Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
Determinants of Corporate Capital Structure: Evidence from
Indian Industries
Arka Kumar Das Mohapatra
Designing an optimal capital structure depends on a host of micro and macro economic factors. Size
of the firm, its profitability, operating leverage, external financing, corporate vulnerability and
industry class have received prominence among these factors. Studies by various researchers
in the past have produced evidences in support and against a particular factor or factors as
clear determinant(s) of corporate capital structure. Scott (1972) and Scott and Martin (1976)
have reported that industry class has a bearing on the firm’s capital structure. Scott and Martin
(1976) are also hold the opinion that size of the firm may influence the firm’s decision on a
particular debt-equity mix. Remmers et al.(1974) on the other hand have presented evidence
that neither ‘size’ nor ‘industry class’ is a clear determinant of the firm’s capital structure. The
present study, conducted on 626 selected non government and non financial companies across
industries in India reveals that ‘size’, ‘class’, corporate vulnerability’, ‘external financing’ and
‘operating leverage’ have significant bearing on the capital structure of Indian firms. The study
however could not account for ‘profitability’ as a clear determinant of corporate capital structure
in India.
Field of Research: Finance
Key Words: External financing, financial leverage, income gearing, operating leverage,
profitability, size of the business.
1. Introduction
Financing decision of the firms has always been a complex proposition. It calls for having
the right blend of sources of finance along with a decision on the amount to be included
from each such source. The decision becomes more complex when the firm has to have a
combination of debt and equity in the total financing keeping the firm’s overall objective of
‘value maximization’ undiluted. The particular combination of debt and equity maintained
by the firm at a given point of time has significant implications for the stakeholders on the
grounds of solvency and profitability. Debt, because of its fixed commitment as to income
and repayment of principal is normally thought of as contributing at the same time to the
opportunity for profit and possibility of loss (Donaldson, 1961).
Although firms tend to take the income advantage of debt, it is certainly not by
compromising on the optimality of the capital structure because a poor financial planning
restricts the firm’s long term success on account of high cost of debt, inadequate liquidity,
and inability to raise funds in the market place.
______________________________________________________________________________
Professor, Head and Dean, Department of Business Administration, Sambalpur University, Sambalpur 768
019, Odisha, India, Tel. +9437158107, Fax +663-2430158, *Corresponding Author E-mail:
akdm.2002@gmail.com
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
Over and above, the need for finance also varies across firms and industries depending
upon the varied length and technical character of their production processes, the rate of
technological advancements, degree of vertical integration, product features, income
elasticity of demand, trade customs, time shape of operations and sales, and customs as
to the type of sources used (Singh,1968). The variations in the nature of industries not only
cause differences in the requirement of gross fixed assets but also in the use of various
sources of long term finance among the industries(Kumar and Jain,1989).
Given the above, and given further that firms need to maximize their values; designing of
an optimal capital structure is the key. Designing an optimal capital structure however is
influenced by a number of macro and micro economic factors. Researchers in the past
have tried to determine the factors that may be considered as determinants of firm’s
capital structure so that firms may give adequate attention to optimize these factors. Some
of these researchers have presented affirmative evidences in respect of a particular factor
or a group of factors as the determinants of corporate capital structure; others have
presented dissenting evidences in respect of the same factor or group of factors as clear
determinant(s) of the capital structure. Scott (1972) and Scott and Martin (1976) have
empirically established that industrial class has got influence on the firm’s capital structure.
They also hold the opinion that size might shape the firm’s debt-equity mix. On the other
hand, Stonehill, Wright and Beekhuisen(1974) have presented a contrary evidence
arguing that none of these factors - size or industry class - is a clear determinant of the
firm’s capital structure. A study conducted by Mohapatra(2012) has revealed that industry
class and size have significant bearing on the capital structure of Indian firms. Another
study by Mohapatra(2012) on Indian firms has also revealed that corporate vulnerability,
external financing and size have influence on the firms’ designing of capital structure.
Against the above backdrop, the present paper has attempted to determine the nature and
extent to which ‘size’, ‘class’, corporate vulnerability’, ‘external financing’, ‘ope rating
leverage’ and ‘profitability’ influence the firms’ designing of capital structure in India.
2 DATA AND VARIABLES
In order to achieve the above mentioned objectives, i.e., to determine if size, class,
corporate vulnerability, external financing, operating leverage, and profitability, have
influence on the firms’ capital structure, financial data of 626 non-government and nonfinancial companies with paid up capital of Rs one core( or10 million USD) and above,
published by the Reserve Bank of India in its monthly bulletins of various issues over a
period of 23 years from 1987-88 to 2009-10 have been collected, compiled and analyzed
against four identified variables, namely, financial leverage (coded as FL), operating
leverage (OL), profitability (Profit), and industry class(IC), by dividing the time horizon into
two parts of 10 years from 1987-88 to 1996-1997 and 13 years from 1997-98 to 2009-10.
Further, the variable ‘financial leverage’ has been taken as the ratio between total debt to
total assets at book value in line with the one taken by Remmers et. al.(1975). Similarly,
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
‘profitability’ has been taken as the ‘pre-tax return on net assets’ and ‘operating leverage’
has been taken as the ‘the ratio between ‘percentage change in average earnings before
interest and taxes to the percentage change in average sales’.
3
METHODOLOGY
The 626 companies as mentioned above covered in the study have been divided into five
groups, called the ‘industry class(IC)’ as follows:
Group –I (coded as IC1) that includes ‘Processing and Manufacturing Companies’
engaged in the production of Foodstuffs, Textiles, Tobacco, Leather and Leather products
thereof.
Group –II (coded as IC2) that includes ‘Processing and Manufacturing Companies’
engaged in the production of Metals, Chemicals and products thereof.
Group –III (coded as IC3) that ‘Processing and Manufacturing Companies’-Not classified
under Group-I and II above, and that includes companies like Cement, Paper and paper
products, Rubber and rubber products, Mineral Oils, China earth ware and structural clay
products.
Group-IV (coded as IC4) that includes ‘Other industries’, i.e., industries not included under
Group-I, II, and III above, and includes companies like Construction, Shipping, Electricity,
Hotels and Restaurants, Land and real estate.
The important techniques used for the analysis of the data are correlation, analysis of
variance (ANOVA), F-test and t-test.
1. ANALYSIS AND FINDINGS
Discussion on the possible association between a firm’s financial structure and its
profitability, operating leverage, income gearing, external financing, industry class and a
host of similar factors has gained considerable importance after the pioneering work ‘Cost
of Capital and Optimal Capital Structure’ by Modigliani and Miller (1958). Studies
conducted by Scott (1972), and Scott and Martin (1976) have indicated that firm’s
financial structure gets influenced by industry class. Study by Remmers et. al.(1975)
could not however establish existence of any significant association between capital
structure and industry class and size.
Keeping this in view, six distinct hypotheses, as listed below were formulated for
investigation if they could be taken as the determinants of corporate capital structure in
India:
H01: Financial leverage is independent of industry size
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
H02: Financial leverage is independent of industry class
H03: Financial leverage is independent of corporate vulnerability
H04: Financial leverage is independent of external financing
H05: Financial leverage is independent of operating leverage
H06: Financial leverage is independent of profitability.
Details of the analysis and observations have been enlisted below:
(i)
Financial leverage and industry size
The first hypothesis relates to the possible association between size and financial
leverage. Large firms are generally more diversified. They enjoy easier access to capital
markets and receive higher credit ratings. Their effective cost of capital is low as they pay
lower rates of interest on borrowed capital. Moreover, as the level of activity increases with
size, more debt is expected in the financial structure of large corporations. Hence, size of
the firm should be positively related to its financial structure (Mohapatra, 2012). The same
logic should also hold good for inter-industry variations. In order to test the validity of the
null hypothesis that financial leverage and industry class are independent, correlation
coefficients between financial leverage and industry size has been calculated for all the
four groups of industries-IC1, IC2, IC3, and IC4 for the period 1987-88 to 1996-1997 and
from 1997-98 to 2009-10. To test the significance of the correlation coefficients, t-values
have also been computed. Table 1.1 exhibits details of the empirical results found in
respect of the hypothesis concerning financial leverage and industry size.
Table 1.1: Correlation Coefficients(r-values), t-values and level of significance of size and
financial leverage
Industry
Class
Period
Correlation
between
r-value
t-value
Table value of ‘t’ at
IC1
Period 1
FL and size
0.325
1.085
1%
3.169
5%
2.228
5.547
1.736
12.392
3.271
0.420
2.845
7.251
3.250
3.169
3.250
3.169
3.250
3.169
3.250
2.262
2.228
2.262
2.228
2.262
2.228
2.262
Period 2
FL and size 0.880
Period 1
FL and size 0.481
Period 2
FL and size 0.972
IC3
Period 1
FL and size 0.719
Period 2
FL and size 0.628
IC4
Period 1
FL and size 0.669
Period 2
FL and size 0.924
Note: FL = Financial leverage, Size= Size of the firm
IC2
It is apparent from Table 1.1 that not only there exists positive correlations between
industry size and financial leverages but also the relations are statistically significant at 5
percent level in period 2 in case of all the industry groups, i.e., IC1, IC2, IC3, and IC4 and at
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
1 percent level in case of IC1, IC2, IC3, and IC4. As far as period 1 is concerned, the
relation is found to be significant at 5 percent level only in case of IC 3 and G4 and at 1
percent level in case of IC3. The null hypothesis that financial leverage is independent of
industry size is therefore rejected. It may therefore be concluded that size has a positive
bearing on the corporate capital structure in Indian industries.
(ii) Financial leverage and industry class
The second hypothesis relates to the possible association between industry class and
capital structure. Firms in the same industry should experience similar amount of business
risk, because they produce similar products, incur similar costs, rely on similar technology
and operate under similar set of rules, regulations, guidelines and environment. Business
risk, defined as uncertainty of future earnings, should substantially determine the amount
of debt the capital market should provide to the firm. Since business risk has got
relationship with the types of product, and the products with types of industry, there is a
reason to believe that a firm’s financial structure is influenced by its industry class. As
industries deal with different products, operate in different environment, use different
technology and have different cost structure, their business risks would be essentially be
different and so also their capital structure.
Thus, to test if financial leverage is independent of industry class that an analysis of
variance (ANOVA) has been conducted on the financial leverage of the four classes of
industry- IC1, IC2, IC3, and IC4 for the study period, the result of which has been displayed
in Table 1.3.
Thus, to test if financial leverage is independent of industry class that an analysis of
variance (ANOVA) has been conducted on the financial leverage of the four classes of
industry- IC1, IC2, IC3, and IC4 for the study period, the result of which has been displayed
in Table 1.2.
Table 1.2 clearly shows that the F-Ratio, i.e., 52.76 is much higher than the table value of
F (i.e., 2.70) at 1 percent level of significance. When compared with the probability F is
even significant at less than 1 percent. This indicates that the means of the financial
leverages of IC1, IC2, IC3, and IC4 differ significantly. Hence, the null hypothesis that
financial leverage is independent of industry class is rejected leading to the inference that
industry class has a bearing on the capital structure.
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
Table 1.2: Analysis of Variance (ANOVA) for financial leverages of IC1, IC2, IC3, and
IC4
Industry class
IC1
IC2
IC3
IC4
Grand Mean
Source Sum
of
of
variatio square
n
s
Betwee 0.246
n
0.136
Within
0.382
Total
(iii)
Mean
0.298
0.271
0.269
0.396
0.308
Degree
of
freedo
m
3
88
91
No. of items
23
23
23
23
92
FProbability
Ratio
Mean
square
0.082
1.5502E03
52.761
4.00
0E-14
F-value
(at 1%)
2.70
(approximately)
Financial leverage and corporate vulnerability
Income gearing is considered to be a measure of corporate vulnerability to fluctuations in
general economic conditions (Scott, et.al, 1976). Since firms operate under different
economic conditions, and economic conditions have bearings on capital and debt markets,
there is likelihood that the firm’s capital structure is influenced by its income gearing.
However, assuming that there is no relationship between firm’s capital structure and
corporate vulnerability, Table 1.3 has been constructed by calculating the correlation
coefficients and t-value.
Table 1.3: Correlation Coefficients(r-values), t-values and level of significance of
corporate vulnerability and financial leverage
Industry Period
Class
IC1
IC2
IC3
IC4
Period 1
Period 2
Period 1
Period 2
Period 1
Period 2
Period 1
Period 2
Correlation r-value
between
t-value
Table value of ‘t’ at
FL and IG
FL and IG
FL and IG
FL and IG
FL and IG
FL and IG
FL and IG
FL and IG
16.210
1.143
0.748
1.590
2.327
0.168
1.685
1.400
1%
3.169
3.250
3.169
3.250
3.169
3.250
3.169
3.250
0.662
0.376
0.230
0.469
0.736
0.054
0.470
0.423
5%
2.228
2.262
2.228
2.262
2.228
2.262
2.228
2.262
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
Note: FL = Financial leverage, IG= Income Gearing or Corporate vulnerability
It can be seen from Table 1.3 that that there exists a statistically significant positive
correlation between income gearing and corporate financial structure. The table further
shows that the correlation between income gearing and financial leverage of IC 1 in period
1 has been positive and also significant at 1 percent and 5 percent levels. In case of IC 3,
the relation has also been positive and significant at 5 percent level in period 1. In case of
IC2 and IC4, the relations though positive are found to be statistically insignificant. In period
2 the relations could not be found to be significant though both positive and negative
correlations apparently exist. Thus, while rejecting the null hypothesis that there is no
association between income gearing and financial leverage, we may conclude that income
gearing and financial leverage are positively correlated.
(iv) Financial leverage and external financing
So far as the packing order theory is concerned, firms prefer internal to external financing,
and they will prefer the safest security first, i.e., they will choose debt before equity
financing, in case they seek external financing to finance real investments with a positive
net present value. This implies that when external financing will increase, the proportion of
debt in the total financing will also increase. Hence there should exist, a positive relation
between external financing and firm’s financial leverage. This logic should also be valid for
inter-industry comparisons. Keeping this in view and assuming that financial leverage is
independent of external financing, that Table 1.4 has been constructed.
Table 1.4: Correlation Coefficients(r-values), t-values and level of significance of
external financing and financial leverage
Industry Period
Class
Correlation r-value
between
t-value
Period 1
FL and EF 0.877
5.771
Period 2
FL and EF 0.497
1.717
IC2
Period 1
FL and EF 0.963
11.300
Period 2
FL and EF 0.678
2.727
IC3
Period 1
FL and EF 0.915
7.159
Period 2
FL and EF 0.171
0.521
IC4
Period 1
FL and EF 0.688
2.998
Period 2
FL and EF 0.388
1.263
Note: FL = Financial leverage, EF= External financing
IC1
Table value of ‘t’ at
1%
3.169
3.250
3.169
3.250
3.169
3.250
3.169
3.250
5%
2.228
2.262
2.228
2.262
2.228
2.262
2.228
2.262
Empirical evidence shows that there exists a strong and statistically significant positive
relation between financial leverage and external financing. Table 1.4 which contains the
correlation coefficients and their corresponding t-values, in fact shows that the correlations
between financial leverages and external financing of IC1, IC2, IC3, and IC4 are significant
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
at 5 percent level in period 1. The table further shows that the relation is significant at 1
percent level in period 1 for IC1, IC2 and IC3. As far as period 2 is concerned, the
relationship is found to be significant at 5 percent level only in case of IC 2. The declining
percentage of external funds in the total financing of the sample companies may be
attributed to this insignificant correlations between external financing and financial
leverages in period 2. Thus, the null hypothesis that financial leverage and external
financing are independent of each other is rejected and we conclude that there exists a
positive relationship between financial leverage and external financing.
(v) Financial leverage and operating leverage
The second hypothesis relates to the possible influence of operating leverage on capital
structure. ‘Operating leverage may be defined as the firm’s ability to use fixed operating
costs to magnify the effects of changes in sales on earnings before interest and taxes’
[12]. Operating leverage occurs any time a firm has fixed costs that must be met
regardless of volume. Ferri and Jones(1979) have put operating leverage as ‘the use of
fixed costs in the firm’s production scheme but is generally associated with the
employment of fixed assets’. According to them, the use of fixed assets can magnify the
variability of the firm’s future income and hence, ‘operating leverage should be negatively
related to the firm’s financial structure’. To determine the validity of this hypothesis, Table
1.5 has been constructed by calculating correlation coefficients between financial leverage
and operating leverage for all the four groups of industries, namely, IC 1, IC2, IC3, and IC4
for the period 1987-88 to 1996-1997 and 1997-98 to 2009-10 along with their t-values to
test the significance and validity of the findings.
Table 1.5: Correlation Coefficients(r-values), t-values and level of significance of
financial leverage and operating leverage
Industry Period
Correlation r-value
t-value
Table value of ‘t’ at
Class
between
1%
5%
Period 1
FL and OL 0.325
1.085
Period 2
FL and OL 0.036
0.108
IC2
Period 1
FL and OL 0.079
0.251
Period 2
FL and OL 0.341
1.088
IC3
Period 1
FL and OL 1.153
0.488
Period 2
FL and OL 0.113
0.342
IC4
Period 1
FL and OL 0.610
2.432
Period 2
FL and OL 0.345
1.108
Note: FL = Financial leverage, OL = Operating leverage
IC1
3.169
3.250
3.169
3.250
3.169
3.250
3.169
3.250
2.228
2.262
2.228
2.262
2.228
2.262
2.228
2.262
The test reveals that there exists negative correlation between financial leverage and
operating leverage, although, the relations could not be found statistically significant
except for IC4 in period 1. In case of IC1 and IC2, a very low degree of positive correlation
exists between financial leverage and operating leverage which may be ignored because
of their low intensities. The null hypothesis of no association between financial leverage
and operating leverage is thus rejected on the basis that there exist negative correlations
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
between them.
(v) Financial leverage and profitability
The firm’s ability to generate internal surplus for business expansion depends more on its
earning capacity. Higher the profitability of the firm, better the firm is in generating internal
funds by way of reserves and surpluses. As reserves and surpluses of the firm grow, the
firm’s dependence on external financing declines; so also its dependence on debt capital.
This is because firms going for external sources of funds will certainly prefer low-cost
source and debt will be the first choice.
Hence, a negative relationship is expected between the firm’s financial leverage and its
profitability. This phenomenon should also be true for industry level comparison, for
profitability differs from industry to industry.
In order to test the null hypothesis that financial leverage is independent of profitability,
correlation coefficient between financial leverage and profitability has been calculated for
all the four groups of industries- IC1, IC2, IC3, and IC4 for the period 1987-88 to 1996-1997
and 1997-98 to 2009-10 along with their t-values to test the significance of the findings as
shown in Table 1.6
Table 1.6: Correlation Coefficients(r-values), t-values and level of significance of financial
leverage and profitability
Industry
Class
Period
Correlation
between
r-value
t-value
Table value of t at
1%
5%
IC1
Period 1
FL and Profit
-0.426
1.476
3.169
2.228
Period 2
FL and Profit
0.366
1.180
3.250
2.262
Period 1
FL and Profit
-0.607
2.413
3.169
2.228
Period 2
FL and Profit
-0.192
0.587
3.250
2.262
Period 1
FL and Profit
-0.432
1.516
Period 2
FL and Profit
0.294
0.923
3.250
2.262
Period 1
FL and Profit
-0.320
1.068
3.169
2.228
Period 2
FL and Profit
0.613
2.325
3.250
2.262
IC2
IC3
IC4
3.169
2.228
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
Note: FL = Financial leverage, Profit = Profitability
Empirical evidence as in Table 1.6 shows that there exists a negative correlation between
financial leverage and profitability in all the industry groups in period one and in case of IC 2
in period 2. For all other groups in period 2 the relationship is found to be positive though
insignificant. Further, the correlation between financial leverage and profitability for IC 2 in
period 1 is found to be significantly negative at 5% level of confidence, whereas the said
relationship is found to be significantly positive for IC4 in period 2 at 5 % level of
confidence. Another feature worth noting is that, the same industry while showing a
negative correlation in period 1 shows a positive correlation in period 2 despite the fact
that its profitability has either remained the same or has gone up. This implies that
profitability does not alone determine the financial structure of a firm. A firm, despite of
being profitable, may even borrow money to meet its additional funds requirement.
Thus, the null hypothesis that profitability and financial leverage are independent of each
other could not be fully rejected in the sense that there exist both positive as well as
negative correlations between financial leverage and profitability in the same industry in
different periods and in different industries in the same period.
5 Conclusion
The current study was undertaken with the objectives of finding out the nature and extent
to which ‘size’ of the firm, industry ‘class’, corporate vulnerability’, ‘external financing’,
Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
‘operating leverage’ and ‘profitability’ influence the firms’ capital structure in India. The
study conducted on the Reserve Bank of India published data on 626 non government and
non financial companies reveals that capital structure of Indian industries gets significantly
influenced by their ‘size’, ‘class’, corporate vulnerability’, ‘external financing’ and
‘operating leverage’ but not by ‘profitability’. This implies that profitability does not alone
determine the financial structure of the firm and instead, firms, despite of being profitable,
may even borrow money to meet their additional funds requirements.
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Proceedings of 9th Annual London Business Research Conference
4 - 5 August 2014, Imperial College, London, UK, ISBN: 978-1-922069-56-6
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