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 structurethough 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

the developed countries. The purpose of this paper is to test the STT and the POT using Indian corporate data. Theoretical Framework and Review of Empirical Studies Myers (1984) segregates the contemporary views on capital structure into two theoretical frameworksStatic Trade-off framework and Pecking Order framework. Under Static Trade-off theory, a firm sets up a target-debt ratio which is the trade-off between interest tax shield and cost of financial distress. 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. In the Pecking order theory, a firm prefers internal to external financing and debt to equity, if it issues securities. There is no target debt-ratio in the pure pecking order. 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. Chirinko and Singha (2000) argue that there are two forms of POTthe strong form and semi-strong or weak form. Under the strong form, a firm never issues external equity and uses internal sources and debt to finance new investment projects. Under the semi-strong or weak form, a firm may issue certain external equity. The POT, indeed, does not reject entirely the issue of new shares. This may happen when a firm needs funds for future unknown events. 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. Harris and Raviv (1991) observe that leverage increases with fixed assets, non-debt tax shield, investment opportunities and firm size, while it decreases with volatility, advertising expenditure, profitability and uniqueness of the product. Kakani (1999) concludes that profitability and capital intensity are negatively associated with leverage, but observe no significance of firms' diversification strategy and size in deciding the leverage level of the firm. Baskin (1989) and Allen (1993) find evidence consistent with Pecking order hypothesis in the US (Baskin) and Australia (Allen). Rajan and Zingles (1995) have used four determinants of corporate leveragetangibility, growth, 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. Fama and French (2005) have pointed out that the two theories share many common predictions about the determinants of corporate leverage; but there are some aspects of corporate financing where the Trade-off and Pecking order theories provide different predictions. These factors are:

Tangibility: According to the Trade-off hypothesis, tangible assets serve as collaterals and provide security to creditors in the event of financial distress. Collaterals also protect the lenders from moral hazard problems caused by shareholders-lenders conflict (Jensen and Meckling, 1976). The Static Trade-off theory, thus, states that, the larger the proportion of tangible assets, the more willing would the lenders be, to supply loans and higher would be the leverage. However, under Pecking order theory, as argued by Harris and Raviv (1991), firms with few tangible assets would have greater information asymmetry problems. Due to the asymmetry of information between the management and outsiders, firms issue debt to finance new investment projects, because equity issue would only be possible by under pricing. The Pecking Order theory, according to Harris and Raviv (1991), predicts an inverse association between tangibility and leverage. As regards the empirical evidence, Titman and Wessels (1988) and Rajan and Zingales (1995) have observed significant positive association between tangibility and total debt. Profitability: The Static Trade-off theory presumes that profitable firms use higher amount of debt capital in their capital structure. Higher the amount of debt capital, the higher would be the benefit of the interest tax shield. Less profitable firms use lower amount of debt capital because of the fear of financial distress. The agency stream, one branch of static trade-off, believes that large amount of free cash flows create the dispute between shareholders and managers, which prompts firms to issue more debt in order to eliminate the problem (Fama and French, 2005). The Static Trade-off theory, thus, predicts positive influence of profitability on leverage. In contrast, Myers (1984) and Myers and Majluf (1984) postulate that profitable firms borrow lessnot due to their low target debt ratio, but on account of their sufficient internally generated funds. 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. The attraction of interest tax shield is considered as second order effect in this theory. Regardless of the industry in question, this theory explains a negative relationship between profitability and leverage. Empirically, most researchers have observed a significant negative association between these two variables. Size: Large firms tend to be more diversified and less prone to bankruptcy (Rajan and Zingales, 1995). The Static Trade-off theory states that large firms have better reputation in the debt market and face lower information cost of borrowing, resulting in a positive relationship between size and debt. The alternative argument is that firm size may be a proxy for information asymmetry between insiders and outsiders. 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, 1995). The Pecking Order theory, thus, predicts an inverse association between firm size and debt ratio. While Rajan and Zingales have observed empirically a significant positive relationship between size and debt ratio, Remmers et al., (1974) find no significant effect of size on capital structure. Dividend: A highly levered firm has higher contractual obligations in terms of payment of interest and repayment of debt. Hence, a firm with higher quantum of debt capital would be more reluctant to follow an aggressive dividend policy. The Static Trade-off theory suggests that dividends are high (retentions low) because external financing is low, implying negative or insignificant relationship between dividend and leverage. On the contrary, the Pecking Order

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

the median have been categorized as highly levered firms. According to profitability, all selected firms have been divided into less profitable firms, medium profitable firms, substantial profitable firms and high profitable firms. High profitable firms are those with a profitability ratio in excess of the 75th percentile of the distribution. Less profitable firms are those with a profitability ratio of up to the 25th percentile of the distribution. Firms with a profitability ratio between the 25th percentile and 50th percentile of the distribution are classified as medium profitable firms. Similarly, firms with profitability ratio above 50th percentile but up to 75th percentile of the distribution are classified as substantially profitable firms. Following the same technique, selected firms have been classified into smallest firms, small firms, large firms and largest firms on the basis of distribution of sales value. For firm specific analysis, 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. Results Static Trade-off theory and Pecking Order hypothesis provide different predictions on tangibility, profitability, size and dividend behavior of firms on corporate leverage. 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). In order to verify the existence of multi-collinearity among the variables used here and dependability of the regression results, condition index and D-W statistic respectively are shown in the tables. If in any run of the regression model, condition index exceeds 10 or D-W statistic is significantly different from the desired norm of 2, the present study has employed the first-difference method of the following form to obtain more acceptable results:

where,

The important feature of this model is that it does not have an intercept term. Hence, the regression result should not contain any statistically significant value for the intercept. 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 reported in Tables 2 through 6 (Appendix) are summarized below. As it may be noted in all these tables, barring a few, the observed F statistics are highly significant and R2 are also quite satisfactory for all runs of the regression model. Thus, 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. The observed D-W statistics and condition index also strongly advocate the dependability of the results. Tangibility: From the perspective of testing the Pecking Order, perhaps the most important of the conventional variables is tangibility. The Pecking Order theory proposes that firms with few

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

Order hypothesis, three of them are not statistically significant. If the transaction costs argument is valid, then large firms will have lower cost of issuing equity. This suggests a positive relationship between equity and firm size and an inverse association between size and debt capital. But this proposition, as revealed by the study, seems not valid in the Indian context. 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. Dividend: The present study could not disentangle the relationship between dividend and leverage. The findings of this study neither strongly support the Trade-off theory nor reject the Pecking Order hypothesis with regard to this issue. While firms were classified on the basis of leverage and profitability (Tables 2 and 3 of Appendixrespectively), negative association as expected in trade-off theory was observed, 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. Industry wise regression results also depict a similar picture. Out of nine industries selected in the study, negative association is found for six cases (Table 5 Appendix). 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. Though the Pecking Order theory does not provide a distinctive theory on dividends, 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. 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. But the findings of this study do not support the view of the Pecking Order theory fully. Rather, to some extent, 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. Conclusion The evidences provided in this paper results in mixed conclusions. The study does not altogether reject the validity of the Pecking Order theory, especially, regarding the association between profitability and corporate leverage. On a balanced consideration, it may be concluded that the findings of this study neither support the Trade-off theory, nor the Pecking Order; though these results provide much evidence in favor of the former. Unlike some of the earlier studies conducted around the world, this study also fails to arrive at any conclusive evidence on the issue. 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. The market structure in this complex scenario may be a useful candidate to influence the firms' financing decision. It is, therefore, suggested that further study should include some proxy to represent the market structure in which a firm operates, along with other variables, in order to arrive at any agreeable conclusion on the determinants of capital structure of Indian companies. References

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