THE DEBT-EQUITY CHOICE- AN

EMPIRICAL ANALYSIS OF INDIAN

COMPANIES

Presented By – Group 5

Introduction Debt-equity choice is one of the most important decisions in

financing policy. Static theory: It implies that firms have target debt ratio and

that firms try to move towards the target ratio. Pecking Theory: It argues that firms adopts a hierarchical order

of financing preference: internal financing preferred over external financing.

The important question facing companies in need of new finances is whether to raise debts or equity capital.

The majority of the studies in this area discuss the effects of leverage on the value and profitability of the firm.

Does use of debt create a value? Standard capital structure of firm includes retained earnings,

debts and equity.

Capital Structure has a great impact in understanding the behavior of firms with respect to their choice among the use of debt or equity. Which actually explain the mix of securities and financing sources used by corporation to finance real investment and focused on the proportions of debt vs. equity observed on the liabilities side of corporations’ Balance Sheet.Tread off Theory: States that firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. It also predicts moderate borrowing by tax-paying firms.Pecking order Theory: States firm’s tendency is to borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. Thus the amount of debt will reflect the firm’s cumulative need for external fundsFree cash floe Theory: States that dangerously high debt levels will increase value, despite the threat of financial distress, when operating cash flow significantly exceeds its profitable investment opportunities.

Literature Review

Study by Booth et al.: debt ratios in developing countries seem to be affected in the same way and by the same types of variable that are significant in developed countries.Study by K.Lakshmi(2008): The higher the institutional investors’ shareholding the lower was the level of debt for the sample firms.Study by D.Dutta & B.Agarwal(2009): Redeeming signal about the Indian corporate behavior which found out to show more dependence on their internally generated funds than on external sources of finance.Study by G.Shanmugasundaram(2008): States that Indian companies are shifting from high debt to high equity over the period clearly indicating consistency with the static “Trade off Theory”.

Literature Review

Objective of the study

The present study analyzes the financing pattern of 300 Indian private sector companies comprising of 20 different sectors for the period 1999-2000 to 2007-2008, duly grouping them under the basis of their region, size, age and nature.

Research Methodology Primary data : Data has been collected rom sampled companies.

Secondary data: moneycontrol.com, periodicals, Govt. Reports, RBI Bulletins and various books.

Sample size: 300 companies from a heterogeneous set of 20 different sectors.

For our study purpose data has been taken from top 15 companies of each sector.

Applied Methods: Cash Flow Analysis, Ratio analysis and correlation analysis

Objective of the study & Research Methodology

DATA ANALYSIS

15%

32%

54%

Classification of companies according to age

Very Old OldNew

Year of Incorporatio

nAge

GroupNo. of

companies

% to Total

Sample

Prior to 1947 Very Old 44 14.671947-1980 Old 95 31.67After 1980 New 161 53.66

Total   300 100

11%

45%28%

15%

Classification of companies according to region

EasternWesternSouthernNorthern

Region/Group

Eastern

Western

Southern

Northern Total

No. of Compa

nies34 135 85 46 300

% of Total

Sample11.33 45 28.33 15.34 100

DATA ANALYSIS

25%

33%

42%

Classification of companies according to size

SMALL Below Rs. 100 CroreMEDIUM Rs.100 Crores to Rs.500 CroreLARGE Above Rs. 500 Crore

Size of the Company

Total Assets as on 31st

March 2008( Rs. In

Crores )

No. of companies

% to Total sample

SMALL Below Rs. 100 Crore 75 25

MEDIUMRs.100 Crores

to Rs.500 Crore

98 32.67

LARGE Above Rs. 500 Crore 127 42.33

TOTAL   300 100

Classification of companies according to sector/ Indus-

tryAgro Based Manufac-turing Industries Tex-tiles Manmade, Food Processing, Edible Oil, Cotton Textiles, Paper, Sugar,

Mineral Based Manufac-turing Industries Chem-icals, Cement, Fertilizer, Construction & Hous-ing, Electric Equip-ment, Pharmaceuticals, Plastic,

Service Industries Computer Software, Hotel, Transport

Plantation Industries Rubber, Tea & coffee,

Industrial Group

Name of the Industry/Sector

No. of Companies

Percentage to Total Sample

Agro Based Manufacturing Industries

Textiles Manmade, Food Processing, Edible Oil, Cotton Textiles, Paper,

Sugar,90 30

Mineral Based Manufacturing Industries

Chemicals, Cement, Fertilizer, Construction &

Housing, Electric Equipment,

Pharmaceuticals, Plastic,

135 45

Service Industries

Computer Software, Hotel, Transport 45 15

Plantation Industries Rubber, Tea & coffee, 30 10

Total   300 100

Findings & Observation The average debt-equity ratio of sample companies during the study

period was 1.12 which is slightly higher than generally accepted norms of 1:1.

An average of 60.54% total funds are raised from internal sources where as external sources contribute only 39.46%.

Issue of share capital had never been a source of long term finance for corporate sector.

The correlation between investment in tangible fixed assets and debt equity ratio shows that the sample companies utilizes a major portion of debt finance in Tangible fixed assets.

The average debt-equity ratio is 1.24 and the southern region is 0.97.

Increment in the size of the investment is mostly financed by debt incase of northern region companies and through equities incase of other region companies.

Conclusion Barring to a few exceptions like small and medium sized

companies in size group and agro based companies and plantation companies in industrial groups it was found that companies prefer mostly internal funds as compared to external funds.

Small sized companies are relies more on debt capital as compare to large size companies.

The average debt-equity ratio of small size companies were found to be more than 3:1 where as incase of large sized companies it is 1 : 1.

The average debt-equity ratio of manufacturing companies were more than double of the average debt-equity ratio of service sector companies.

A result of debt dominated capital structure the Indian corporates are exposed to a vey high degree of total risk.

Thank You