CHAPTERV SUMMARY & CONCLUDING OBSERVATIONS 5.

1 Summary
The theory of capital structure is important for firms as they are constantly making investment decisions driven by financing decisions. Corporate decisions on capital structure policy have long been a subject of debate and still remain an unresolved issue. This decision typically involves the decision of raising debt and equity. It is important to note that factors or determinants that affect the capital structure of a firm exhibit different impact according to different theories. It is important to carry out the study for Indian firms and not rely on the results from other economies. Literature has identified four main theories of capital structure: the MM proposition, the Trade off theory, the Pecking order theory and the Agency theories. Of these the trade off and the pecking order theory is widely accepted and hence studied here. The trade off theory is based on balancing the advantages and disadvantages of the debt and equity. This theory suggests existence of an optimal debt level at which the value of the firm is maximum. The pecking theory says that firms prefer internal fund over the external and if external resource is required, firms rely on debt more than equity. The optimal debt and debt capacity are unobservable and have to be imputed from other observed variables like size, profitability growth options, asset structure, maturity etc. The trade off theory predicts that debt level should increase with asset size, maturity, tangible assets and profitability; it decreases with intangible assets, risk, non debt tax shields and growth options. According to the pecking order theory, leverage is positively related to intangible assets, growth options, dividends, capital expenditure and it is negatively related to the tangible assets, maturity, firm size and profitability. Further, while testing the trade off and the pecking order theory, no agency control variables have been used. There have been no previous attempts to compare capital structure of the firm across industries and capital structure across different economic scenarios. Based on the literature review and research gap, the following questions have been identified to be carried out as the part of the proposed project:

67

What explains the behavior of Indian firms capital structure behavior: the trade off theory or the pecking order? Does the behavior of the Indian firms remain same or vary across the industries in terms of the capital structure theory followed? Does the behavior of the Indian firms remain same or vary across the industries?

Due to the cross sectional and time series nature of the data under study, least square panel regression method has been used. The proposed research has been carried out on the firms from five industries (automobiles, pharmaceuticals, Consumer durables or electronics, information technology, and FMCG) for the period 2003-2011.

5.2 Main Findings

As expected, the level of significance of different variables and their impact on capital structure has come out to be different across various industries. Table 5.1 - Industry wise comparison
FMCG

=
.05

=
.10

Automobile = .05 .10

Consumer Durables

IT

Pharmaceuticals

= .05
Not Significant

= .10
Trade off theory

= .05

= .10

= .05

= .10

Size

Pecking order theory Not Significant Not Significant Not Significant Not Significant Not Significant Opp. To trade off theory

Pecking order theory Not Significant Pecking order theory Trade off theory Trade off theory Not Significant Trade off theory

Pecking order theory

Not Significant Pecking order theory

Profitability

Pecking order theory

Trade off theory

Growth

Not Significant

Not Significant Not Significant Trade off theory

Not Significant

Tangibility

Not Significant Pecking order theory

Not Significant

Age

Trade off theory Not Significant Trade off theory

Not Significant

Depreciation

Not Significant

Not Significant Opp. To trade off theory

Risk

Not Significant

Not Significant

68

The Size variable is primarily in conformance with pecking order theory for FMCG, Automobile and IT industry implying that firms belonging to these industries prefer to use equity or internal funds with higher sales. This variable is non significant for Consumer durables and pharmaceuticals at 95% confidence interval whereas it has contrarily complied with trade off theory at 90% confidence interval for consumer durable sector suggesting the presence of optimal capital structure. There is a surprising observation for profitability variable as it is in agreement with pecking order theory for Consumer Durables and Pharmaceuticals for which Size Variable was insignificant. Also, it is reflecting insignificant impact on capital structure of FMCG & Automobile for which Size Variable was significant. One more interesting observation is that IT firms with higher profitability prefer higher debt-equity ratio to take advantage of financial leverage to increase the return to shareholders. The Growth variable has shown insignificant impact on capital structure of FMCG, Consumer Durables, IT and Pharmaceutical industry where as it follows pecking order theory for Automobile sector implying that the capital intensive assets of automobile industry are primarily financed with equity capital. The asset structure measured by the Tangibility variable confirms trade off theory for Automobile and IT firms implying utilization of higher debt raising capacity with capital intensive assets for Automobile industry. It is insignificant for other industries at 95% confidence level. The maturity of the firm is non significant for FMCG & Pharmaceuticals where as it confirms with trade off theory for Automobile and IT sector implying established firms in these sector taking advantage of financial leverage due to their increased credibility. The non-debt tax shield measured by depreciation does not have significant influence on capital structure of any industry at 95% confidence level. The Risk variable which has been measured by variation in earnings suggests exactly opposite to trade off theory for FMCG and Pharmaceutical sector showed a higher debtequity ratio for higher variation in earnings. As the future performance of pharmacy firms are characterized by R&D capability of the pharmacy firm, success of which yield high return with a major breakthrough in medical field, the pharmacy sector is high risk high return investment opportunity. It might be due to the variation

69

of earning on the positive side which suggest that creditors are ready to take higher risk by investing in such firms to earn higher return. Economic scenario wise comparison As per our empirical study conducted, only the Maturity variable has shown consistent significant impact on capital structure of the companies considered for both the economic slowdown (2007-11) and economic boom period (2003-07) There are two variables size and profitability supporting trade off theory for the economic boom period which is in contrast with the above industry wise results. These variables have shown insignificant impact on capital structure during economic slowdown (2008-11). Table 5.2 Comparison across diverse underlying Economic scenarios

Size Profitability Growth Tangibility Age Depreciation Risk

Economic Boom Period, 2003-07 = .05 = .10 Trade off theory Trade off theory Not Significant Not Significant Pecking order theory Not Significant Not Significant

Economic Slowdown Period, 2008-11 = .05 = .10 Not Significant Not Significant Not Significant Not Significant Pecking order theory Opp. To trade off theory Not Significant

The study has given some interesting observations from the results. As observed that, firms with greater sales and profitability follow trade off theory during bullish economic phase, it implies that these firms want to take maximum advantage of financial leverage to multiply the return to shareholders by using higher debt compared to equity to fund their projects during the bullish phase of the economy. As the maturity attribute of the firms measured with Age variable converges with pecking order theory (Table 5.2) irrespective of the underlying economic situation it can be concluded that firms with greater maturity on an average prefer to use internal funds compared to debt to fund their projects during the bullish phase. This gives a redeeming signal about the Indian corporate behavior which is found out to show more dependence on their
70

internally generated funds than on external sources of finance. Two positive effects can come out of it. Firstly, from macroeconomic point of view this can signify more investments with the household savings getting supplemented by corporate savings. Secondly, this implies that the firms are not exposed to the vagaries of interest rates and thus volatility in interest rates and liquidity in the market may not have lethal impact on the corporate investment. This gives another clue that the mature firms may be less exposed to credit uncertainty. Low leverage can help the firms to avoid second agency conflict between shareholders and debt holders as well. But at the same time it can increase the conflict between managers and shareholders. As per the empirical results shown above in table 5.1 & 5.2, few variables support pecking-order theory and few support trade-off theory (refer Table 1, Appendix). So it is concluded that behavior of the Indian corporate sector regarding capital structure is eclectic. This is what is expected. Real life situation does not totally match with only one theory. But some interesting observations, as discussed above, from results have been made.

As a concluding note, a few limitations of this study includes the limitation of the scope of the study to only five industrial sectors, viz. Automobile, Information Technology, FMCG,

Consumer Durables and Pharmaceuticals. The other limitation is of short time series for research. The empirical study for economy wise comparison consist of very short period but it is uncontrollable as the economic conditions have changed over the short period of four or five years in the recent past. One more limitation is that Only public listed companies were included in the study as the private limited companies do not have access to the capital markets so they cannot raise finance from the secondary market. The empirical study is limited to Indian companies and does not give a holistic picture of global trend in capital structure. The capital structure of a company can have many other determinants like management style, kind of product, ownership structure etc. but only the prominent ones like profitability, size etc. are considered. The inclusion of these parameters in the study can be very illuminating to identify their any impact on the capital structure during the bullish phase of the economy. This should be a future research agenda to build upon the present study.

71