Determinants of capital structure decisions in large mature corporations: an empirircal analysis

Abstract

The objectives of the study were to find answers to the following questions: 1. Are agency cost measures significant determinants of the debt equity choice? (Agency costs implying costs borne by equity shareholders, because debt holders recognize the equity appropriating tendencies, given the fact equity holders have claims on residual earnings whereas risk borne is limited.) 2. Have ownership patterns of financial institutions affected the agency cost problem? 3. What are the possible reasons for the capital structure of Indian companies being more leveraged than foreign controlled companies as suggested by the existing literature? 4. Is the pecking order hypothesis valid under the India context? The empirical investigation involved both quantitative and qualitative approaches. In the quantitative analysis, the sample was drawn from the Centre for Monitoring Indian Economy (CMIE) publication ‘Key Financial Data on Large Business Units: Top 500 Corporate Giants’. From the list of 500 companies, public sector and joint sector companies were excluded. Given the level of direct government participation, their financing pattern would not be comparable with those in the private sector. Further, companies for which operating profit was negative in any year was dropped on the ground that financing decision in such cases might reflect compulsions, hence vitiating comparability. The selection of large, mature (to the extent that, they were operating for at least nine years) companies was solely based on the assumption that they would be much more likely to quantitative analyses. This resulted in a sample of 197 companies for the purpose of cross – sectional analysis using the method of multiple regression. Financial information relating to the period 1982-1990, was based on data available in the official Directory of the Bombay Stock Exchange. Agency costs were found to be significant. Ownership patterns of financial institutions were not found to have mitigated the agency cost problem. The most significant factor which contributed to a less leveraged capital structure for foreign controlled companies was the sensitivity to variabilities in cash flows. Ceteris paribus, capital structure is logically determined out of a static trade off between the tax advantage of debt and the risk of bankruptcy. However empirical evidence in the US and Europe have tended to support the pecking order hypothesis, where companies usually avoid new equity issues, and debt tends to be determined as supply of internal accruals. Tests of some of the propositions resulting from the pecking order hypothesis, in the Indian context, provided evidence broadly in support of the hypothesis. The qualitative analysis was primarily aimed at an understanding of the institutional context which determines capital structure. The case of Indian Aluminium Company Limited was taken up to understand the implications of administered pricing on a foreign controlled company. The financing decision was significantly dependent on choices of the foreign counterpart. The regime of administered pricing had implications for the product-mix and the overall operating viability of the company, which affected the financing decisions taken. The case of Reliance Industries Limited was analyzed so as to understand the implications which a controlled capital market had in motivating the introduction of innovative means of financing. The financing pattern of Reliance exemplified how in a regime of controlled interest rates and administered pricing, a mix of debt and equity was used effectively to raise large amounts of capital from the market to finance a rapid pace of growth.