Submitted to Prof. Kousik Guhathakurta
Bharat Subramony PGP/16/012
Ranjan Kumar Sharma PGP/16/040
Utkarsh Rastogi PGP/16/056
A-1. There appears to be a significant trend in the Capital Structure of Indian Inc. as reported by the Reserve Bank of India, which can be seen from the table below. By aggregating the data from the RBI reports provided from 2001 to 2010, we can extrapolate and determine its asymptotic value of the Debt-Equity ratio, which signifies the Capital structure to an approximate value of 40.
Industry | 2001-02 | 2002-03 | 2003-04 | 2004-05 | 2005-06 | 2006-07 | 2007-08 | 2008-09 | 2009-10 | Target |
Debt-Equity ratio in % | 67.3 | 61.1 | 55.5 ...view middle of the document...
Profitability Increasing reinvestment of retained earnings
It can be clearly seen that the companies included in the sample for report, have opted to reinvest more and more part of their retained earnings into the firm’s capital, instead of dividend payout or kind. This is in complete affirmation to the Pecking Order theory, which states that, profitable firms will preferably choose to opt for internal sources of finance, before going for debt-financing, and that equity financing must be kept out as the last option. Although, according to agency cost theory, profitable firms will find it easy to obtain leverage.
ii. Less dependency on equity-financing, increasing use of debt financing
By careful screening of the data obtained for amount of capital raised through equity financing for all the companies included in Indian Inc., it can be seen that, the capital raised through equity has grown at an average of 17.57% (neglecting the effect of increasing number of companies involved in sampling), while debt financing has grown by 21.55%. Growth opportunities can produce moral hazard effects and push firms to take more risk. In order to mitigate this problem, assets in growth opportunities should be financed with equity instead of debt due to minimizing the loss/risk per stockholder, but this opposes the Pecking-Order.
iii. Easy availability of cheap debt capital
It has been observed that the prime-lending rate, in case of borrowing from banks, has reduced considerably from 12% in 2000s to about 9% in 2010. The availability of cheap bank debt is also one of the reasons for the changing capital structure.
Firms with high liquidity will borrow less. A firm with more current assets is expected to generate more internal inflows, which can be used to finance its operating and investments activities. Thus a negative relationship between liquidity and leverage is expected. Friend and Lang (1988) Deesomsak, et al. (2004), Sbeiti (2010), and Icke and Ivgen (2011), found liquidity are negatively and significantly related to leverage.
v. Earnings Volatility Long-term investment planning
Earnings Volatility is a measure of business risk. According to Frank and Goyal (2003), the companies with more volatile cash flows face higher expected costs of financial distress and should use less debt in the objective of maintaining a moderate total risk profile. This suggests a negative relation between earnings volatility and leverage. However, risky firms are more likely to suffer from information asymmetries that make it difficult for firms to issue equity at higher price, and they are expected to have higher levels of leverage. There is an increasing dependency on debt-financing as compared to equity-financing, which signifies that, the companies, are strategically planning to maintain some financial slack at the same time invest the debt funds, to invest in technology for long-term growth, which also affirms the fact that...