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, [email protected], Type V/D-02, Faculty Housing, Gautam Buddha University, Greater Noida, India **Dr. AMAN SRIVASTAVA, Associate Professor, Jaipuria Institute of Management, Noida, India, [email protected], M1/12, Vinayak Apartment , GH-4, Sec-9, Vasundhra, Ghaziabad, India ***Dr. Dinesh Sharma, Assistant Professor , Gautam Buddha University, Greater Noida, India, [email protected], Type V/D-11, Faculty Housing, Gautam Buddha University, Greater Noida, India

1. Introduction
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 is a topic that continues to keep researchers pondering. Capital structure is directly related with the financing decision of the company. Primarily, it consists of the debt and equity used to finance the firm. Researchers continue to analyze capital structures and try to determine whether optimal capital structures exist. An optimal capital structure is usually defined as one that will minimize a firm's cost of capital, while maximizing shareholders wealth. Hence, capital structure decisions have great impact on the financial performance of the firm. Exactly how firms choose the amount of debt and equity in their capital structures remains an enigma. 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, because the actions of managers will affect the performance of the firm, as well as will influence how investors perceive 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. One of the major cornerstones of determining this goal is financial ratios. Financial ratios are commonly used to measure firms performance. Generally, corporations include these in their annual reports to stakeholders. Investment analysts provide these to investors who are considering the purchase of a firms securities. Although there has been a great deal of research on the subject of capital structure, 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

environment where there are no personal taxes, a flat corporate tax rate, and a financial market system that is not very efficient. Lack of market efficiency means information flow is not objectively available to all the interested parties. However, before looking into the specifics of these companies, 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. Most of the research studies on capital structure have used the data from American and European 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. Survival and growth needs resources but financing of these resources has limitation. Therefore, application of these should be in a way that creates an appropriate share of value for both providers and users of resources. Providers of resources are related with different levels of risk, benefit and control. Consequently, their expected returns are not the same. Use of debt leads to tax savings but on-time interest payments is a risktaking way. On the other hand, lavishing stock holders wealth increases the value of expected returns of share holders so financing expenses will also be high. 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. The objective of this paper is to investigate the impact of financial leverage on the performance of publicly traded Indian companies. Financial leverage refers to the use of debt in a firm's capital structure.

The paper proceeds along the following lines. Section-2 presents the review of literature, Section-3 discusses the research methodology, hypothesis and data, variables, Section-4 discusses data analysis and results and Section-5 offers findings and conclusions.

2. Literature Review
In this section, the reviews of literature are sub-divided into following parts, which are explained respectively as under.

2.1 Measures of leverage There are various measures of leverage, which can be classified as accounting based measures, market-value measures and quasi-market value measures. When choosing a measure of leverage, 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. Since market values of leverage may be difficult to obtain, accounting based measures are often applied as proxies. Rajan & Zingales (1995) discuss various accounting based measures of leverage and their informational content. They suggest that the choice of measure should be based on the objective of the analysis. For instance, the ratio of total liabilities to total assets can be considered as a proxy for what is left for shareholders after liquidation, but is not a good indication of the firms risk of default in the near future. Also, since total liabilities include such balance sheet items as accounts payable, which are used for transactions purposes rather than for financing, it may overstate the amount of leverage. This measure can be improved by subtracting accounts payable and other liabilities from total assets. There is still one issue of concern since the measure contains liabilities that are not related to financing, e.g., pension liabilities, thereby underestimating the size of leverage. The ratio of total debt to capital, where capital is

defined as total debt plus equity, is assumed to solve this problem and can be seen as the best accounting based proxy for leverage (Rajan, Zingales, 1995).

2.2 Different theories about capital structure Since Modigliani and Miller published their seminal paper in 1958, capital structure has generated great interest among financial researchers. 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. Prior to MM theory, conventional perspective believed that using financial leverage increases companys value. In this respect, there is an optimized capital structure that minimizes capital costs. In a subsequent paper, Modigliani and Miller (1963) eased the conditions and showed that under capital market imperfection where interest expenses are tax deductible, firm value will increase with higher financial leverage. Models based on impact of tax, suggest that profitable companies should have more debts these firms have more need for tax management in corporations profit. However, increasing debt results in an increased probability of bankruptcy. Hence, the optimal capital structure represents a level of leverage that balances bankruptcy costs and benefits of debt finance.

2.2.1 Static trade off theory Jensen and Meckling (1976) suggest that the firms optimal capital structure will involve the tradeoff among the effects of corporate and personal taxes, bankruptcy costs and agency costs, etc. Agency costs rose from separation of ownership and control and conflicts of interest between categories of agents. One of the problems that cause conflict

between managers and shareholders is free cash flows. Jensen (1976) defined debt as a disciplinary tool to ensure that managers give preference to wealth creation for the equity-holders. Thus, in the companies that have high cash flow and profitability , 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. The other conflicting problem is that managers may not receive all the benefits of their activities. This is seen when managers share in ownership of company is low. When the managers increase stock is high, this inefficiency decreases. Therefore, it is appropriate that by increasing debts instead of stock issuance prevent from decreasing of managers share of ownership interest (Huang, Song, 2005). Stulz (1990) like Jensen believes that debts payment decreases cash flows available for managers. But, on the other hand, he states that this decrease will decrease the opportunities of profitable investing. Thus, companies with less debt have more opportunities for investment and in comparison with other active firms in industry, have more liquidity. Additional costs of debt include potential bankruptcy costs, and agency costs associated with the monitoring of investments by bondholders. Costs and benefits of alternate financial sources are traded off until the marginal cost of equity equals the marginal cost of debt, yielding the optimal capital structure, and maximizing the value of the firm.

2.2.2 Choice pecking order theory of financing The alternative theory, discussed by Meyers (1984), Myers and Majluf (1984) and Fama & French (2002), describes a firms debt position as the accumulated outcome of past investment and capital decisions. In this theory, commonly called the Pecking Order

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

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

between firms performance and leverage level. In a study of listed firms in Ghana, Abor (2005) found that Short-term and Total Debt are positively related with firm's ROE, whereas Long-term Debt is negatively related with firm's ROE. While examining the relationship between capital structure and performance of Jordan firms, Zeitun and Tian (2007) found that debt level is negatively related with performance. In a similar study on microfinance institutions in sub-Saharan Africa, Kyereboah-Coleman (2007) found that high leverage is positively related with performance (i.e. 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. A study by Ibrahim El-Sayed Ebaid, (2009) based on a sample of non-financial Egyptian listed firms from 1997 to 2005 reveals that capital structure choice decision, in general terms, has a weakto-no impact on firm's performance Results of some studies (Myers, 2001; Eldomiaty, 2007) show that capital structure is not the only way to explain financial decisions. Probably this explains the contradictory results of the studies that empirically tested the predictions of relationship between leverage and firm's performance. 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. 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. As compared to the developed markets like Europe, America etc. it is found by the Eldomiaty (2007) that capital markets are less efficient and suffers

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. Research Methodology, 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. Therefore, the following hypotheses are extracted: 1) There is a significant relation between capital structure and return on investment (ROI); 2) There is a significant relation between capital structure and Return on equity (ROE); 3) There is a significant relation between capital structure and return on stock (RET); 4) There is a significant relation between capital structure and earnings before tax to sale ratio (EBT / S); and 5) There is a significant relation between capital structure and operational profit to sale ratio (OPR/S). The starting point of our study is the firms listed at the National Stock Exchange of India. The 100 respondent firms in National Stock Exchange of India constituted the sample in our empirical test of the theoretical model. For these firms we collect data for the fiveyear period 2006-2010 from Prowess database of CMIE. Moreover, financial firms were excluded due to the peculiarity in terms of operations, structure of assets and liabilities that would hinder analysis and inter-company comparisons. 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. Archives, reports and

documents are examples of internal secondary data. In the case of missing information, complementary data was collected by using reports available in the library and on the internet. Data was processed by descriptive statistics containing Mean, S.D and inferential statistics containing Pearson Correlation, ANOVA test using Statistical Package for Social Sciences (SPSS).

4. Data Analysis and Results

Data analysis is done as mentioned above and the results are drawn thereof.

4.1 Data Analysis After gathering necessary data, they were analyzed by Excel and the variables were calculated. Then the variables entered in SPSS software and then correlation between dependent and independent variables were measured by using Pearson correlation coefficient. The difference between variables of capital structure is a result of the way of assessing equity in adjusted debt ratios, average price of selected firms at the end of the terms and average of shares in each of the studying terms has been used. For computing the market value of leverage, we use market value and the number of issued stock at the end of each term. To test the hypotheses, correlation matrix between capital structure and performance is used. Also to show the meaning fullness of the correlation between variables, instead of critical value of students T test, significance level has been used when significance level is less than %5, H0 (null hypothesis) is rejected. In H0, it is assumed that there is not a link between two variables. Table 1 represents the empirical results from correlation matrix between variables. It is obvious that almost all the correlations (except tow items) are meaningful in level of %1.

<Insert Table 1>

According to obtained results, AJMV v(adjusted market value), MV (market value) and BV (book value) of capital structure respectively have the most correlation with financial performance measures;

rPr,AjMV > rPr,MV > rPr,BV

4.2 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%. This correlation between return on stock and adjusted market value is 95% and among other variables is equal to 99%. 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, in the other correlations, adjusted value has the strongest relationship with performance measures. The negative relationship is consistent with Myers (1984) notion that in general firms prefer internal to external financing sources. Profits as internal sources reduce the dependency of firms on leverage.

<Insert Table 2>

Rajan and Zingales (1995) found that if return on stock and investments are fixed in a short term, and the main way of external financing is debt, there is a negative correlation between performance and leverage.

4. 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. Those who favor the use of the book value measure present two strong arguments. First, the main cost of borrowing is the expected cost of financial distress in the event of bankruptcy. Financial distress affects the weighted average cost of capital and consequently the optimal leverage. In such a situation, the value of the distressed firm is closer to its book value. Once the debt has been issued, changes in the market value of that debt do not affect the interest tax shield cash savings. Furthermore, if bankruptcy occurs, the accurate measure of debt-holders liability is the book value of debt and not the market value of debt. Second, previous studies have shown that managers think in terms of book rather than market values. Unlike market values, book values are more easily accessible, more accurately recorded and not subject to market volatility. On the other hand, those who prefer the market value to book value argue that the market value ultimately determines the real value of a firm. 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. In practice, both measures of book and market values are often used. Results of this study demonstrated that market value and adjusted value measures of capital structure in comparison with

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

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Table 1. The results of correlations

Table 2. The results from tests on hypothesis