CHAPTERI INTRODUCTION 1.

1 Overview
The mere existence of a business organization is characterized by the fact that it must create facilities for carrying on its operations; manufacturing, trading or rendering services. These facilities are created by acquiring fixed assets and current assets. The decision pertaining to acquisition of these assets is known as investment decision. Once the investment decision is made there arises a need for determining the appropriate amount of different sources of finance for fulfilling investment needs. This decision is known as capital structure decision.

Firms can use internal or external sources to finance their investments. While internal source includes retained earnings, the external financing can be in the form of borrowings or the stock issue. These decisions are important as firms are constantly making investment decisions for sustenance and growth. Hence, the finance is rightly called as the growth capital. The countrys economic growth is also related to the growth capital. The theory of capital structure is important for firms as they are constantly making financing decisions. This theory attempts to explain the sources and strategy of finance for assets of the firm.

One of the prominent forms of dilemma is choosing between debt and equity for financing. How is the leverage of the firm determined in the world in which future cash flows are uncertain and in which capital can be obtained in various forms ranging from pure debt to pure equity is quite a paradox. Adding to this is the complex agency problem at all levels i.e. between insiders and the outsiders as well as among the insiders. Corporate decisions on capital structure policy have long been a subject of debate and still remain an unresolved issue.

1.2 Equity versus Debt financing

Equity capital is the investment made by shareholders in the form of equity shares for which they do not necessarily expect any fixed rate of return every year on the other hand debt capital

represents that part of capital for which a fixed rate of return in the form of interest is expected by the suppliers of such capital.

A company that finances whole of its assets through equity capital may be in a very advantageous position since no fixed return is required to be paid to anybody. Such a company may also be able to manage its finances very efficiently as it does not have to fulfill its commitments of outstanding loans or arrange further financing through loans. But equity capital may not come forward to the full extent in the case of all companies. In the case of highly profitable companies, the difficulty of meeting the financial requirements to the necessary extent will not arise. This is because if investors are assured of a fixed rate of return, they may be prepared to invest to the full extent of funds required for financing the projects. A question may arise as to whether it is desirable that the entire assets of a company are financed by equity capital. This is not desirable because using of long-term funds (equity capital) for short term purposes may not be sound form of use of the available savings of the community. Besides, due to the total quantum of equity finance available in a country being limited and some companies following a policy of financing their entire assets through equity capital, certain other companies may not be able to go into production for want of equity capital Further, a company which is making high profits will not like to increased equity capital if others sources of finance are available. This is because equity capital gets all the residual profits. Also, lending institutions which may not like to invest their funds on long-term basis may be satisfied with a lower rate of return and be prepared to advance loans carrying a lower rate of return than what the equity shareholders can get. Thus. it is both in the interest of equity shareholders and the lenders that a company does not finance the entire assets through equity capital. Pros and Cons of Equity Financing Advantages The equity capital is the most impot1ant long term source of financing. It offers a number of advantages to the company. 1. Long-term Permanent Capital

Equity shares provide long-term capital to the company. They are the Chief risk-takers. Since equity capital is not redeemable, the company has not liability for cash outflow coupled with its redemption. It is a perpetual capital, and available for use as long as the company exists.

2. Creditworthiness The equity capital enlarges the company's financial base, and thereby its financial limits. Lenders generally provide funds in proportion to the company's equity capital. By issuing equity shares, the company strengthens its financial capacity enabling it to borrow when it needs additional funds.

3. No Fixed Burden Equity capital carries no fixed burden in terms of return. It does not carry any fixed rate of interest like debt funds. So, it does not create any fixed obligation on the company's income statement. After meeting all the fixed charges payable on borrowed capital, the remaining amount of profits belong to the equity shareholders. Thus in terms of financial difficulties, It can reduce or suspend payment of dividend. and thereby avoid cash outflow .

.4. Other Advantages Equity shares may, at tunes, be sold more easily than the debt. They appeal to certain investor groups for two reasons. They typically carry a higher expected return than preference share or debt capital. Equity capital provides the investors with a better hedge against inflation because it represents the ownership in the company. Equity share increase in value when the value of real assets rises during an inflationary period. Limitations Equity capital possesses some limitations for the company as compared to other sources of longterm finance.

l. High Floatation Cost

The costs of underwriting and selling equity shares are generally higher than those for underwriting and selling debentures and preference shares, etc. The specific cost of equity shares is also typically higher than that of debt funds.

2. Uncertain Income to investors Equity shares are riskier from investors point of view as there is uncertainty regarding dividend and and capital gains. Therefore, they require a relatively higher rate of return This makes equity capital as the highest cost source of long-term finance

3. Dilution in Control The each sale of equity shares gives power of control to the additional shareholders. For this reason inter alia additional equity financing is often avoided by new and small companies because the existing management may be unwilling to share control of the concern with outsiders.

4. No Advantage of Leverage If a company always issues equity shares to meet the requirement of additional funds, it cannot avail of advantage of leverage. The use of debt may enable the company to use funds at low fixed cost, whereas equity shares give equal rights to new shareholders too to share the net profits of the company.

5. No tax- Advantage Dividends on equity shares are not deductible as an expense for determining the taxable income of the company, while interest on debt is admissible. This is why debt is considered to be a cheaper source of finance than equity capital.

6. Inflexible Capital Structure Equity shares once issued and allotted cannot be redeemed. The use of equity capital creates inflexibility in the capital structure of the company. On the other hand, redeemable preference shares and redeemable debentures provide the flexibility.

In view of the above factors, equity capital has proved to be the most prominent source of financing. It also appeals to a large number of investors who are venturesome and willing to assume risks for larger income. By purchasing equity shares, they share the prosperity and progress of the company. However, there is a danger of losing control to outsiders if the company decides to raise substantially large amounts through equity shares, controlling position of the existing shareholders is jeopardized. Existing shareholders may, therefore, be averse to additional financing raising additional capital through equity shares will not be taking the valuable benefits of trading on equity. Pros and Cons of Debt Financing Advantages A basic question arises as to why a company uses debt capital. Its answer is very simple. A company uses debt to magnify the return to its equity shareholders as debt capital is a cheaper source of funds. There are some obvious advantages of debt capital which motivates the companies to use debt capital in its capital structure.

1. No Dilution of Control As the lenders do not have voting rights. debt capital does not result in to dilution of ownership.

2. Lower Average Cost of Capital The debt funds enable the management to lower down the average cost of capital because interest charges are usually lower than the expected dividend rate on preference shares as well as equity shares.

3.Tax Advantage The interest payable on debts is an admissible expenditure in computing the taxable earnings of the company. Thus. its real cost is reduced by the marginal tax rate applicable to that company. This advantage is not available in respect of preference share capital or equity share capital because dividend is an appropriation of profits.

4. Flexible Capital Structure

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The use of debt capital incorporates necessary flexibility in the capital structure of the company as it can be redeemed during the periods when it is no more needed in the business.

Limitations

Debt financing has some limitations also, the important of which are as follows: 1. Riskier financing Debt involves an element of risk, primarily because interest and principal payments are fixed charges. If a company has unstable earnings, it runs the risk of being unable to pay interest during periods of low earnings, and of inviting receivership.

2. Contractual Restrictions Sometimes. the bankers or financial institutions providing loans to the company that impose such restrictions upon the company that additional loans cannot be raised by that company without their prior approval Such terms and conditions naturally obstructs the use of net capital in future.

3. Cost of Borrowings Another limitation of debt financing is that with successive issues of debt the company is required to pay higher rate of interest since each dose of debt involves the lender greater financial risks.

In view of the aforesaid factors. companies with certain peculiar characteristics can avail of the benefits of debt. Only those companies whose earnings are reasonably stable and high enough to cover fixed interest charges on debt capital should use the debt funds Companies not sure of future earnings would incur the risk of in solvency by using debt funds. Any factor contributing to instability of income would call for the company to restrict its financing mainly to equity share capital Thus, a company pursuing a new industrial activity would have to depend upon the issue of equity shares to raise long-term funds. A new manufacturing concern requiring large and expensive plants and machines would place relatively less reliance on debt because its earnings are uncertain. Projects with longer gestation period and lower rate of profitability should have strong equity base while keeping the debt funds to the minimum. Therefore, while deciding upon
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the use of debt vs. equity, the actual decision should be based on a judgement about the relative importance of the several underlying factors and principles.

Since Modigliani and Miller published their seminal paper in 1958, the issue of capital structure has generated great interest among the financial researchers1. From the theoretical point of view there are two widely used models for capital structure: the trade off theory and the pecking order theory. They are the more accepted theory to model the financing behavior followed by the firms. According to the trade off theory of the capital structure, there exists an optimal leverage ratio of the firms. A firm would always want to be near the optimal (target) debt level and if any deviation happens, it gradually moves back to it. This optimal level is achieved by making trade off between the gains from debt or equity to loss from them. Benefits include interest tax shield and the costs include bankruptcy costs, agency costs, etc. On the other hand the pecking order hypothesis, first suggested by Myers and Majluf2 (1984) says that there is no well defined target debt level which firms try to achieve. Firms raise external finance only when internal finance is not sufficient. The theory says that firms prefer internal finance over external finance and debt over equity. The establishment of the theory which explains a particular firms behavior is more of an empirical issue. Hence a careful testing based on proper model is very crucial for understanding the capital structure behavior. It is important to test which hypothesis between the trade off theory and the pecking order theory is more powerful in explaining the behavior of the firms financing decisions. This can be tested by both time series as well as cross sectional hypothesis. There are no conclusive results of the same. Shyam-Sunder and Myers3 (1999) claimed that pecking order theory is more powerful in explaining the behavior of the firms than the trade off theory. However it was challenged by

Myers, S.C., (2003), Financing of corporations. Constantinides, G., M. Harris, and R. Stulz (eds.) Handbook of The Economics of Finance: Corporate Finance Volume1A, Elsevier North Holland. 2 Myers, S and Majluf, N. (1984), Corporate Financing and Investment Decisions When Firms have Information Investors do not have, Journal of Financial Economics, 13, 187-221. 3 Shyam-Sunder, L. and S.C. Myers, (1999) Testing Static trade-off against Pecking Order Models of Capital Structure, Journal of Financial Economics, 51, 219-244.

many like Chirinko and Singha4 (2000) methodologically. Fama and French5 (2002) found that the some firms followed pecking order while others followed the trade off model and none of them could be rejected.

It is important to note that factors that affect these theories are country specific. For example, take the benefit which trade off theory assumes for the debt namely the interest tax shield. Now this benefit depends on the effective rate and differential rate between the corporate and personal tax rate. A country with high tax rate and hence more perceived tax advantages will be expected to have higher target debt levels ceteris paribus and so are the other factors affecting the capital structure. The factors which may be important for one economy may not be hold for another economy. Hence, it is important to test the theories (or factors) for each country separately and not take the general outcomes found somewhere else. Wald6 (1999) demonstrated that institutional differences could contribute to differences in the capital structure.

Firms in the emerging economies are expected to behave differently than the firms in the developed economies. They may have different financing objectives too. Most of these emerging economies historically have been dominated by the state owned enterprises and family controlled firms also termed as crony capitalism7 . Legal protection and investor protection laws are also different in emerging economies as compared to the developed ones. The emerging markets typically have narrower range of financial instruments when compared to their developed counterparts. Even the accounting and auditing differs between the nations and this may affect the choice of capital structure via variables like taxable income, depreciation, deferred items etc. Singh and Hamid8 (1992) and Singh9 (1995) found that firms in the developing economies relied more on equity than debt.
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Chirinko, R. and A. Singha, (2000) Testing Static trade-off Against Pecking Order Models of Capital Structure: A Critical Comment, Journal of Financial Economics, 58, 417-425. 5 Fama, E. and French, K. "Testing Tradeoff and Pecking Order Predictions about Dividends and Debt," Review of Financial Studies 15 (Spring 2002), 1-37 6 Wald (1999), How firm characteristics affect capital structure: An international Comparison, Journal of Financial Research 22, 161187. 7 La Porta, R., F. Lopez-de-Silanes, A. Shleifer and R.W. Vishny, (2000) Agency problems and dividend policies around the world, Journal of Finance, 55(1), 1-33. 8 Singh and Hamid, (1992) Corporate Financial Structure in Developing Countries,Working Paper. 9 Singh, A., (1995), Corporate financial patterns in industrialising economies A comparative international study, IFC Technical Paper No. 2, Washington D.C.: International Finance Corporation.

Among the emerging economies too the capital structure financing differs due to the different history and development of the capital and debt markets. Each market is unique and should be analyzed in its own economic, legal and institutional framework. There is limited work done in India related to capital structure theories. The results have been mixed so far.

The present study aims to examine the compliance of Indian firms with trade off theory and pecking order theory. Do Indian firms follow trade off or the pecking order or some new hybrid theory is needed? The broader motivation behind this objective is to address the following questions: Do Indian firms belonging to different industries follow same theories or different theories? Do Indian firms map their capital structure to a particular theory during different economic conditions or adapt it to better utilize the different economic conditions ?

1.3 Indian Capital Market

Indian capital markets are unique in many ways because of its unusual history. Until mid 1992 the Indian capital markets were controlled in terms of product, price and size by the Controller of Capital Issues, Government of India. The instruments were not supposed to be efficient during that period as could be seen from huge underpricing in that period and various scandals, etc. During that time major source of finance were long term loans from financial institutions. To make the markets more free, the Indian Government set up Securities and Exchange Board of India (SEBI) under SEBI Act, 1992. Under the SEBI regulations, firms were given more freedom in designing and pricing capital markets instruments along with the decision of the amount to be raised. These reforms prompted many privately owned firms to become public and many public firms started raising money through the capital markets. This trend is reflected in the amount raised via the capital issues. In the year 2005-06, Rs. 27,382 crores was raised through equity market which rose to Rs. 33,508 crores in the following year i.e. 2006-07. The Indian wholesale debt market (WDM) raised Rs. 2,19,106 crores in the year 2006-07 and Rs. 4,75,523 crores in the year 2005-06 as per annual report of RBI for the year 2006-07.