3.research methodology

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CHAPTERIIIRESEARCH DESIGN AND METHODOLOGY

3.1 Need and Significance of Study

India is the one of the fastest growing economy in the world at present. This is one of the

important emerging economies in the world in terms of foreign capital inflow. In order to make a

mark in the global arena India has to make large investment in different sectors and its corporate

sector has to gear itself up for global competition. For this purpose, effective sourcing of funds is

very crucial. Against this backdrop, the study of the determinants of capital structure of the

Indian firms assumes significance.

It could be argued that the spotlighting on India should not be a concern, because we could

merely take the results of the prior studies that have already been conducted in the context of the

developed markets. And, in reality, several researchers have already exposed the tendency of

convergence between emerging markets and developed economies. The emerging markets are

steadily reaching the debt levels of developed countries. It would be convenient if we could

apply the finding of the developed markets research when dealing with any capital structure

problems on emerging markets. However, the matter is complex and not as straightforward as

that seems to be. It is crucial to be sure that the companies, operating in emerging or developed

capital market, actually follow the worldwide tendencies and that they choose their capital

structure following the same logic. Alves and Ferreira1

(2007) and several others argued that

the determinants of Capital Structure are significantly affected by jurisdictional factors like

Corporate and Personal Tax System, Corporate Governance, Laws and Regulations of the

country. Similarly, the development of the bond/capital markets, Rule of Law, Credit/Share

holders Protection, etc, are quite specific to individual countries. It is therefore, very important to

study individual emerging countries by themselves rather than the countries pooled together. Dueto the uniqueness of India as a country as explained here, it is important to understand the

behaviour of the companies by studying the country individually. This project will be focused on

the BSE listed companies in different industry sectors.

1Alves P, Paulo F. And Ferreira, Miguel A., (2007),Capital Structure and Law Around the World 14th Annual

Conference of The Multinational Finance Society.


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Only few of the previous empirical studies on the determinants of capital structure conducted for

Indian companies before have tried to compare the situation in a bullish phase (2003-2007) and

slowdown phase (2008-2011) of economy. The present empirical study is for the period of 2003-

2011. The time period chosen from 2003 to 2011 is significant as it involves rapidly growing

economic scenario followed by global slowdown. So the study will also be conducted separately

for 2003-2007, the economic boom period and 2008-2011, the economic slowdown period so as

to try to find out the differences in the significance of determinants of capital structure during

different economic scenarios. The comparisons in different economic scenarios may help in

gaining new insights regarding the following of trade-off theory and pecking ordering theory by

determinants of capital structure under different economic scenarios, which is the primary need

and motivation for this study.

3.2 Objectives of the Study

The study aims to achieve the following objectives :

a) To determine whether the determinants of capital structure vary in accordance with trade-off

theory or pecking order theory.

b) To determine if there is an influence of prevailing economic condition on the capital structure

determinants by considering the specific period of bullish phase (2003-2007) and slowdownphase (2008-2011) of economy.

c) To identify the differences, if any, in the determinants of capital structure, among different

industry sectors, in terms of the capital structure theory followed.

3.3 Hypotheses

Following are the hypotheses considered for the study

a) Financial Leverage is positively influenced by Growth

b) Financial Leverage is positively influenced by Tangibility

c) Financial Leverage is positively influenced by Size

d) Financial Leverage is positively influenced by Profitability

e) Financial Leverage is positively influenced by Maturity


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f) Financial Leverage is positively influenced by Business Risk

g) Financial Leverage is positively influenced by Non debt tax shield

3.4 Scope of Study

Scope of the present study is limited to private sector companies only. The public sector has been

excluded from the present study because it raises funds from state Govt. or central Govt. The

public companies do not have much discretion with regard to designing of their capital structure.

In the private corporate sector, the private limited companies do not have access to capital

market as they are prohibited from raising capital through public issues. Due to this reason the

private limited companies do not have access to capital market as they are prohibited from

raising capital through public issues. Due to this reason the private limited companies are also

excluded from the scope of the study. Therefore only public limited companies having access to

the capital market are included in the present study.

The present study covers a period of 9 years, 2003-2011. The period for study has been divided

in two phases, 2003-2007 and 2008-2011, which is determined on the basis of changing

economic scenario. The study has been conducted for 2003-2007, 2008-2011 and complete

period of 2003-2011 so as to facilitate comparison between different economic scenarios.

3.5 Research Methodology

3.5.1 Methodology

In order to econometrically study the role of various determinants in determining capital

structure of Indian firms, regression analysis has been used. Since the data set contain both cross

section as well as time series data, there is a panel data set. Therefore, there were two options

going for either fixed effect LSDV regression or random effect regression.

Then, a test was conducted to determine whether it is statistically justified to go for panel data

regression with fixed effect. F test or the Redundant Fixed Effect Test shows that the nullhypothesis of no statistically significant variation among companies is rejected although null

hypothesis that there is no statistically significant variation among periods cannot be rejected. So


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only the Cross Section Fixed Effect Test, with LSDV regression was required. It was also

checked whether to go for random effect or concentrate only on fixed effect study. For this

purpose Hausmans Test was conducted to check the null hypothesis that there is nomisspecification in the analysis when random effect regression was carried out assuming the

intercept term as randomly distributed among companies in the linear relation. Hausman test,

however, rejects this hypothesis of no misspecification in case of random effect and hence it was

decided to stick to fixed effectregression only. All the results related to Hausman test have beenprovided in the appendices. For all the statistical calculations, Eviews econometric software has

been used.

The cross section fixed effect regression has been applied to study the impact of various

variables on dependent variable i.e. leverage ratio. The present study has used the following

variables as the explanatory or dependent variables for the testing of the cross- sectional

variation among the companies debt levels:

Size

Profitability

Growth opportunity

Tangibility

Maturity

Non debt tax shields

Business Risk

The model (Frank and Goyal, 2003):

Y = b0 + b1(Size) + b2(Profitability) + b3(Growth opportunity) + b4(Tangibility) +b5(Age)

+b6(NDTS) +b7(Business Risk)

Where Y refers to leverage ratio and NDTS stands for non-debt tax shield.

There are many problems in the measurement of dependent and independent variables. In the

present study, the dependent and independent variables have been measured as follows:


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a) Size of the company

Warner2

(1977), found that direct bankruptcy costs appear to constitute a larger proportion of

the companys value as that value decreases. Large companies tend to be more diversified and

hence less prone to bankruptcy. The equity and debt issuing costs also seem to reduce with the

company size. The trade off theory predicts positive relationship between the company size and

leverage. However, large companies are mostly more profitable and need has more retained

earnings and hence the pecking order theory predicts a negative relationship between it and the

leverage. Therefore, the relationship between the size and leverage is more of an empirical issue.

Most studies use logarithm of sales or total assets or average turnover as the proxy for company

size. Alderson andBetker3

(1995) and Hussain4

(1997) used logarithm of total assets as the

proxy for the company size. Titman and Wessels5 (1988) used logarithm of sales as the

company size variable. Present study will measure size of the company as follows:

Size = log(sales)

b) Growth Opportunities

Growth is a pre-requisite for the long term survival of the company in an uncertain and

constantly changing environment. Therefore, Growth, can be one of the significant determinant

of capital structure. Growth options are assets that add value to the firm but are cannot be

collateralized and hence do not generate current taxable income. The trade off theory predicts

negative relationship between the growth assets and leverage while the pecking order theory

predicts a positive relationship between them. Most studies use either Market to Book ratio, R &

D expenditure, percentage change in assets, capital expenditure and advertising expenditure as

the proxy for growth assets. Titman and Wessels6

(1988) use capital expenditure, percentage

2Warner, J. (1977) , Bankruptcy Costs: Some Evidence, Journal of Finance, 32, 337 -347.

3Alderson, M.J. and B.L. Betker, (1995) Liquidation costs and capital structure, Journal of Financial Economics, 39

(1), 45-69.4Hussain, Q., (1997) The determinants of capital structure: A panel study of Korea and Malaysia, In Kowalski, T.

(ed.), Financial Reform In Emerging Market Economies: Quantitative and Institutional Issues, Poznan: Akademia

Ekonomiczna w Poznaniu, 209-228.5Titman, S., and R. Wessels, (1988) The determinants of capital structure choice,Journal of Finance, 43, 1-21.

6Ibid.


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change in assets and R&D expenditure as the proxy. Rajan and Zingales7

(1995), Hirota8

(1999) used Market to Book ratio as the growth assets. For this study, two measures of growth

have been taken.

For Service based industry like IT sector,

Growth, G = (R1R0) * 100/ R0

Where R1= Revenue at the end of current year

R0= Revenue at the end of previous year

For other industries,

Growth, G = (A1

A0) * 100/ A0

Where A1= Assets at the end of current year

A0= Assets at the end of previous year

c) Profitability

Relationship between the profitability and leverage is ambiguous. The Pecking order says that

firms prefer internal source over external source and hence as profitability increases, leverage

should decrease. Agency theory predicts that as profitability improves information asymmetry

declines and hence a direct relationship is expected between debt-equity ratio and profit of the

firm. The trade off theory too suggests that leverage should increase with profitability as the

collateral value of the firm increases. Various profitability ratios have been used as the variable.

Titman and Wessels9

(1988) used operating income to total assets and operating income to sales

as the profitability and found negative relationship between it and the debt-equity ratio. Rajan

andZingales10 (1995) used earnings before interest, taxes and depreciation/ book value of assets

7Rajan, R.G., and L. Zingales, (1995) What do we know about capital structure? Some Evidence from

international data, Journal of Finance, 50, 1421-1460.8Hirota, S., (1999) Are corporate financing decisions different in Japan? An empirical study on capital structure,

Journal of the Japanese and International Economies, 13 (3), 201-229.9

Titman, S., and R. Wessels, (1988) The determinants of capital structure choice,Journal of Finance, 43, 1-21.10

Rajan and Zingales, op. cit. , 1421-1460


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as the proxy and got negative relationship. Earnings before interest & tax /total assets by taken as

the measure of profitability by Wiwattanakantang11

(1999) and he too found a negative

relationship between leverage and profit of the firm. Hirota12

(1999) employed operating income

plus depreciation/ total assets as the variable for profitability. The present study measure

profitability as follows:

Profitability = Profit before tax / sales

d) Tangibility

Capital structure theories suggest that asset structure affect the choice of debt-equity ratio.

Myers13 (1977) suggests that as the collateralized value of the company increases, debt capacity

increases. Tangible assets (collateral value/liquidation value) also reduce the financial distress

costs. Hence, a positive relation is expected between the collateral value of assets and debt ratios.

This asset structure or liquidation value can be captured by the ratio of intangible assets by total

assets or ratio of plant & machinery by total assets. In the former ratio a negative relation is

expected whereas a positive relationship is predicted for the latter one. Rajan and Zingales14

(1995) and Hirota15

(1999) found a positive relationship between liquidation value and leverage.

Kim and Sorensen16

(1986) found no such relationship. The present study measures tangibility

as follows :

Tangibility = Fixed assets / Total assets

e) Non Debt Tax Shields

11Wiwattanakantang, Y., (1999), An empirical study on the determinants of the capitalstructure of Thai firms,

Pacific-Basin Finance Journal, 7 (3-4), 371-403.12

Hirota, S., (1999) Are corporate financing decisions different in Japan? An empiricalstudy on capital structure,

Journal of the Japanese and International Economies, 13 (3), 201-229.13

Myers, S.C., (1977) Determinants of corporate borrowing Journal of Financial Economics, 5, 147-175.14

Rajan and Zingales, op. cit. , 1421-146015

Hirota, op. cit. , 201-22916

Kim and Sorenson, (1986) Evidence on the Impact of the Agency Costs of Debt on Corporate Debt Policy,

Journal of Financial and Quantitative Analysis 21, 131-144


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Tax deductions from other sources like depreciation etc are the substitute for the tax benefits of

the debt financing. As a result, if these other sources increase, there is lesser need to raise debt

for its tax shield benefit and hence we arrive at a negative relation between the non debt tax

shields and the leverage. Most of the studies use depreciation or investment tax credits for the

proxy of the non debt tax shields. Here, depreciation has been used as a substitute for non debt

tax shield for this study .

Non debt tax shield = Depreciation

f) Maturity

With more maturity or age, a company establishes its credibility and the information asymmetry

related to it reduces. Value of the company can be ascertained more easily for more mature

companies and hence the cost of equity reduces for them. The pecking order theory predicts

inverse relation between the maturity and the leverage. On the other hand, trade off theory

predicts a positive relationship between the maturity and leverage . The maturity of the company

can be captured by age of the company. This age can be calculated from the year of

incorporation. Age is an important variable which can test for the presence of pecking order or

trade off in the companies but still it has been largely neglected by the research in the capital

structure. The present study measures the maturity as the ratio of age of company since

incorporation to the age of the youngest company in data set.

g) Business Risk

The investor attitude is an important factor in designing the capital structure.It has been argued

that firms optimal debt level is a decreasing function of the risk or volatility of the earnings.

Business Risk and leverage are inversely related due to the trade off theory. Financial distress

increases with the risk or volatility of the earnings or cash flow stream. Greater the risk greater is

the compensation required by the investors. The business firms have to face threats from a

variety of internal and external sources, resulting into variability in income. This variability in


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income is considered as business risk. In the present study, business risk will be measured with

the help of coefficient of variation in the operating profits as follows:

Business Risk =

Standard deviation of EBIT of last 5 years

Arithmetic mean of operating profits of last 5 years

h) Leverage

Financial Leverage is an important tool of financial planning as it is said to have a magnifying

effect on the earnings available to equity shareholders. In present study, financial leverage is the

dependent variable and it is used as a measure of capital structure. Though there are different

equations available for financial leverage, but in this study Financial leverage has been measured

as follows

Financial leverage, D/E = DL+PC / Equity

Where DL = Long term debt

PC = Preference share capital

And Equity = Equity share capital + Reserves and Surplus

3.5.2 Data and selection of sample

In order to test the hypotheses, financial data of BSE listed companies from five different BSE

industry sectors from 2003 to 2011 were collected. Companies were selected from five sectors,

viz. Automobile, Information Technology, FMCG, Consumer Durables and Pharmaceuticals (or

Healthcare) as these sectors have been prominently included in earlier studies also. Companies

for which data was not available for the entire period of study have been left out. Therefore, 54

companies out of total 57 companies present in total five BSE industry indices viz. BSE Auto

index, BSE IT index, BSE FMCG Index, BSE Consumer Durables Index and BSE HealthcareIndex have been taken for the study. In these 54 companies, there are 10 companies from the

FMCG sector, 17 companies from the Healthcare sector and 9 companies each from the IT

sector, Automobile sector and Consumer Durable sector. To represent each industry, the

companies have been selected on the basis of following criteria:


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a) Necessary financial data required for calculating the measures of dependent and independent

variables are available in prowess database of Centre for Monitoring Indian Economy (CMIE)

for the period of study (2003-11).

b) The capital structure of the company have undergone change during the period of study.

The financial data has been collected for all the selected companies over a period from 2003 to

2011 from prowess database of Centre for Monitoring Indian Economy (CMIE).

3.6 Limitations of the Project

The scope of the study is limited to only 5 industrial sectors, viz. Automobile, Information

Technology, FMCG, Consumer Durables and Pharmaceuticals. Only public listed companies can

be 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 etc. but only the following prominent ones, given by Frank and Goyal17

(2003) are

considered :

Size

Profitability

Growth Opportunities

Tangibility

Maturity

Non debt tax shields

Business Risk

So the impact of the other determinants like ownership structure etc. has been not be included in

the study.

17Frank, M.Z. and V.K. Goyal, (2003) Testing the pecking order theory of capital structure, Journal of Financial

Economics, 67, 217-248.

3.research methodology

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