DETERMINANTS OF CAPITAL STRUCTURE: AN EMPIRICAL EVALUATION OF INDIAN FIRMS

Abstract

With the globalization of the Indian economy, it has witnessed a tremendous movement of capital from various companies across the globe. As a result, there is a shift of corporate goals from socio – economic front to an increasing shareholder’s wealth. The capital structure decision plays a crucial role which decides the success of the firm. For an emerging economy like India, it becomes extremely important to decide the right mix of debt and equity. As, any debt without its earning potential can be hazardous to the financial health of the firm. It has well proven in the past that high debt attracts the risk of bankruptcy. It is important to understand the complexities of the capital structure. Any wrong financial decision on the part of the firm can shake the trust of the various investors and stakeholders of the firm. The financial manager of the firm should try to achieve that leverage mix which can maximize the value of the firm, keeping, in concern of the overall cost of capital. Hence, it has become necessary to understand all those factors which help in determining the optimal capital mix. Till 1950’s, the literature of corporate finance comprises mostly descriptions of approaches and foundations. It was in 1958, when Modigliani and Miller (MM) provide a major breakthrough on the subject, when they argue that capital structure is irrelevant in determining the firm’s value under certain assumptions. Despite, the various numbers of capital structure theories and empirical studies, researchers in corporate finance have not found a benchmark that can provide an optimal capital structure. There is no universal theory of capital structure which can solve the problem of debt-equity mix. The control of various determinants to decide the leverage level is not constant. More than five decades have passed since MM proposition, but there are still many questions that remain unresolved. Also, most of the previous studies have been largely restricted to the United States and a few other developed countries. The significance of capital structure in relevance to the Indian manufacturing sector has yet to be established. Thus, this empirical study tried to examine some of the questions related to the capital structure of the selected firms operating in the Indian manufacturing sector. vi The primary objective of the present study is to identify the key determinants of capital structure of the selected Indian manufacturing firms. Then, it validates which theory propositions are more applicable to the Indian manufacturing sector, i.e. trade-off theory or pecking order theory. Further, it will analyze the leverage trends and the impact of leverage mix on the value and performance of the sample firms. Then, it analyzed the effect of ownership structure on the capital structure of the sample firms. Finally, the study examines the relationship between leverage, liquidity and performance of the firm. The sample size of the present study consists of 422 trading Indian manufacturing firms on the Bombay Stock Exchange (BSE). The data were analyzed for a period of ten years from 2004 to 2013. This study employs panel data regression technique to attain the desired objectives. The panel data regression is an advanced analytical technique which employs both time-series and cross-sectional data. Since the last decade or so, panel data technique has occupied a central stage in the field of quantitative research. It has become popular among various social and behavioral science scholars. It has become one of the most practical and advanced practice of literature in Econometrics. This study performs a robust analysis of capital structure in the Indian manufacturing sector in terms of determinants, trend analysis and linkage with firm performance indicators. It was found that firm specific factors like size, age, tangibility, growth rate, profitability, non-debt tax shield and uniqueness are the key significant factors that determine the capital structure of the selected 422 Indian manufacturing firms. The large sized and profitable Indian manufacturing firms prefer internal financing over external source of financing. Both trade-off and pecking order theory explains the capital structure of the sample firms. It is observed from the leverage trends that firms prefer debt financing over equity financing. The Modigliani and Miller (MM) proposition of a firm’s value is independent of its capital structure doesn’t hold true for the firms operating in the Indian manufacturing sector. The financial leverage affects the various financial parameters of the selected firms. Thus, the present study contributes to the existing literature and provides an insight of the capital structure of Indian manufacturing firms. It will aid the regulators in making better financial policies for the development of the Indian manufacturing sector. Valuable insights and analysis vii opportunities given by the study models will help the financial managers, analyst and other stakeholders to better evaluate the firms’ leverage structure. The study also helps the managers in understanding the areas of weakness and strengths in financial management and how much extra strength is required in order to become as good as their competitors. It is therefore recommended that Indian manufacturing firms should follow a balanced and target approach for financing needs, which will maximize the wealth of the shareholders. They should use retained earnings in financing new investments and operational cost. With the past financial crisis in mind, Indian firms should increase their cash generation capacity through efficient asset management, increase competitiveness, establish healthy bank relations and provide highly trained managerial personnel to upgrade technologies with the new global trends.