needed, they should issue the safest securities first, then the risky debt and, at last, external equity. Between the two, many empirical studies attempted to identify the theory that has the best explanatory power for the determinants of corporate leverage in the context of the developed countries and, a few have reported international comparison of capital structural determinants. There are a few studies that provide evidence on the capital structure in developing countries (Singh et al., 1992; and Booth et al., 2001). Extensive empirical work using Indian corporate data is necessary, specifically after the opening up of the Indian economy, in order to verify whether alternative capital structure theories yield results comparable to those obtained with respect to

if it issues securities. does not reject entirely the issue of new shares. indeed. Theoretical Framework and Review of Empirical Studies Myers (1984) segregates the contemporary views on capital structure into two theoretical frameworks²Static Trade-off framework and Pecking Order framework. but there are some aspects of corporate financing where the Trade-off and Pecking order theories provide different predictions. Under Static Trade-off theory.the developed countries. while it decreases with volatility. Fama and French (2005) have pointed out that the two theories share many common predictions about the determinants of corporate leverage. Under the strong form. growth. Harris and Raviv (1991) observe that leverage increases with fixed assets. Baskin (1989) and Allen (1993) find evidence consistent with Pecking order hypothesis in the US (Baskin) and Australia (Allen). non-debt tax shield. profitability and uniqueness of the product. This theory also focuses on the agency conflicts. The Agency theory states that debt helps in solving problems derived from the firm's excess cash flow. Under the semi-strong or weak form. investment opportunities and firm size. size and profitability and have tested their influence on leverage by the following regression equation: Frank and Goyal (2003) have used financing deficit as an added factor apart from the above four independent variables used by Rajan and Zingles (1995) in the conventional regression equation. Chirinko and Singha (2000) argue that there are two forms of POT²the strong form and semi-strong or weak form. There is no target debt-ratio in the pure pecking order. The purpose of this paper is to test the STT and the POT using Indian corporate data. This may happen when a firm needs funds for future unknown events. a firm may issue certain external equity. Research studies pertaining to the determinants of corporate leverage indicate that there is no uniformity in the determinants of capital structure and the factors influencing corporate leverage. a firm sets up a target-debt ratio which is the trade-off between interest tax shield and cost of financial distress. Kakani (1999) concludes that profitability and capital intensity are negatively associated with leverage. In the Pecking order theory. Myers and Majluf (1984) point out that a firm is reluctant to issue new equity mainly due to asymmetric information between the management and the stockholders. The POT. These factors are: . a firm never issues external equity and uses internal sources and debt to finance new investment projects. advertising expenditure. Rajan and Zingles (1995) have used four determinants of corporate leverage²tangibility. but observe no significance of firms' diversification strategy and size in deciding the leverage level of the firm. a firm prefers internal to external financing and debt to equity.

tangible assets serve as collaterals and provide security to creditors in the event of financial distress. implying negative or insignificant relationship between dividend and leverage. but on account of their sufficient internally generated funds. the more willing would the lenders be. 1976). The attraction of interest tax shield is considered as second order effect in this theory. Myers (1984) and Myers and Majluf (1984) postulate that profitable firms borrow less²not due to their low target debt ratio. resulting in a positive relationship between size and debt. thus. which prompts firms to issue more debt in order to eliminate the problem (Fama and French. This implies that the cost of informational asymmetry is higher for large firms and it is more difficult for them to raise external finance (Rajan and Zingales. as argued by Harris and Raviv (1991). Higher the amount of debt capital. Less profitable firms issue debt because they do not have sufficient internal sources and because debt financing is the first in the Pecking order of external financing. this theory explains a negative relationship between profitability and leverage. one branch of static trade-off. The Static Trade-off theory. Titman and Wessels (1988) and Rajan and Zingales (1995) have observed significant positive association between tangibility and total debt. In contrast. Due to the asymmetry of information between the management and outsiders.. predicts positive influence of profitability on leverage. 1995). Dividend: A highly levered firm has higher contractual obligations in terms of payment of interest and repayment of debt. The Static Trade-off theory states that large firms have better reputation in the debt market and face lower information cost of borrowing. the larger the proportion of tangible assets. The alternative argument is that firm size may be a proxy for information asymmetry between insiders and outsiders. The agency stream. to supply loans and higher would be the leverage. firms with few tangible assets would have greater information asymmetry problems. Profitability: The Static Trade-off theory presumes that profitable firms use higher amount of debt capital in their capital structure. thus. Size: Large firms tend to be more diversified and less prone to bankruptcy (Rajan and Zingales. Empirically. firms issue debt to finance new investment projects. under Pecking order theory. states that. most researchers have observed a significant negative association between these two variables. However. As regards the empirical evidence. On the contrary. Hence. Collaterals also protect the lenders from moral hazard problems caused by shareholders-lenders conflict (Jensen and Meckling. The Static Trade-off theory suggests that dividends are high (retentions low) because external financing is low. predicts an inverse association between firm size and debt ratio. the Pecking Order . The Pecking Order theory. believes that large amount of free cash flows create the dispute between shareholders and managers. Less profitable firms use lower amount of debt capital because of the fear of financial distress. the higher would be the benefit of the interest tax shield. The Pecking Order theory. because equity issue would only be possible by under pricing. 2005). Remmers et al. 1995). While Rajan and Zingales have observed empirically a significant positive relationship between size and debt ratio. (1974) find no significant effect of size on capital structure.Tangibility: According to the Trade-off hypothesis. a firm with higher quantum of debt capital would be more reluctant to follow an aggressive dividend policy. Regardless of the industry in question. predicts an inverse association between tangibility and leverage. thus. according to Harris and Raviv (1991). The Static Trade-off theory.

bPRF and bLS > 0 and bDIV < 0. As explained earlier. However. For segregating the sample into high and low leverage. The nature log of sales is widely used as the proxy to measure firm size and the same has been adopted in the present study. Kakani (1999) has used total debt. in the capital structure of Indian companies. the usual prediction of POT is that bT.theory holds that dividends are a component of the firm's financial deficit (Shyam-Sunder and Myers. the common prediction of STT is that bT. the following multiple regression model is used: . The present study seeks to investigate the influence of the four aforementioned variables. T is asset tangibility. 1995) and is most commonly used in empirical studies. Appendix). Dividend per rupee is measured by the ratio of equity dividend divided by book value of equity. In contrast. there is no widespread agreement on whether book or market values are appropriate for testing the capital structure theory. profitability in this study is defined as cash flow from operations normalized by the book value of total assets. The use of the log of sales instead of sales is justified by the non-linearity between sales and size from some points onwards. There are again conflicts among researchers regarding the definition of profit. profitability and size. DIV is dividend per rupee and LS is the natural log of sales. (2001) have measured leverage using total debt. debt to asset (or debt to capital) is a more appropriate measure of leverage (Rajan and Zingales. Again. long-term debt and short-term debt to calculate leverage. following Rajan and Zingales (1995). the median value has been taken as the cut-off point.(1) where.. D is the debt ratio (leverage).. Database and Methodology The present study is based on a sample of 160 Indian companies selected from nine manufacturing sectors (number of firms selected from each sector is shown in Table 1. PRF is profitability. Titman and Wessels (1988) have also used different measures of leverage. firms selected for the present study have been categorized on the basis of degree of leverage. In order to test which of the above two influential theories has the power to explain the capital structure of Indian companies appropriately. long term book debt and long term market debt. 2005). as predicted differently by Static Trade-off and Pecking Order theories. bPRF and bLS < 0 and bDIV > 0. However. Firms with debt ratio above . The ratio of total book debt (excluding taxation and provisions) to total assets at book value (fixed assets plus current assets) is used in the present study to measure leverage. Tangibility is defined as the ratio of fixed assets to total assets.. 1999) and are positively associated with debt (Fama and French. Booth et al. The study period is sufficiently large to consider the effect of liberalization and globalization on capital structure of Indian companies. Several definitions of leverage have been used by researchers depending upon the objective of analysis. In order to test the validity of the Static Trade-off and Pecking Order theories to explain the capital structure of Indian companies. The relevant secondary data have been collected from CAPITALINE database for a period of 14 years from 1990-91 to 2003-04.

profitability. medium profitable firms. As it may be noted in all these tables.the median have been categorized as highly levered firms. Similarly. The Pecking Order theory proposes that firms with few . According to profitability. Hence. Following the same technique. the goodness of fits of these models does not suffer from any serious limitation so as to describe the relationship among the chosen variables of this study. size and dividend behavior of firms on corporate leverage. Less profitable firms are those with a profitability ratio of up to the 25th percentile of the distribution. condition index exceeds 10 or D-W statistic is significantly different from the desired norm of 2. 20 large firms have been selected out of 160 sample firms on the basis of combined quantum of total assets and sales value during the study period. substantial profitable firms and high profitable firms. Equation 1 was used to test the validity of the two theories in the Indian corporate scenario and the observations are summarized in Tables 2 to 6 (Appendix). perhaps the most important of the conventional variables is tangibility. large firms and largest firms on the basis of distribution of sales value. If in any run of the regression model. selected firms have been classified into smallest firms. firms with profitability ratio above 50th percentile but up to 75th percentile of the distribution are classified as substantially profitable firms. Tangibility: From the perspective of testing the Pecking Order. In order to verify the existence of multi-collinearity among the variables used here and dependability of the regression results. Regression results using first-difference form are shown in the tables for these cases as the signs of the regression slopes obtained through the above test mechanism remained same with those obtained by means of using the original variables. Results Static Trade-off theory and Pecking Order hypothesis provide different predictions on tangibility. The observed D-W statistics and condition index also strongly advocate the dependability of the results. barring a few. Results reported in Tables 2 through 6 (Appendix) are summarized below. all selected firms have been divided into less profitable firms. For firm specific analysis. condition index and D-W statistic respectively are shown in the tables. Thus. The important feature of this model is that it does not have an intercept term. Firms with a profitability ratio between the 25th percentile and 50th percentile of the distribution are classified as medium profitable firms. small firms. the present study has employed the first-difference method of the following form to obtain more acceptable results: where. the observed F statistics are highly significant and R2 are also quite satisfactory for all runs of the regression model. the regression result should not contain any statistically significant value for the intercept. High profitable firms are those with a profitability ratio in excess of the 75th percentile of the distribution.

It is evident from Tables 2. Similarly. Rajan and Zingales (1995) and Frank and Goyal (2003). but one (Steel industry). as expected in the Pecking . In contrast. firms with high profits employ higher amount of debt to gain tax benefits. predicts that large firms are expected to employ higher amount of debt capital in their capital structure. the degree of such an association decreases with the increase in firm size. to a large extent. speak in favor of the efficacy of the Pecking Order theory. the results are statistically significant. as tangible assets generally serve as collateral.). While the observed slope coefficient for `high profitable firms' is greater than the other classes of profitable firms. where profitable firms rely more on internal sources than external sources of any sort²debt or equity. thus. Significant negative association between profitability and debt ratio is observed for all cases when firms are classified on the basis of degree of leverage. Though negative association is observed in case of four companies. 3. In contrast. the relationship is found to be positive. giving priority to the internal sources. Regression results for selected 20 large firms (Table 6 Appendix) also support this positive association. Insignificant negative association is observed in case of three companies (TISCO Ltd. the findings of this study lend credence to the Trade-off theory. On the other hand. Profitability: According to the Static Trade-off theory. 3 and 4 of Appendix respectively). barring a few. the pecking order hypothesis postulates negative association between profitability and leverage because firms' prefer to sequence financing. of which the results for just 15 firms are statistically significant. The findings strongly support the proposition of the Static Trade-off theory. Appendix) also strongly support the efficacy of the Trade-off hypothesis regarding the association between tangibility and debt ratio. Except in the case of `Cement industry' where insignificant negative association is revealed. followed by debt and external equity. Irrespective of the degree of leverage and classes of profitability (shown in Tables 2 and 3 of Appendix respectively) the association is found to be positive and statistically significant. The findings strongly advocate the Pecking Order hypothesis with regard to this issue. The Static Trade-off theory. Associated Cement Company Ltd and Birla Corporation Ltd. Significant positive association is also observed when firms were classified on the basis of size. only one result is statistically significant. except in case of small firms (Table 4 Appendix). profitability and size (Tables 2. Appendix) also confirm the justification of the Pecking Order theory where negative association is found for all.tangible assets will tend to accumulate more debt over time due to the `asymmetric information' problem. Industry wise regression results (Table 5. the Static Trade-off theory predicts positive associations between them. Positive association is found in case of Hero Honda Motors Ltd and Zindal Iron and Steel Co. 4 and 5 (Appendix)that the association between firm size and debt ratio is positive and to a large extent. Significant positive association is observed for all but one (Tea industry). the Pecking Order theory expects an inverse association between them because of the cost of information asymmetry. Industry wise regression results (Table 5. It is important to mention here that these findings are consistent with Titman and Wessels (1988). The findings of this study indicate that large firms use higher amount of debt capital as proposed by the Trade-off theory. Results obtained for large 20 companies selected from the sample size of 160 also confirms the proposition of the Trade-off theory where the association is seen to be positive for 17 firms. Of those. Thus. the association is seen to be positive for 18 firms of which 12 results are statistically significant. On the contrary. regression results for selected 20 firms. Ltd. Size: Large firms are generally more diversified and have better reputation in the debt market.

Shyam-Sunder and Myers (1999) and Frank and Goyal (2003) have used dividend as a component of the firm's financial deficit and hence have hypothesized positive association with debt. Out of nine industries selected in the study. therefore. regarding the association between profitability and corporate leverage. The positive association between size and debt may suggest that the cost of financial distress is low and agency cost of debt is inversely related to firm size. negative association is found for six cases (Table 5 Appendix). This suggests a positive relationship between equity and firm size and an inverse association between size and debt capital. Conclusion The evidences provided in this paper results in mixed conclusions. The findings of this study neither strongly support the Trade-off theory nor reject the Pecking Order hypothesis with regard to this issue. seems not valid in the Indian context. While firms were classified on the basis of leverage and profitability (Tables 2 and 3 of Appendixrespectively). Unlike some of the earlier studies conducted around the world. in order to arrive at any agreeable conclusion on the determinants of capital structure of Indian companies. The study does not altogether reject the validity of the Pecking Order theory. If the transaction costs argument is valid. a firm's maintainance of a high dividend payout ratio will imply that profitable investment projects will have to be financed by a greater proportion of external funds than if the payout ratio was lower. suggested that further study should include some proxy to represent the market structure in which a firm operates. Industry wise regression results also depict a similar picture. though these results provide much evidence in favor of the former. But the findings of this study do not support the view of the Pecking Order theory fully. nor the Pecking Order. it speaks in favor of the Static Trade-off theory where it is expected that a highly levered firm will not maintain high pay out ratio. But this proposition. On a balanced consideration. It is. References . as revealed by the study. this study also fails to arrive at any conclusive evidence on the issue. The market structure in this complex scenario may be a useful candidate to influence the firms' financing decision. Rather. Dividend: The present study could not disentangle the relationship between dividend and leverage. then large firms will have lower cost of issuing equity. along with other variables. A mixed result is also evident from Table 6(Appendix) where negative association is found in case of 12 firms out of 20 selected firms. three of them are not statistically significant. especially. but the said association was seen to be positive for large firms (Table 4). It is also important to note here that all results are statistically insignificant. Though the Pecking Order theory does not provide a distinctive theory on dividends. to some extent.Order hypothesis. it may be concluded that the findings of this study neither support the Trade-off theory. The reported findings of various previous studies and also the present effort prompt us to think that some other variables remain unidentified which may have significant influence on the firms' financing decisions. negative association as expected in trade-off theory was observed.

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