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Capital Structure Decisions

  • P. K. Jain
  • Shveta Singh
  • Surendra Singh Yadav
Chapter
Part of the India Studies in Business and Economics book series (ISBE)

Abstract

Capital structure practices/decisions assume vital significance in corporate financial management as they influence both return and risk of equity owners of corporate enterprises. Whereas excessive use of debt may endanger their very survival, a conservative policy deprives them of its advantages to magnify the equity rates of return. The objective of this chapter is to have an in-depth examination of the capital structure/financing decision practices pursued by the sample companies.

As far as designing of capital structure is concerned, the study brings to fore that debt (which was the most important constituent of corporate financing during pre-economic liberalisation period) is steadily being replaced by equity by the majority of the sample companies in India. This is an aspect that is corroborated as well, from the steadily declining debt–equity ratios over the past two decades brought forth by the earlier studies.

The sample companies (having profitable operations) in view of large internal cash accruals at their disposal to meet their investment requirements are using less amount of debt as external financing requirement not because they have low target debt ratios but because of preference for internally generated funds. This flouts sound tenets of finance theory. Such firms, due to favourable financial leverage, could have magnified their RoR (rate of return) for their equity owners by employing higher debt. In other words, it is reasonable to conclude that the tax shield on interest is now being treated as a secondary consideration in designing capital structure.

Another notable finding of the study is that there seems to be a significant portion of short-term debt in the total debt. Reliance on short-term debt to such a marked extent in preference to long-term debt is again not in conformity with sound tenets of finance theory as it causes grave risk, at least, in terms of its non-renewal and interest rate fluctuations. Therefore, there is need for substitution of short-term debt with long-term sources, in particular, when the requirements are permanent in nature.

It is also pertinent to emphasise here that the development/public financial institutions (DFIs/PFIs) constituted the backbone of the Indian financial system until 2000; however, their relative significance in the emerging financial scenario had been declining, indicating a shift in corporate financing in India, in terms of greater reliance of industry on non-institutional sources of finance and greater recourse to the capital market.

Yet another notable finding of the study is that the sample companies seem to be comfortable with the servicing of debt in terms of both payment of interest and repayment of principal. It is pertinent to note here that this level of comfort could also be brought about by the steadily declining proportion of debt in the capital structure of such companies (over the past two decades). Further, companies are even able to meet their total external obligations comfortably indicating sound earning capacity. Given the fact that the companies raise funds (externally) to meet their financial needs, they are, perforce, to have sound fundamentals in terms of reasonable/low risk and so on. It is satisfying to note, then, that they have low operating and financial risk (as per operating and financial leverage).

A matter of concern is the finding of a low component of secured loans to total borrowings. These large sample companies with substantial assets base should be able to raise finance from secured loans as it will relatively (probably) be the cheaper source of finance compared to other borrowings. Hence, there is untapped opportunity of lowering cost of capital by having relatively lower cost of debt.

Another important finding is that the sample companies show non-adherence to the pecking order hypothesis (in its entirety). This could perhaps be due to the robust capital markets in the country making it easier for the companies to raise equity. This further strengthens our contention that equity for aspects like signalling theory and reduction in agency costs is finding favour with the sample companies over the traditional model of debt being utilised first and equity finance only being raised as the last resort (under the pecking order hypothesis).

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Copyright information

© Springer India 2013

Authors and Affiliations

  • P. K. Jain
    • 1
  • Shveta Singh
    • 1
  • Surendra Singh Yadav
    • 1
  1. 1.Department of Management StudiesIndian Institute of TechnologyNew DelhiIndia

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