Abstract - The empirical study tries to find out the capital structure of listed firms in the cement industry of India. This article has examined the influence of 9 determinants on capital structure asset collateral, asset composition, age of firm, size of firm, business risk, growth rate, flexibility, profitability, non tax shield as independent variables -considering leverage (Debt-Equity ratio) as dependent variable, using Two Stage Least Square method by running multiple regression analysis on the dataset of listed cement companies of India for the period 1991-92 to 2011-12. Different capital structure theories are reviewed in order to formulate testable propositions concerning the levels of debt of the Indian cement companies. The results of this study have conferred some insights on the capital structure of Indian cement firms. Our analysis divulges that the asset composition, size and non-debt tax shields are found to have statistically positive relationship with debt-equity ratio which supports many earlier research findings and age, profitability and asset collateral have significant negative relations with leverage. The other factors such as business risk, flexibility, growth opportunities do not seem to have any significant impact on capital structure. Keywords - Financial Leverage, Capital Structure, Cement Firms, India, Determinants
1. Introduction
The management of capital structure affects the prices of shares in the stock market and returns to the share holders. A firm can combine different proportions of debt and equity in an attempt to increase the market value of the firm and it is recognized as capital structure of the firm. Therefore, the financial manager is confronted with the job of determining the careful mix of debt and equity in order to maximize the wealth of the shareholders. This can be done only when all those factors which are significant to the companys capital structure are appropriately analyzed and balanced. Capital structure is the mix of debt and equity securities that are used to finance a companys assets. It is the amount of permanent short-term debt, preferred stock and common equity used to finance a firm. In financial management, the critical problem being faced by the companies is of whether to raise debt or equity. Usually, companies requiring additional funds issue equity shares if they have already exceeded their target debt level and debt if the existing debt level is below the target. Capital structure decisions assume vital implication in corporate financial management owing to their influence both on return and risk to the shareholders. Opting for more debt primarily may trigger off a high interest burden, demolish profit and depress the earnings per share and above all, may endanger the very survival of the corporate firm. On the other
hand, a conservative policy may deprive the corporate firm of its advantage in terms of magnifying the rate of return to its equity owners as a higher equity component results in allow earning per share. In fact, a companys choice of particular financing instruments depends on the difference between its current and target debt equity ratio. Since decision on capital structure or long term financing is influenced by several institutional characteristics as well as internal factors, we need to ascertain their likely determinants. The institutional characteristics include asset composition, business risk, corporate size, debt service capacity, growth rate, earning rate (profitability), cost of capital, tax rate, industry class, the corporate ownership pattern etc. Following the seminal work of Modigliani and Miller (1958, 1963), a great deal of effort has been put forward in corporate finance to determine the factors that affects a firms choice of capital structure. The pertinent question facing companies in need of new finance is whether to raise debt or equity capital. A number of theories have been developed in the last couple of decades to explain variations in the debt equity ratios across firms. Although there has been an inconclusive debate on the issue of association between financing decision and firms valuation, there is relatively little empirical evidence on how companies actually select between financing instruments at a given point of time. Above all, the theories developed in the developed countries need to be tested for their adaptability in the developing countries like
48
India in recent times specially in liberalized trade scenario. Despite their useful contributions supported by the empirical evidences mostly from the companies in the US and other developed countries, a question still remains before financial manager in the Indian context whether to issue debt or equity. In view of the above discussion, the objective of this study is to examine the relationship between a firms financial structure and its probable determinants. The basic objective of the present study is to examine the blueprint (debt-equity mix) of asset financing by Indian cement companies during post liberalization period. An attempt has been made to examine the influence of various factors influencing capital structure decisions. More specifically, the study is focused on analyzing and explaining the asset composition effect, business risk effect, growth effect, profitability effect, collateral value of asset effect, life effect, corporate size effect, industry class and corporate ownership pattern effect on debt equity ratio. The study is thus expected to enlighten on how the liquidity conditions, economic and financial performance of the cement firms in India as well as other factors such as business risk, company size, growth opportunities, tax shield effects, and the composition of the companys assets affect the choice of debt/equity instruments and debt ratios. The rest of the paper is organized as follows. Section 2 depicts the brief overview of literature. Section 3 describes the economic and econometric model, data collection, the research methodology and section 4 discusses results of the analysis and finally section 5 presents summary and conclusions.
2. Literature Survey
The optimum balance between debt and equity issues has been a fundamental issue in corporate finance. The theories suggest that firms select capital structures depending on attributes that determine the various costs and benefits associated with debt and equity financing. There are several theories on capital structure. David Durand (1952) suggested the net income approach of capital structure which states that firm can increases its value or lower the cost of capital by using the debt capital. Net operating income approach is reverse to this approach which contends that the value of a firm and cost of capital are independent to capital structure. Therefore, the firm can not increase its value by judicial mix of debt and equity capital. Since the emergence of modern theory of capital structure begun with the distinguished paper of Modigliani and Miller in 1958, there has been a debate in the financial literature as to whether the proportion of debt and equity in a firms capital structure affects its value. In this paper, they supported the net operating income approach and rejected the traditional theory of capital structure. They argued that the capital structure decisions are irrelevant given certain set of assumption like no corporate taxes , perfect capital market, no default risk or agency problem etc.The firms value is unaffected by its capital structure and is given by capitalizing its expected
return at the rate appropriate to the risk class. This was tentatively very sound but was based on the assumptions of perfect capital market and no tax world which were not valid in reality .Therefore, incorporating the effect of tax on the value and cost of capital of the firm, they contended that in the presence of corporate tax, the value of the firm varies with the variations of the use of debt due to tax benefit on interest bill. The other school associated with Ezra Soloman (1963) holds the view that value of the firm goes on increasing to a certain level of debt capital and after then it tends to remain constant with a moderate use of debt capital and finally the value of the firm decreases. Jensen and Meckling (1976) developed the capital structure theory based on the agency cost where firms incur two types of agency costs- cost associated with the outside equity holders and cost associated with the presence debt in capital structure. Total agency cost first decreases and after certain level of outside equity capital in capital structure, it increases. The total agency cost becomes minimal at certain level of outside equity capital .They argue that an optimal capital structure can be obtained by trading off the agency cost of debt against the benefit of debt. Two sets of capital structure theories were developed during 1970-80.Ross (1988) developed one set of capital structure theories based on asymmetric information where it pleads that the choice of firms capital structure signals to outside investors the information of insiders. Myers and Majluf (1984) developed another set of theories where it contends that capital structure is designed to mitigate the inefficiency in the investment decision caused by the information asymmetry (Harris & Raviv,1991).In Peaking Order theory developed by Myers(1984), management strongly favors internal generation as a source of new funds even to the exclusion of external sources except for unavoidable occasional bulge in the need of funds. This theory explains the negative relations between profitability and debt ratio and contends that there is no target debt-equity ratio. In financing, first, management prefers the internal equity financing and then debt financing and finally external equity financing (Martin et al., 1988).Therefore, this theory explains the financing behaviors of management. Moreover, the conclusions drawn by some of the researchers documented on the subject so far in India and abroad are presented here. Chudson (1945) observed that there is direct evidence on the companies with high proportion of fixed assets tending to use more long term debt. Gordon (1962) found that gearing increased with size; return on investment is negatively related with debt ratio and also confirmed the negative association between operating risk and debt ratio. Baxter (1967) concluded that leverage will depend on the variance of net operating earnings and concluded that there was negative association between variance of net operating earnings and leverage. Bray (1967) reported that risky firms are more likely to have lower debt ratio and found a negative association between total debt and proportion of fixed assets, between return on investment and debt ratio, no
Dr. Sarbapriya Ray: Investigating Capital Structure Determinants in Listed Cement Companies of India
49
simple linear relation between size and debt ratio. Schwartz and Aronson (1967) concluded that financial structure measured by book values does not vary significantly within an industry, but varies significantly among industries. Gupta (1969) proposed that total debt ratios were positively related to growth and negatively related to size.Lev (1969) concluded that there is a significant relationship between industry class and debt ratio. Ferri and Jones (1979) observed that the industry class was linked to a firms leverage but not in a direct manner than what has been suggested in other researches and concluded that firms use of debt is related to its size. Bhat (1980) divulged that firms financial leverage is not associated with its size and growth rate and further concluded that there is negative relation of financial leverage with debt service capacity and dividend pay out. Titman and Wessels (1988) recommended that firms with unique or specialized products have relatively low debt ratio. Marsh (1982) has revealed that the companies are heavily influenced by market conditions and the past history of securities prices in choosing between debt and equity. Barclay and Smith (1995) indicated that firms optimal debt is a decreasing function of the vitality in its earning. Mathew (1991), Taub (1975) and many other scholars have highlighted the different determinants of capital structure in their respective empirical studies. Dev, et al., (1997) in the increasingly turbulent environment facing business the strategic management of the firm has become more predominate. However to date, the linkage between strategic management and financial management of the firm has largely not been explored. This research utilizes two different methods of analysis to confirm the linkage between capital structure and strategic posture of the firm. Specifically, managers were found to structure the selection of debt and capital intensity in a means consistent with the strategic goal of long run control of systematic risk. The majority of the research results has been derived from the experience of the developed economies that have many institutional similarities (see Hodder and Senbet, 1990; Rajan and Zingales, 1995; Wald, 1999; Ozkan, 2001; Bevan and Danbolt, 2002, 2004). It is only during recent years that questions about such determinants have gained importance in the context of the fast changing institutional framework of these countries. Developing countries have been introducing many market-oriented reforms in their financial sectors. Moreover, the institutional set-up within which firms have operated has undergone substantial transformation since the mid-eighties and early nineties. The move towards the privatization/free market, coupled with the widening and deepening of various financial markets including the capital market, has provided the scope for the corporate sectors to optimally determine their capital structure. Few empirical studies have attempted to shed light on the capital structure issue within the institutional specificities of developing countries. Booth et al. (2001) were among the ones who provided the first comprehensive empirical study to test the explanatory power of capital structure models in developing countries. Collecting data from 10 developing countries to assess
whether capital structure theory was portable across countries with different institutional structures, they provided evidence that firms capital choice decisions in developing countries were affected by the same variables as they were in developed countries. Nevertheless, there were persistent differences of institutional structures across countries indicating that specific country factors were at work. Their findings suggest that although some of their insights from modern finance theory are portable across countries, much remains to be done to understand the impact of different institutional features on capital structure choices. Recently, Deesomsak, Paudyal and Pescetto (2004) also investigated the determinants of capital structure of firms operating in the Asian Pacific region, in four countries (namely Thailand, Malaysia, Singapore and Australia) with different legal, financial and institutional environments. they found that capital structure decisions of firms are influenced by the environment in which they operate as well as firm specific factors identified in existing literature. In effect, little research work has been done to enhance our knowledge of capital structure within developing countries that have different institutional structures and to our knowledge none for the case of small island developing economies. Given the specificities of the financial markets and the economy in general in these economies and coupled with this the fact that they have relatively young stock markets and underwent substantial transformation during the previous decade, empirical evidences from the latter are expected to yield important insights on the debate and to supplement the existing literature Philippe, et al., (2003) in this paper analyze the determinants of the capital structure for a panel of 106 Swiss companies listed in the Swiss stock exchange and found that the size of companies, the importance of tangible assets and business risk are positively related to leverage, while growth and profitability are negatively associated with leverage. The sign of these relations suggest that both the pecking order theory and trade off hypothesis are at work in explaining the capital structure of Swiss companies, although more evidence exists to validate the latter theory. Wolfgang & Roger (2003) test leverage predictions of the trade-off and pecking order models using Swiss data. At an aggregate level, leverage of Swiss firms is comparatively low, but the results depend crucially on the exact definition of leverage. Confirming the pecking order model but contradicting the trade-off model, more profitable firms use less leverage. Firms with more investment opportunities apply less leverage, which supports both the trade-off model and a complex version of the pecking order model. Leverage is also closely related to tangibility of assets and the volatility of a firms earnings. Finally, estimating a dynamic panel model, we find that Swiss firms tend to maintain target leverage ratios. The results are robust to several alternative estimation techniques. Keshar & Baral (2004) try to scrutinize the determinants of capital structure-size, business risk, growth rate, earning
50
rate, dividend payout, debt service capacity, and degree of operating leverage-of the companies listed to Nepal Stock Exchange Ltd.as of July 16, 2003. This study shows that size, growth rate and earning rate are statistically significant determinants of capital structure of the listed companies. Fakher, et al, (2005) show that both the static trade-off theory and the agency cost theory are pertinent theories to the Libyan companies capital structure whereas there was little evidence to support the asymmetric information theory. The lack of a secondary market may have an impact on agency costs, as shareholders who are unable to offload their shares might exert pressure on management to act in their best interests. Joshua (2008) in his study compares the capital structures of publicly quoted firms, large unquoted firms, and small and medium enterprises (SMEs) in Ghana. The regression results indicate that age of the firm, size of the firm, asset structure, profitability, risk and managerial ownership are important in influencing the capital structure decisions of Ghanaian firms. For the SME sample, it was found that factors such as the gender of the entrepreneur, export status, industry, location of the firm and form of business are also important in explaining the capital structure choice. Boodhoo(2009) provides a brief review of literature and evidence on the relationship between capital structure and ownership structure. The paper also provides theoretical support to the factors (determinants) which affects the capital structure. Mehmet & Eda (2009) tested whether average leverage level of sector and leverage level of sector leader are effective on capital structure decisions of selected firms and sectors listed in ISE. They depended on the Approach of Behavioral Finance to this matter as a supplementary approach of traditional finance to capital structure. In respect of its influence on leverage levels of the firms in four sectors they addressed for the period of 1999- 2006 (White Goods and Electronic, Banking, Cement, Paper and Packing), while sector averages are effective at a meaningful extent in white goods sector, it was seen that it affects leverage level of sector leader considerably. In the study, it was seen that both sector average and sector leader display a positive relation with leverage level of firms with a significance of 10%. B.Nimalathasan & Valeriu Brabete (2010) pointed out capital structure and its impact on profitability in a study of listed manufacturing companies in Sri Lanka. The analysis of listed manufacturing companies shows that Dept equity ratio is positively and strongly associated to all profitability ratios (Gross Profit, Operating Profit & Net Profit Ratios) Puwanenthiren Pratheepkanth (2011) analyzes the capital structure and its impact on Financial Performance capacity during 2005 to 2009 (05 years) financial year of Business companies in Sri Lanka. The result shows that the relationship between the capital structure and financial performance is negative in Sri Lanka. Hence Business companies mostly depend on the debt capital and therefore, they have to pay interest expenses much.
Thian Cheng Lim (2012) investigates the determinants of capital structure of financial service firms in China. Using a relative regression of accounting data for 36 A-share financial listed companies over the years 2005-2009, an empirical study on determinants of capital structure in financial industry is conducted. The results show that profitability, firm size, non-debt tax shields, earnings volatility and non-circulating shares are significant influence factors in financial sector. Moreover, firm size is positively related to the corporate leverage ratio. It is also found that Chinese institutional characteristic affects the capital choice decision. While it confirmed that capital structure determinant of financial firms are similar to other industry, the largely state ownerships do affect capital structure choices. Sobia Qayyum (2013) endeavors to answer the very questions of what determines the capital structure of Pakistani listed cement companies. The data of 20 companies for three financial years 2007, 2008, 2009 is taken. The study shows that except size, all other variables have significant relationship with leverage and can be used for making decisions by companies in cement industry. The study helps the management in decision making while setting their leverage ratio, as they will be able to know that up to what extent profitability, growth & tangibility will be affected by decrease or increase in leverage.
Dr. Sarbapriya Ray: Investigating Capital Structure Determinants in Listed Cement Companies of India
51
dent variable(s).Further,t and F tests have been used to check the level of significance of regression coefficients. Durbin-Watson (DW) test has also been applied to detect any auto-correlation among residuals. The correlation matrix for the entire period has been calculated between all the variables which have been done to find out any multicollinearity among the independent variables, which, if present could affect the reliability of regression results. Finally, SPSS software was used for the analysis. 3.3. Dependent and Independent Variables Considered The selection of the variables (dependent and independent) is primarily guided by the results of the previous empirical studies and the availability of data. For the present study, 9 independent variables have been chosen to analyze the impact on two dependent variables. The measures for the variables are given in details as follows: Dependent variables: The universally used measures of leverage are debt-equity ratios and interest coverage ratio. Financial leverage is usually measured by the ratio of long term debt to the total long term capital or the net worth. If other liabilities are treated as debt equivalent, then these have to be added to long term debt. Therefore, the following measures have been used as indic0ators of the financial leverage for the purpose of the analysis: Long term debt-Equity Ratio (DE1) = Total liabilities / Net worth. Total debt-equity Ratio (DE2) = Long-term debt / Net worth. Another measure of financial leverage is the extent to which interest is covered by earning before depreciation, interest and taxes (Debt- Service Coverage Ratio-DSCR).Since there is a cause and effect relationship between leverage and DSCR, it has been excluded from our estimation. Independent variables: Asset composition Ratio (ASSET) = Net fixed asset / Total asset. Collateral value of asset (COLLATERAL) =(Net fixed asset + Inventory + Account receivable) / Total asset. Earning Rate (Profitability) = PROF1= EBIT / Total asset. PROF2= EBIT / Sales. Corporate size = Natural logarithm of Sales. Risk (Earning volatility) a) VOLA1 = Natural logarithm of standard deviation of EBIT b) VOLA2= EBIT / EBIT Non-debt tax shield (NDTS) = Depreciation / Total assets. Flexibility (FLEX) = Cash and marketable securities / Current assets. Growth Opportunity (GROWTH): GROWTH1 = % change in total assets (TA), compounded annually.
= n TAn TA0 TAn = Total assets at the end of observed period. TA0 = Total assets at the beginning of observed period n = number of observed period. GROWTH2 = % change in Sales(S), compounded annually. = n Sn S0 Sn = Total sales at the end of observed period. S0 = Total sales at the beginning of observed period. n = number of observed period. 3.4. Hypothesis Formulated Keeping in view the results of various related research studies on capital structure as mentioned and corresponding to the objectives of the present study, the following hypotheses have been formulated and tested. Hypotheses: H0: Debt-equity ratios of the firms are not influenced by financial variables. H1: Debt-equity ratios of the firms are influenced (positively/ negatively) by the above- mentioned financial variables. Alternative hypothesis H1 can be further subdivided into the following categories. H01 : The debt equity ratio is positively influenced by the asset composition. H02 : The debt equity ratio is positively influenced by the collateral value of assets. H03 : The debt equity ratio is negatively influenced by earning rate. H04 : The debt equity ratio is positively influenced by the size of the firm. H05 : The debt equity ratio is negatively influenced by the age of the company. H06 : The debt equity ratio is negatively influenced by the business risk. H07 : The debt equity ratio is positively related to Non-debt tax shield. H08 : The debt equity ratio is negatively related to flexibility. H09 : The debt equity ratio is negatively related to growth opportunity. 3.5. Econometric Model Previous empirical literature has been reviewed to specify the econometric model on the determinants of capital structure. We thus posit that leverage can be explained by the following determinants: LEVERAGE= f (Asset composition, Asset collateral, Profitability, Size, Age, Business risk, Non-debt tax shield, Flexibility, Growth opportunities) (1) The econometric model of equation (1) is specified and expanded as follows:
52
LEVERAGE= + 1 ASSET +2 COLLATERAL + 3 PROF1 + 4 PROF2+ 5SIZE + 6AGE +7 VOLA1 + 8 VOLA2 + 9 NDTS + 10 FLEX + 11 GROWTH1 + 12 GROWTH2 + (2) is the error term, which represents measurement errors in the independent variables, and any other explanatory variables that have been omitted, and other variables as defined above. The independent variables are the proxies used for the determinants. The study employs two measures of the dependent variable LEVERAGE. These has been extensively used in the literature and recently by Booth et al. (2001) and Huang and Song (2006). Firstly, we use book total liabilities Ratio (DE1) and this is defined as total liabilities divided by total liabilities plus book value of equity (Net worth). Secondly, we also use book long term Debt Ratio (DE2) which is defined as total liabilities less current liabilities divided by total liabilities less current liabilities plus book value of equity (Net worth). DE1 is used as a measure of leverage for this study because of the strong theoretical support in the local context. In fact when a firm wants to obtain more debt, the creditors Table1. Descriptive Statistics
Variables Definition
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 also affects the debt capacity of a firm. Secondly, many companies in India use trade credit as a means of financing, so accounts payable should also be included in the measure of leverage. Lastly, it is true that trade credit does not provide tax shield. Therefore, DE2 is essentially employed for robustness checks.
ASSET COLLATER PROF1 PROF2 SIZE AGE VOLA1 VOLA2 NDTS FLEX GROWTH1 GROWTH2
Asset composition Ratio Collateral value of asset Profitability(EBIT / Total asset) Profitability( EBIT / Sales) Corporate size Number of years since establishment Volatility(Natural logarithm of standard deviation of EBIT) Volatility( EBIT / EBIT) Non-debt tax shield Flexibility % change in total assets(TA),compounded annually % change in Sales(S), compounded annually.
Minimum Statistic 0.43 0.66 0.08 0.18 7.95 41.00 6.13 0.64 0.03 0.30 0.04 0.01
Maximum Statistic 0.61 0.89 0.19 0.33 10.38 56.00 8.28 1.15 0.05 0.56 0.12 0.15
Mean Statistic 0.5368 0.7859 0.1329 0.2354 8.9826 48.5000 6.9715 0.8406 3.981E-02 0.4549 7.919E-02 9.850E-02
Std. Deviation Statistic 5.327E-02 5.188E-02 3.505E-02 4.116E-02 0.7125 4.7610 0.5314 0.1415 4.694E-03 5.303E-02 2.273E-02 3.495E-02
Skewness Statistic -0.378 -0.305 -0.025 0.428 0.480 0.000 0.556 1.193 -1.452 -1.219 0.058 -0.958
Kurtosis Statistic -0.404 2.125 -0.459 -0.107 -0.577 -1.200 1.474 0.994 2.607 5.209 -0.820 1.407
We have used SPSS software to conduct multiple regression. To regress the data, two stage Least Square Estimation Method has been adopted to test the set hypotheses or more clearly to test how the independent variables explain the capital structure. Before running the regression, investigation into the multicollinearity problem was carried out using the Pearson Correlation method. First of all, bivariate (pair-wise) correlations among the independent variables were examined to find out the multicollinearity problem. The existence of
correlation of about 0.90 or larger indicates that there is problem of multicollinearity (Lewis-Beck 1993). Table 2 presents the Pearson correlation coefficients for the variables used in the study. Before going to regression analysis, we have analyzed correlation among independent variables and find that different independent variables are weakly correlated with each other. None of the pairwise coefficient of correlation was 0.90 or larger.
Dr. Sarbapriya Ray: Investigating Capital Structure Determinants in Listed Cement Companies of India
If there exists high degree of correlation among independent variables in a multiple regression analysis, it is difficult to identify the unique contribution of each variable in predicting the dependent variable because the highly correlated variables are predicting the same variance in the dependent varable.Some statisticians opines that correlations above 0.70 indicate multicollinearity and another set of statisticians are in favor of argument that correlations above 0.90 indicate multicollinearity. Multicollinearity is assessed by examining tolerance and the Variance Inflation Factor (VIF) which are two collinearity diagnostic factors that can help to identify multicollinearity. If a low tolerance value is accompanied by large standard errors and no significance, multicollinearity may be an issue. The variables tolerance is indicated by 1-R2. Table3. Collinearity Statistics ASSET COLLATER PROF1 PROF2 SIZE AGE VOLA1 VOLA2 NDTS FLEX GROWTH1 GROWTH2
a Dependent Variable: DE. Source: Own estimate
A small tolerance value indicates that the variable under consideration is almost a perfect linear combination of the independent variables already in the equation and that it should not be added to the regression equation. The Variance Inflation Factor (VIF) measures the impact of collinearity among the variables in a regression model. The Variance Inflation Factor (VIF) is 1/Tolerance, it is always greater than or equal to 1. There is no formal VIF value for determining presence of multicollinearity. A commonly given rule of thumb is that multicollinearity exists when Tolerance is below 0.1 and values of VIF that exceed 10 are often regarded as indicating multicollinearity. When those R2 and VIF values are high for any of the variables in regression model, multicollinearity is probably an iss VIF 3.462 2.851 1.947 3.052 1.280 1.688 2.120 1.700 2.083 7.63 3.40 5.26
Tolerance 0.289 0.351 0.514 0.328 0.781 0.592 0.472 0.588 0.48 0.131 0.294 0.19
Sometimes, eigen values, condition index and condition number will be referred to when examining multicolinearity.We take into consideration the condition number which is equal to condition index with highest value which is also equal to square root of the largest eigen value divided by lowest eigen value. An informal rule of thumb is that if the condition number is 15 or more, multicolinearity is a concern and if it is greater than 30, multicoliearity is very serious concern.
From our analysis to test whether there exists multicolinearity, it is found that correlations among independent variables are moderate which do not exceed the general rule of thumb. Moreover, tolerance for these variables are moderately high which also are beyond the specified minimum ceiling (0.10) and VIFs do not exceed the specified rule of thumb of10.The condition number is 13.964 which is also within the range. This indicates that multicolinearity is not at a issue of concern in this study.
54
Table 4 and 5 presents the estimated results. Explanatory power of the models as indicated by R2 (multiple coefficient of determination) and adjusted R2 is fairly good. The two models explain around 42% and 49% respectively of the variation in the dependent variable/capital structure. The F values which are the measure of overall significance of the
Regression result Beta coefficients 2.463 -0.939 -30.95 -12.75 4.48 -0.41 0.149 -0.937 10.73 2.01 -38.05 1.39 -16.56 0.42
estimated regression are 8.1875 and 7.59 respectively.The significant values of F prove that the relationship between the debt ratio and determinants are linear. The Durbin-Watson statistic (D-W Statistic) being more than 2 suggests that there is no auto-correlation among residuals.
Table4. Estimation of Determinants of Capital Structure by Two Stage Least Square(TSL)Technique(Dependent Variable: DE1)
Explanatory variables ASSET COLLATER PROF1 PROF2 SIZE AGE VOLA1 VOLA2 NDTS FLEX GROWTH1 GROWTH2 constant Adjusted R2
F =8.1875 D-W Values=2.46
SE 1.238 0.278 11.578 6.378 1.770 0.141 0.534 1.326 3.119 0.837 13.292 4.060 10.124
t ratios 1.99 -3.370 -2.673 -1.999 2.529 -2.912 0.280 -0.706 3.444 1.405 -2.863 0.343 -1.636
Implications Significant** Significant* Significant* Significant** Significant** Significant* Insignificant Insignificant Significant* Insignificant Significant* Insignificant Insignificant
Dependent Variable: DE1 * Significant at 0.01 level. ** Significant at 0.05 level. Source: Own estimate
Table 4 and 5 show the summary results for two regression analysis (considering DE1 and DE2 are dependent variables respectively). The parameter estimates in table 4 reveal that out of twelve independent variables, eight variables are found to be significant determinants of capital structure and table 5 depicts that also eight independent variables are found to be significant determinants of capital structure of
Indian cement sector. After analyzing the results for the effects of independent variables on financial leverage, it is found that asset collateral, profitability, life, flexibility and growth are negatively related with leverage whereas asset composition, size and non debt tax shield of the firms are positively correlated.
Table5. Estimation of Determinants of Capital Structure By Two Stage Least Square(TSL) Technique(Dependent Variable: DE2)
Explanatory variables ASSET COLLATER PROF1 PROF2 SIZE AGE VOLA1 VOLA2 NDTS FLEX GROWTH1 GROWTH2 Constant Adjusted R2
F=7.59 D-W Values=2.63
Regression result Beta coefficient 1.650 -1.225 -25.25 -9.91 3.48 -0.325 0.125 -0.963 8.93 1.84 -30.40 .600 -11.71 0.49
SE 0.6004 0.345 9.948 3.446 1.57 0.125 0.474 1.177 2.61 1.27 11.80 3.60 8.99
t ratios 2.748 -3.544 -2.538 -2.875 2.217 -2.590 0.263 -0.818 3.416 1.451 -2.577 0.167 -1.303
Implications Significant* Significant* Significant** Significant* Significant** Significant* Insignificant Insignificant Significant* Insignificant Significant** Insignificant Insignificant
Dr. Sarbapriya Ray: Investigating Capital Structure Determinants in Listed Cement Companies of India
Now, we discuss each of the determinants used in our study that influence corporate capital structure of Indian cement companies. Asset Composition: The coefficient for asset composition in both case of DE1 and DE2 were positive indicating that the ratio of net fixed asset to total asset, being positive is a good predictor of total debt-equity ratios. Therefore, it can be inferred that there is a tendency on the part of the Indian cement firms to finance fixed assets with debt. The theoretical predictions on the relationship between asset composition and leverage are as follows the trade-off and agency theories predict a positive relationship whereas the pecking-order theory predicts a negative one. Beta co-efficient of asset composition ratio confirms the prediction of Jensen and Mecklings (1976) agency cost theory and Myers version of trade-off theory. Asset composition, with beta coefficients of 2.463 and 1.650 respectively is positively related to leverage. That means, all other things remaining the same, debt ratio increases by 2.463% and 1.650 % respectively for DE1 and DE2 for 1 percentage point increase in asset composition ratio which is statistically significant. This shows that asset composition is one of the most important determinants of leverage in cement companies of India. Collateralized Assets: Theoretical research predicts positive relationship between collateralized asset and leverage. Prior empirical studies use fixed assets as its proxy and the findings are consistent with theoretical predictions. The findings of this paper show opposite result: leverage decreases as the proportion of fixed asset in the total assets of the firm increases (see Table 4&5). The Indian cement industry is usually characterized by a relatively high level of fixed assets. Current assets can more easily be converted to cash and thus have more liquid capacity than fixed asset. Lending institutions generally attribute more significance to the capacity to convert borrowers assets into cash and we assume that in the cement industry, the importance of current rather than fixed assets plays an important role in their decision to offer loans to firms with high ratio of current to total assets, or a low ratio of fixed to total assets. This supply-side argument might explain why firms who own relatively high ratios of fixed to total assets may have lower leverage. The findings of this paper are similar to those reported by Biger, Nguyen, and Hoang (2008). Size: It is evident from the results that corporate size has significant influence on DE1 and DE2 and the value of regression coefficient is positive. The t statistic of SIZE for DE1 and DE2 are found to be 2.529 and 2.217 indicating that size has a very positive impact on long-term debt-equity ratio. Thus, the effect of corporate size on leverage worked in favourable direction which supports the hypothesized direction. This finding is consistent with the previous findings of Marsh (1982), Rajan and Zingales (1995), Wald (1999) and Booth et al. (2001) except for Germany, and with the trade-off and agency theories, confirming that larger firms tend to have better borrowing capacity relative to smaller firms. In fact,
Wald (1999) found positive coefficient between size and leverage for UK, France, US and Japan. This evidence may reflect several features. First, larger Indian firms may have better access to financial markets to raise long term debts. Second, the ratio to the bankruptcy costs to the firm value in India may be higher for smaller firms since these costs include fixed costs, which can be negligible for larger firms. Age: Business maturity or age is negatively related to debt (Petersen & Rajan, 1994;Weston & Brigham, 1981).The age of a business, referred to as AGE, which is measured as the number of years that have passed since the business in question was founded, is also considered an important determinant of debt (Berger &Udell, 1998; Coleman & Carski, 1999; Romano et al. 2000). The time elapsed has enabled businesses to save funds and therefore avoid resorting to debt. As a result, a negative relationship is expected between this variable and the level of debt. Profitability: The two variables for the measurement of profitability PROF1 and PROF2 assumed their conventional characteristics. The significant negative relationship between profitability and leverage was confirmed. The coefficients of PROF1 in DE1 and DE2 were -30.95 and -25.25 and for PROF2 (DE1,DE2) are -12.75 and -9.91 respectively. This postulates that profitability is an important determinant of leverage and evidence emerges that profitability of firms exert a negative influence on firms borrowing decisions in cement industry in India.. The estimated coefficient is significant in almost all cases at 1% and 5% level respectively. The negative sign of profitability is consistent with the pecking order theory of Myers and Majluf[1984] that predicts a preference for internal finance rather than other external finance. This also confirms that the tax advantage of debt financing does not have much relevance in this industry. The above result is in line with most previous studies of Kester (1986), Rajan and Zingales (1995), Booth et al. (2001) reporting a significant negative effect of profitability on leverage. In fact, Wald (1999) found negative coefficients of profitability in UK, France, Germany, Japan and US. Intuitively, the negative relationship between profitability and debt in Indian cement firms seem to support the pecking order model. However, upon taking another look, there may be other reason for the negative relationship rather than those proposed by the pecking order hypothesis such as to avoid underinvestment problems and new projects being mispriced. Non-debt tax shield (NDTS): The coefficient for NDTS was found to be 10.73 and 8.93 with t ratios 3.444 and 3.416 for DE1 and DE2 respectively indicating positive correlation between non debt tax shields and debt-equity ratios.In the regression results of Indian cement firms, NDTS has positive coefficients inconsistent with most previous studies but support the studies of Bradley, Jarrel and Kim (1984) and Harris and Raviv (1990). This implies that firms other than those in the industry sector with a high level of NDTS which can be deducted from the taxable
56
income tend to have more debt. However, the findings are diametrically opposite to this. They have found that NDTS has a negative correlation with debt. Growth Rate: From our study, growth rate (GROWTH1) was found have significant negative relationship with DE1 and DE2 and growth rate(GROWTH2) holds positive relationship with DE1 and DE2.although statistically insignificant. It can be precisely concluded that the proportion of debt financing reduces when the total assets grow. Contrary to this, the positive coefficient of growth variable holds the relation postulated by pecking order theory true in Indian context. Increase in sales is implicitly financed by current assets, resulting in a corresponding increase in short term debt or long term debt depending upon the sources of financing available to the firm. This implies that small firm rely more on debt than large firms which have better access to equity sources. This is because a higher growth rate implies a higher demand for funds, and, ceteris paribus, a greater reliance on external financing through the preferred source of debt [(Sinha 1992), Kester (1986), (Myers 1984)]. However, this findings contradicts with the result found by Chowdhury (2004), Barclay et al. (1995) and Rajan and Zingales (1995), Titman and Wessels (1988) and Kim and Sorensen (1986). Business risk/volatility: VOLA1 and VOLA2 are used as a surrogate to measure a firms volatility. It has been observed that debt ratios DE1 and DE2 are positively related to VOLA1 and negatively related to VOLA2 though t ratios are insignificant. Both VOLA1 and VOLA2 are used as measures of business risk. VOLA1, being natural logarithm of standard deviation of EBIT, represents an absolute measure of the volatility of earnings. The positive association of leverage with risk (VOLA1) may be because cement firms that encounter a risky business climate in India seek new investment in the form of debt and can secure it. In this case, financial distress may not be a problem because a small number of large bank creditors may provide an easy transference of control in case of bankruptcy. Volatility in earnings may instead be correlated with company or industry restructuring and debt may be less expensive way of obtaining new long term financing. In a nut shell, firms with risk projects prefer to finance them by use of debt leading to high debt ratios. The relationship between business risk/volatility (VOLA2) and total liabilities and long term debt ratios is negative in the both regression results of cement industry in India which are consistent with the previous empirical studies but such relationship is not strong. However, being negative, VOLA2, representing the proportion of the coefficient of variance, implies that firms with risk projects prefer to finance them by use of debt leading to high debt ratios. Leverage and risk are negatively correlated for cement firms imply that these firms are more likely to issue equity rather than debt, because of the uncertainty about the future economic and financial performance in the cement industry. Flexibility: The results indicated a positive relationship between debt ratios and flexibility (FLEX).The regression coefficients observed are 2.01 and 1.84 respectively for DE1 and
DE2 .These results are diametrically opposite to the Peaking Order Hypothesis of Myers [1977]. He established that firms with sufficient financial slack (defined as firms highly liquid assets- cash and marketable securities plus any unused debt capacity) will be able to fund most of their investment opportunities internally and will not have to issue debt or equity securities, which means that flexibility and debt ratios are inversely related.
5. Conclusions
The study of capital structure has been a very vital issue in the research of corporate finance. This article has examined the influence of 9 determinants on capital structure considering leverage(Debt-Equity ratio) as dependent variable , using Two stage Least Square method by running multiple regression analysis on the dataset of listed cement companies of India for the period 1991-92 to 2007-08. The multiple regression analysis suggests that the model explains around 42% of the variation in the dependent variable/debt ratio. The t statistics are significant for most of the variables. Two stage least square method of regression suggests that the key determinants of capital structure in cement firms of India are profitability, size, age, tangibility and non debt tax shield (NTDS). The asset composition, size and NDS are found to be statistically positive relationship with debt-equity ratio which supports many earlier research findings and age, profitability and asset collateral have significant negative relations with leverage. The other factors such as business risk, flexibility, growth opportunities do not seem to have any significant impact on capital structure. Results of the study depict that a specific industry exhibits distinctive attributes which is generally not evident in the combined analysis of many sectors, and so similar studies can be conducted for other sectors of India.The present study is confined to only a single industry-cement industry based on secondary data set. The study would perhaps provide more meaningful results if determinants of capital structure adopted in the present study can be fragmented into more explanatory components. The study provides useful recommendations for policy direction and management of these firms. Policy makers should place greater emphasis on the facilitation of equity capital since it provides a base for further borrowing, reduces businesses sensitivity to economic cycles, and provides firms with access to syndicates of private and institutional venture capital suppliers. There could also be policies intended to encourage establishing financing schemes to assist firms in specific industries. The impetus for conducting this study was to address the insufficiency of earlier studies. These studies were based on fewer years of data and less observations. Based on the empirical results, we conclude that the determinants of capital structure are industry specific. The study also highlights that more industry specific studies should be undertaken to further explore the problem. It would be rewarding to model and examine a causal association between economic liberalization and optimizing corporate behavior, such as in the realm of
Dr. Sarbapriya Ray: Investigating Capital Structure Determinants in Listed Cement Companies of India
11
capital structure choice. Constrained previously by scantiness of reliable data, such research may well be practicable in the upcoming future. The paucity of high-quality databases might constitute the main barrier on conducting capital structure research in India. As a result, there is a necessity to develop validated databases as more data becomes available in future. Using such databases, it can help examining and identifying additional variables that could influence the financing behaviour of other Indian manufacturing companies like cement.
References
Booth, L., Aivazian, V., Demirguc-Kunt, A. and Maksimovic, V(2001): Capital structure in developing countries,Journal of Finance, Vol. 56, pp. 87-130. Bevan and Danbolt (2002), Capital structure and its determinants in the UK-A decompositional analysis, Applied Financial Economics,Vol.12,no.3,pp159-70. Bevan and Danbolt (2004),Testing for inconsistencies in the estimation of UK capital structure determinants, Vol.14,no.3,pp55-66. Bhat, Ramesh Kumar ( 1980): Determinants of Financial Leverage: Some Further Evidence, Chartered Accountant,vol. 29,pp451-456. Baxter, N.D(1967), Leverage, Risk of Ruin and the cost of capital, Journal of Finance,vol.22,pp395-403. Bray,J.N(1967):The risk and use of Debt Financing, Unpublished Ph.D Dissertation, UCLA,1967. Bradley, M. G.A. Jarrel & E. Han Kim. (1984). On the existence of an optimal capital structure: Theory and evidence. The Journal of Finance. Vol.39,pp 5780. Barclay,M.J, Smith, C.W and Watts,R.L(1995),The determinants of corporate leverage and dividend policies,Journal of Applied Corporate Finance, vol.7,no.4,pp 4-19. Berger, A.N. & G.F. Udell. (1998), The economics of small business f inance: The roles of private equity and debt markets in the financial growth cycle, Journal of Banking and Finance,vol. (22),pp 61-73. Biger N, Nguyen NV, Hoang QX(2008), The determinants of capital structure: evidence from Vietnam, International Financial Review, vol.8,pp307-26. Boodhoo, Roshan (2009), Capital Structure and Ownership Structure: A Review of Literature, The Journal of Online Education, New York, January 2009, Electronic copy available at: http://ssrn.com/abstract=1337041. Choudhury,D(2004),Capital Structure Determinants: Evidence from Japan and Bangladesh, Journal of Business Studies,vol.xxv,no.1,June,pp23-45. Chudson,W.A,(1945):The Pattern of Corporate Financial Structure, National Bureau of Economic Research. Coleman, S., & Carsky, M. (1999), Sources of capital for small family-owned businesses: Evidence from the National Survey of Small Business Finances, Family Business Review, 12(1), 7386. Deesomsak, R. Paudyal, K. & Pescetto, G. (2004), The determinants of capital structure: evidence from the Asia Pacific region, Journal of Multinational Financial Management, Vol.14,pp 387-405. Durand, David (1959), Cost of Debt and Equity Funds for Business: Trends and Problems of Measurement. In The Management of Corporate Capital. Edited by Ezra Solomon. New York: The Free Press. Dev Prasad, Garry D, Bruton and Andreas G. Merikas .(1997)."Long-Run Strategic Capital Strucure", Journal of Financial and Strategic Decisions, Vol.10(1),pp47-58. Ezra Soloman (1963), The Theory of Financial Management, Columbia University Press . Ferri, M.G and Jones,W.H(1979):Determinants of financial structure:A new methodological Approach, Journal of Finance,vol.34,no.3 Autumn,pp631-644. Fakher. Buferna. Kenbata, Bangassa. & Lynn, Hodgkinson(2005),Determinants of CapitalStructure: Evidence from Libya,University of Liverpool, Chatham Street, Liverpool L 69 7 ZH. UK.University of Wales, Hen Goleg, College Road Bangor. Gwynedd. LL57 2DG. UK.
Gupta,M.C(1969),The effect of size, growth and industry on financial structure of manufacturing companies, Journal of Finance, vol.24, no.3,June,pp517-29. Gordon, M.J (1962): The Investment, Financing and Valuation of the Corporation, Homewood,III:Irwin. Grossman SJ, Hart O(1982), Corporate financial structure and managerial incentives. The Eco of Information and Uncertainty: Chicago, University of Chicago Press. Hodder, J. E. and L. W. Senbet,( 1990), International Capital Structure Equilibrium, Journal of Finance ,vol. 45, pp1495-1515. Huang, G. and Song F.M (2006), The determinants of Capital Structure: Evidence from China, China Economic Review,vol. 17(1), pp. 14-36. Harris, M., and Raviv, A(1991), The theory of capital structure, Journal of Finance, Vol. 46, pp. 297-355. Hall, G.,Hutchinson,P.,&Michaelas, N. (2000), Industry effects on the determinants of unquoted SMEs capital structure. International Journal of the Economics of Business, vol.7, pp297-312. Joshua, Abor(2008) Determinants of the Capital Structure of Ghanaian Firms, Department of Finance ,University of Ghana. Jensen M, Meckling W.(1976), Theory of the firm: managerial behaviour, agency costs and ownership structure, Journal of Financial Economics, vol. 3,pp 305-60. Kester, Carl W(1986): Capital and Ownership Structure : A Comparison of United States and Japanese Manufacturing Corporation, Financial Management ,vol.15,pp 5-16. Lev,B(1969): Industry average as targets for financial financial ratios, Journal of Accounting Research, vol.7, Autumn,pp290-299. Lewis-Beck, M. (1993), "Applied Regression: An Introduction, in Regression Analysis, ed. Michael S. Lewis-Beck. International Handbook of Quantitative Applications in the Social Sciences, vol. 2, Singapore: Sara Miller McCune, Sage Publications, Inc. 1:68. Petersen, M. A., & Rajan, R. G. (1994), The benefits of lending relationships: Evidence from small business data. Journal of Finance, vol.99(1), pp337. Romano,C.A.,Tanewski, G.A.,& Smyrnios, K. X. (2000). Capital structure decision making: A model for family business. Journal of Business Venturing, 16, 285310. Kim, W. S and Sorenson, E. H. (1986), Evidence on the impact of the agency cost of debt in corporate debt policy, Journal of Finance and Quantitative analysis, Vol. 21, pp. 131-144. Kester, Carl W(1986),Capital and Ownership Structure : A Comparison of United States and Japanese Manufacturing Corporation. Financial Management ,Vol.15,pp 5-16. Modigliani, F., Miller, M(1958), The cost of capital, corporation finance, and the theory of investment. American Economic Review,vol. 48, pp.261297. Modigliani, F. and Miller, M.H. (1963), "Corporate Income Taxes and the Cost of Capital; A Correction, The American Economic Review,vol.53(3),pp. 433-443. Marsh P(1982): The choice between equity and debt: An empirical study, Journal of Finance; vol.37,pp 121-44. Myers SC( 1977), Determinants of corporate borrowing, Journal of Financial Economics ,vol. 9, pp147-76. Myers, Stewart C( 1984): The Capital Structure Puzzle, Journal of Finance, vol.39,pp 575-592. Myers, S.C. and Majluf, N. S. (1984), Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics, Vol.13, pp. 187-221. Mathew,T(1991): Optimal Financial Leverage-The ownership factor,Finance India, vol.5no.2,June,pp195-201. Nimalathasan, B., Valeriu B(2010), Capital Structure and Its Impact on Profitability: A Study of Listed Manufacturing Companies in Sri Lanka (2010), Revista Tinerilor Economisti/The Young Economists Journal ,Vol.13,pp55-61. Ozkan, A. (2001). "Determinants of Capital Structure and Adjustment to Long Run Target: Evidence from UK Company Panel Data". Journal of Business Finance & Accounting,vol. 28,no. 1 & 2,pp 175-198. Philippe,Gaud. Elion, Jani Martin, Hoesli and Andre, Bender (2003),The capital structure of Swiss Companies: an empirical analysis using dynamic panel data, University of Geneva(HEC),Switzerland. Pratheepkanth,P(2011),Capital structure and financial performance: evidence from selected business companies in Colombo stock exchange Sri Lanka., Researchers world-Journal of Arts, Science & Commerce
58
-International Refereed Research Journal, Vol. II, Issue 2,April,pp171-83. Ross,Stephen (1988),Comment on Modigliani and Miller Proposition, Journal of Economic Pespectives,2,pp127-34. Rajan, R.G. and Zingales, L(1995): What do we know about capital structure? Some evidence from international data, Journal of Finance, Vol. 50, pp.1421-60. Sobia Qayyum(2013), Determinants of capital structure: An empirical study of Cement industry of Pakistan, Interdisciplinary Journal of Contemporary Research in Business, vol 4, no. 11,pp.784-95. Sinha .Siddhart(1992),Inter industry variation in capital structure in India, Indian Journal of Finance and Research, vol.2,pp13-26. Schwartz, E. and J.R. Aronson (1967), "Some Surrogate Evidence in Support of the Concept of Optimal Financial Structure," Journal of Finance, vol.22, March, pp. 10-18.