Capital Structure and Performance: Evidence from a Transition Economy on an Aspect of

Corporate Governance
Author(s): Sumit K. Majumdar and Pradeep Chhibber
Source: Public Choice, Vol. 98, No. 3/4 (Jan., 1999), pp. 287-305
Published by: Springer
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Public Choice 98: 287-305, 1999.

@ 1999 KluwerAcademicPublishers. Printed in the Netherlands.

287

Capitalstructureand performance:Evidencefrom a transition

economyon an aspectof corporategovernance
SUMIT K. MAJUMDAR1and PRADEEPCHHIBBER2
'The ManagementSchool, ImperialCollege of Science, Technologyand Medicine,London
MI.
SW72PG, U.K.;2Departmentof Political Science, Universityof Michigan,Ann
Arbor,
48109, U.S.A.
Accepted 21 January1997
Abstract. This paperexamines the relationshipbetween the levels of debt in the capital structure and performancefor a sample of Indianfirms.Existing theory posits a positive relationship; however,analysis of the data reveals the relationshipfor Indianfirms to be significantly negative. The structureof capital marketsin India, where both short-termand long-term
lending institutionsare government-owned,is hypothesizedto accountfor the finding of this
relationship,and it assertedthat corporategovernancemechanismswhich work in the West
will not work in the Indiancontext unless the supply of loan capitalis privatized.

1. Introduction
A core issue in the corporategovernanceliteratureis the natureof the relationship between the level of debt in firms' capital structureand economic
performance(Williamson, 1988). Thoughthe Modigliani and Miller (1958)
theorem suggested that the level of debt or equity was inconsequentialfrom
an economic view-point, a numberof qualificationssuggest thatthe level of
debt might have a non-neutralimpact on firms' behavior and performance
(Jensenand Meckling, 1976; Myers and Majluf, 1984; Stiglitz, 1988).
This paperreportsthe resultsof a studyexaminingthe relationshipbetween
the levels of debtin firms'capitalstructuresandtheirperformance,for a large
sample of Indianfirms.From the point of view of enhancingawarenessand
understandingof corporategovernanceissues, a relevantquestion is: do the
canons of the contemporarygovernanceliteraturealso hold in the context of
a transitioneconomy? The ideas in the governanceliteraturehave evolved
againsta backdropof contemporarycapitalistinstitutions,andtheirdevelopment has been heavily influencedby the natureof the political and economic
environmentfirms face in the West. While there is now a large literature
evaluatingthe behaviorand performanceimplicationsof debt in a Western
context (Barton and Gordon, 1988; Bettis, 1983; Bradley,Jarrel,and Kim,
1980; Hoskisson and Hitt, 1994; Titman and Wessels, 1988), very little is
empirically known about such issues in transitioneconomies. Therefore,a

288
point at issue is: are Westerncorporategovernanceideas valid in transition
or developingeconomy contexts,or do they need to be re-assessedin light of
what datamight reveal aboutthese differenteconomies?
The Indianeconomy is in the throes of a majoreconomic transitionsince
1991, and Indiais in the news as a location of contemporaryeconomic consequence;yet, extremely little factual evidence about the behaviorand performanceof Indian firms exists in the literature.This paper attemptsto fill
the gap that exists between interestand evidence, exploring a narrowgovernance issue to do so, andthe paperunfoldsas follows. In Section 2 theoretical
issues are discussed, and the empiricaldetails of the study are describedin
Section 3. Section 4 briefly reportsthe results obtainedwhich are discussed
in detail in Section 5, while Section 6 concludes the paper.

2. Theoreticalissues
2.1. TheModigliani-Milleridea
The Modigliani-Miller(MM) idea deals with the issue of value differences
between leveraged and unleveragedfirms. Leverage is a measure of firms'
indebtednessrelativeto the size of its asset base. It is a mechanismby which
a companycan magnify the results of the activities undertakenon behalf of
its owners. By adding lenders' funds to its owners' funds, a company can
increase the scope of its operationsand still retainthe residualclaim to the
profitsthatremainafterpaymentof intereston the borrowings.As Auerbach
(1987) states, financingfirms' operationswith more borrowedfunds has the
effect of increasingthe risk and returnper unit of equity; therefore,an issue
is does the total value of the debt plus equity fluctuateas the leverageprocess
occurs? If an investmentof A were to be financed fully by equity, then its
returnof rA might have a value of Vo. The same investment, if financed
partiallyby debt D carryinginteresti, would yield its owners a returnof rA
- Di, with a value V1. V1 i Vo since the total returnto equity is reducedby
the interestpayments,but the point at issue is does the value of equity fall
(Auerbach,1987)?
The MM theoremasks: can the firm change its overall value by changing
the division of its underlyingreturns?If the returnsand investors' abilities
to enjoy them remainunaffectedby the way the firm divides them between
equity earningsand interestpayments,then the value of the firm's equity is
derivedas the residualof the value of its equity as if it had no debt less the
value of the debt it has incurred.The key MM ideas are that:the total market
value of a firm is independentof its capital structure;the cost of equity is a
linear function of the leverage ratio; the marketvalue of a firm is indepen-

289
dent of its dividendpolicy; andthe shareholdersof a firmare indifferentto its
financialpolicy. These ideas are corollariesof the suppositionthat if shareholders can undertakethe same financialtransactionsas the firm, and at the
same prices, they can reverse the effect of any corporatefinancialpolicy at
no cost, with the absence of arbitragebeing a compelling assumptionin the
MM scheme (Duffie, 1987; Ross 1988).
The MM argumentassumes two firms with identical cash flows, with one
firmfully financedby equity and the otherfinancedby a combinationof debt
and equity;also, the firmthatis leveragedis worthless thanthe unleveraged
firm. Purchasingan equal percentageshare of the leveragedfirm's debt and
equity will then cost less than the same percentageshareof the unleveraged
firm, but entitle the investorto the same cash flow. Such an arbitragepossibility would raise the price of the leveragedfirm's equity and lower that of
the unleveragedfirm until the two firms had the same value. Conversely,if
the leveraged firm were to be relatively overvalued,then by combining the
unleveragedfirm'sequity with privateborrowingan investorcould duplicate
the returnon the leveragedfirm'sequity at a lower cost (Ross, 1988).
With respect to the no arbitrageidea, Dybvig and Ross (1987:43) write
that:"Oneappealof resultsbased on the absence of arbitrageis the intuition
that absence of arbitrageis more primitivethan equilibrium,since only relatively few rationalagents are needed to bid away arbitrageopportunities,
even in the presence of a sea of agents driven by 'animal spirits.' " Therefore, the compositionof the capital structureof a firm cannot systematically
predictexcess positive or negativereturnsto shareholdersover time. Excess
returnswill be arbitragedaway, according to the MM theorem. The MM
model deals with firms' valuationswhich are a function of their cash flows.
What the MM model explicitly assumes is that the size of the cash flows of
leveragedand unleveragedfirms are both equal. This assumption,however,
is unrealisticbecausethe profitabilityor cash-flowgeneratingability of firms
can also intrinsicallydepend on the composition of their capital structure,
and it is the specific relationshipbetween capital structureand performance
which is empiricallytested in this paper.
2.2. Capitalstructureand performance
A large body of literaturehas evolved to deal with cases where the MM
results may not apply. Shareholdersmay not be able to undertakethe same
financialtransactionsas firms and at the same price (Duffie, 1987), or face a
creditconstraints(Stiglitz, 1988). The idea of the debt tax shield (Modigliani
andMiller, 1963; Miller, 1977) has also been influentialin alteringthe applicability of the original MM model. Anothermajorstrandof literature,how-

290
ever, has evolved which suggests that leverage has a non-neutralimpact on
firms' behaviorand performance,irrespectiveof whetheror not arbitrageis
possible, thus leading to the generationof greateror lesser cash flows thanif
a firmwere to be fully equity financed.
In the alternativestrandof literature,four ideas arerelevant.The firstis the
incentive signaling approach.If two firms have differing prospects, which
are known by managementbut not discernedby investors,debt can be used
to signal the fact that prospects differ and equity issues may be interpreted
as a negative signal (Greenwald,Stiglitz and Weiss, 1984; Leland and Pyle,
1977; Myers and Majluf, 1984). Ross (1977) argues that a firm with better
prospects can issue more debt than one with lower prospects, because the
issue of debt by the latter will result in a higher probabilityof bankruptcy
because of debt-servicingcosts which is a costly outcome to management.
Therefore, a higher level of debt will be associated with a higher level of
performance.
The second idea, one of resource constraints,is advancedby Jensen and
Meckling (1976). Where an entrepreneurhas limited resources,then should
capitalbe raised as equity or debt becomes an issue. The placementof equity dilutes an owner-manager'sshare of profits, and thereby entrepreneurial
incentives, motivatingon-the-jobconsumption.Raising debt avoids the sacrifice of incentiveintensitysince the entrepreneurcan internaliseto a greater
degreethe benefitsof superiorprofitability.Therefore,morehighly leveraged
firms will be more profitable,since the entrepreneuror owner-managerwill
not have undertakenon-the-jobconsumption.
As Williamson(1988) contends,however,the modem corporationwith no
single owner-manager,with diverseownership,andwhere thereis separation
of ownershipand control, is more ubiquitousin the contemporaryindustrial
landscape. Therefore,the role that debt plays in influencing corporateperformancewhen it is a part of the capital structureof a large corporation,an
organizationalform seen also in the Indian context, is more germane. The
relevantidea with which to addressit is one of bonding (Grossmanand Hart,
1986; Jensen, 1986). The behavioralassumptionunderlyingthe idea of bonding is one of managerialism(Marris,1964), and the bonding idea combines
ideas of both incentivesignaling and resourceconstraint.
Assumingthatmanagementowns little equity,as a resultof which a switch
from debt finance to equity finance does not change managements'benefit
from an increase in profit directly, the incentive effect of debt is to avoid
bankruptcy,because the calling-in of a loan can quite easily upset the liquidity position of a firm andjeopardise growthpossibilities (Baxter, 1967).
Grossman and Hart (1986) and Jensen (1986) assume managerialdiscretionary behavior, and debt serves both as a signal as well as a check on

291
managerialdiscretion.The issuance of debt, a fact which is easily observed,
permitsthe marketto make inferencesabouta firm'sstrategies,the qualityof
projects and its likely performance,and these influences are reflectedin the
market'svaluationof a firm. Since the seeking of externalfunding exposes
firms' strategiesto scrutiny,managersare exposed to increasedmonitoring
which inhibits their engagementin discretionarybehaviorand the threatof
defaultalso elicits greatermanagerialeffort (Jensen, 1989).
A firm may, therefore,issue debt to persuade the marketthat the management will pursueprofits,which will generatethe necessary cash so as to
service the debt, ratherthan indulge in managerialdiscretionarybehavior.
By issuing debt, management,as agent, deliberatelychanges its incentive
structureso as to bring it in line with those of shareholders,the principals,
because of the resulting impact on market value; or, in other words, management bonds itself to act in the best interest of its shareholders.Hence,
higher levels of debt in the firm's capital structurewill be directly associated with higherperformancelevels (Grossmanand Hart,1986). The principal
hypothesisprevalentin the literatureis that a higher level of debt in a firm's
capital structureis associatedwith a higher level of performance,leading to
the generationof greatercash flows.
An alternativehypothesis,however,also exists which statesthathigh leverage is associatedwith long-termperformancedeclines. Debt holders are assumed to be more risk aversethanequity holders (Smith and Warner,1979).
Consequently,they force managersto abandonriskyprojectsandcut back on
R&D expenditures.Thereis evidence suggestingthat a negativerelationship
exists between R&D intensityand long termdebt (Baysingerand Hoskisson,
1989). Leverage is, therefore,associated with decline in firms' innovativeness and the long-run consequences of such decline in innovativenessis a
worseningof performance.
2.3. Thepropertyrights situation
The principalassumptionassociated with the above hypotheses is that suppliers of debt capital are privately-ownedinstitutions,which themselves are
subject to monitoringby their own owners or suppliers of capital. Where
debt capital is supplied to firms by state-ownedenterprisesa negative association between leverage and performancecan be the primaryobservedrelationship because of the distinctionsthat exist between privately-ownedand
state-ownedenterprises.State-ownedenterpriseshave been very visible on
the financialandindustriallandscapeof most developingandtransitioneconomies. Therefore, their role as debt suppliers warrantsspecific theoretical
analysis.

292
As in prior work (Majumdar,1996a), the propertyrights thesis can be
invoked to analyze the behavior and performancedifferences between private and state-ownedenterprises.Property-rights,which are rights over the
enjoymentand disposal of income streamsand assets, are attenuatedin state
or government-ownedinstitutionsbecause a marketfor corporatecontrol is
absent. Unlike in the situationwhere privately-ownedfinancialinstitutions
themselves are subjectto marketdiscipline and controlfrom theirowners,in
situationswhere financialinstitutionsare state-ownedthey do not face any
such constraints,and there is one majorconsequence as a result of the existence of such a situation.
Because state-ownedfinancialenterprisesare not subjectto any discipline
by their owner-principal,which is the government,firms which have taken
loans from these financialinstitutionsdo not feel the need to change their
own incentive structuresby the bonding behavior that Grossmanand Hart
(1986) suggest might happen.The state-ownedfinancialinstitutionswhich
are owed debt by firms are not likely to be called upon to suffer from making bad loan-decisions by their own principals,because the government,in
theory,has deep pockets and the encouragementof industrialdevelopment
in economic environmentswhere capitalmarketsare thin is often one of the
goals of the governmentwhen setting up financialenterprises(Jalan, 1991).
Financialinstitutions,therefore,have reducedincentivesfor monitoringtheir
debtorfirms.From the debtorfirms' point of view, the knowledge that debtholders' presence is irrelevantor inconsequential,then, can encouragemanagerstowardsundertakingdiscretionarybehavior,with negativeperformance
consequences.
In a practical sense, the above situation also ought not to exist because
financialinstitutions'ownershipis normallyvested in one governmentdepartment which holds all the shares on behalf of the government.Thus, ownership is not diffused but vested in one owner who can exercise control.From
the debtor firms' perspective,this fact ought to encouragebonding because
theirdebt suppliersarelikely to face strongmonitoringpressuresthemselves.
This, however,is not the case since the fuzziness of owners' identity crops
up. The governmentdepartmentwhich owns shares in financialinstitutions
is itself an agency for citizens who are the dejure owners of the financial
institutions.This implies thatthe controlof state-ownedfinancialenterprises,
being undertakenby civil servantsof the concernedgovernmentdepartment,
is vested in persons who are themselves agents of the citizens of the state,
monitoringotheragents, the financialinstitutions'managers.
The consequencesof the above situationcan be articulatedas follows. As
a collection of many principals,citizens of a state face several agency problems. Citizens in a democracyneitherhave the incentives, because of free-

293
ridingproblems(Olson, 1965), nor do they find it easy to controlmanagersin
state-ownedenterprisessuch as financialinstitutions.The very diffusenessof
public ownershipimplies that citizens acting individuallyhave small probabilities in influencing outcomes, or in expressing their voice. As a result,
financial enterprisesbecome proprietaryorganizationsowned de-facto by
civil servants or politicians, who seek their own rents, while managers in
such institutionsknow that they are free of both marketdiscipline or sanctions from the ultimateprincipals,the citizens of the state.
For debtorfirms' managers,debt is felt to be owed to the public-at-large
who can effectively do nothing. Thus, the greaterthe quantumof debt in
the capital structure,the greateris the profligacyor the lack of effort on the
partof managers,unlike the situationwhere privately-owneddebt suppliers
can exercise a check on discretionarymanagerialbehavior (Jensen, 1986),
and corporateperformanceis negatively impacted.The principalalternative
hypothesisthat can be advancedis that:where debt capital is primarilysupplied by state-ownedfinancialinstitutionsa negativerelationshipwill be noted between the level of debt and performance.
3. Empirical analysis
An extensive firm-leveldata set, containinginformationfor over 1,000 Indian firms, forms the basis for empirical analysis. These data were obtained
from the Center for Monitoringthe IndianEconomy and supplementedby
Bombay Stock Exchange data. Guidancein data collection was providedby
the Departmentof StatisticalAnalysis and ComputerServices of the Reserve
Bank of India.The dataarecross-sectionalfor each firmand are collected for
one of the years between 1988 and 1994, dependingon the availabilityof all
key variablesfor that year, with missing value problemsbeing sought to be
avoided.Given data-collectionconstraintswhich were not resolvable,it was
not possible to develop a full cross-sectionaltime-seriespanel data set.
To assess the impact that leverage has on corporateperformancein the
Indiancontext, DEBT EQUITY,which is a ratio of the debt to equity in the
capital structureof the firms studied, is used as the principal explanatory
variablein a model where the dependentvariableis profitability.Profitability
may be measuredas the percentageof profitto sales, following precedence
in the industrialorganizationand strategicmanagementliteratures(Capon,
Farley,and Hoenig, 1990; Cowling andWaterson,1976). However,the profit
rate of sales has no necessary link with either agency or governanceinfluences, since the investmentdimension is ignored in this profit measure. A
more relevantmeasure,therefore,is the returnon net worth. If governance
influences are at work, then they should reflect themselves in incentives for
managementto work effectively for shareholders.Accordingly,the appropri-

294
ate measureof profitabilityis returnon net worth which capturesthe return
thataccruesto shareholderson theirinvestments.
In explanationsof profitabilitya numberof otherfactorscan have an impact.
These may be firm-related,industry-relatedor relatedto aspectsof the institutionalenvironmentandhave to be controlled.The controlvariablesare discussed next, andthe discussionwith respectto these variablesis kept as short
as possible, since the objective is to control for other intrinsicand extrinsic
factorswhich also impacton performance.
How large firms are can be an importantdeterminantof performance,and
following standardpracticeSIZE is measuredas the log of total sales. Larger
firmshave a greatervarietyof capabilitiesand can enjoy economies of scale;
these can impact positively on performance(Penrose, 1959). Additionally,
larger firms can exploit marketpower (Shepherd, 1986), both in productmarketsas well as in factor-markets,an issue which is particularlygermane
in the Indian context where institutionalfactors have fostered rent-seeking
(Bardhan,1984) and firmsare able to earngreaterprofits.Conversely,larger
firms have problemsof coordinationwhich can negatively influence performance(Williamson,1967). Nevertheless,given the Indianinstitutionalscene,
it is likely thatmarketpowerargumentswith respectto size arelikely to dominate over coordinationfailure issues, and size and profitabilityis expected
to display a positive relationship.
The age of firms is also an importantdeterminantof performance,with
AGE, measuredas the numberof years since inceptionto the date of observation, introducedas a controlvariable.Olderfirmscan gain experience-based
economies based on learningand can avoid the liabilities of newness (Stinchcombe, 1965); however,with age inertiaand rigidities in adaptabilityset ins
leading to lower performance(Marshall,1920). A-priori,no relationshipis
posited and is left to be empiricallydeterminedfrom the data.
Diversificationby firms is one way for excess resources to be exploited
(Penrose, 1959), and the subsequentforay into new lines of business increases the repertoireof total skills and capabilities within firms which impacts
upon the total performanceof the organization.Data on sales from specific
business areas,per se, arenot available;therefore,an index variable,DIVERSITY,is created,takingon the valuesof 0 for no diversification,1 for multiple
lines of activities in relatedareasand 2 if firmsare very widely diversified.
Similarly,in the Indian context a numberof firms are owned by a common industrialhouse (Mohan and Aggarwal, 1990), much in the mannerof
Koreanchaebols. Such common ownershipcan lead to the spillover of firm
specific capabilitiesamong all membersof the group,with an impact on the
performanceof each member(Amsden, 1989). However,a numberof these
business groupingsare family-dominated,if not family-controlledby virtue

295
of ownershippatterns,and a recent phenomenonhas been the occurrenceof
family feuds, with respect to the division of spoils, and controversiesas to
what partsof the family controlwhich companies.The numberof such feuds
have lately been the grist of the popularbusiness-pressmill, and it is quite
likely that such behavioralfactors may have had a negative impact on the
performanceof individualcompanies within the group. GROUP is a dummy variabletaking on the value 1 if the firm belongs to an Indianindustrial
group,andis 0 otherwise.The sign of the relationshipis left to be empirically
ascertained.
The impact of foreign ownershiphas to be controlled, and a reason why
firmsinvest abroadis thatthey possess superiorcapabilities(Dunning,1981).
The possession of these capabilitiesmay lead a firmto display superiorperformancerelativeto domestically-controlledfirms,and FOREIGN,which is
a dummy variabletaking the value 1 if there is some non-zero element of
foreign ownershippresentin the Indianfirm and with the variabletakingthe
value of 0 if no foreign ownership at all is present, is introducedinto the
regression.
EXPORTS,which capturesthe export orientationof the firms studied, is
introducedto control for the export orientationof Indianfirms. If domestic
and overseas marketsare equally competitive,or both closed for thatmatter,
differencesin competitiveintensity are going to be similar and performance
differencesbetweenexport-orientedanddomestically-orientedfirmsarelikely to be minimal. On the other hand, if domestic marketsare controlledand
closed, as has been the case in many developing and transitioneconomies
such as India, as comparedto the exportmarketsin which firms from these
countries operate in, then significantly superiorperformancewill be noted
for firmsthathave a relativelygreaterexportorientation(De Melo and Urata, 1984). Thus, the sign for EXPORTSis postulatedto be positive.
A numberof control variables are introducedbased on empiricalperformance studiesandliteraturereviewedin Caves (1992). The ratiosof advertising, distributionand marketingexpendituresto total operatingexpenditures,
ADVERTISING,DISTRIBUTIONand MARKETING,controlat once both
firm-relatedand industry-relatedfactors. Some firms may spend heavily on
advertising,distributionand marketingto gain increasedmarketshares,with
a consequentimpact on profitability.The variables,therefore,capturefirmlevel predilections. On the other hand, some industry-settingmay require
heavier spendingon advertising,distributionand marketingactivities;thereby, industry-effectsare also controlledto some degree.
Another industry-relatedfactor is capital intensity,which is measuredas
the ratio of net fixed assets to total assets, CAPITALINTENSITY.Additionally,the ratioof inventoryto total assets, INVENTORY,helps controlindus-

296
try-effectsgiven situationswhere some industriesneed greaterstockholding,
but business-cycle effects are also controlledfor since in downturnsinventories tend to accumulate,and vice-versa. No a-priorirelationshipis posited
for CAPITALINTENSITY,but INVENTORYis expected to yield a negative relationshipsince the stocking of inventoriesmeans greaterneed for
working-capital,higherinterestcosts and,therefore,an erosion of profitability.
A variable which also has attributesin controlling industry-relatedand
business-cycle factors is LIQUIDITY,which is the quick assets ratio or the
ratio of cash to total currentliabilities. Cash requirementsmay be conditioned by industrypractices,but also by the overall economic climate, since
in lean times cash-flowcrises can arise.Additionally,LIQUIDITYalso helps
capturefirm-specificattributes,since the ability to manage working capital
and acquirea greaterquantityof cash balances relativeto currentliabilities
reflects superiorskills which are also likely to be reflectedin a firm's ability
to generaterelativelygreaterprofitssince a lesser cost burdenwith respectto
the use of short-termfinanceis faced.
SALES GROWTH,which is the rate of change in sales between the observation-yearand the preceding years also capturesbusiness-cycle effects
and environmentalvolatility.In marketswhere sales growthis high, thereare
possibilities for firmsto make largerprofits;on the otherhand, such growth
trendsmay attractnew entrants,quite a common occurrencein India in the
post-reformperiod, and averageprofitsfor all players may be reduced.The
actualrelationshipbetween SALES GROWTHand performanceis left to be
empiricallydetermined.
EXCISE and IMPORTSare two variablescontrollinginstitutionalfactors
specific to the Indian context (Mohan and Aggarwal, 1990). The ratio of
excise duties borne to gross sales, EXCISE, capturesthe indirect tax incidence firms face. The greaterthis ratio, the lower the performanceof firms
since there are less incentives to be commercially-successfulif a principal
task is being an adjunct arm of the Indian customs and excise collecting
authority.The ratio of imports to total operating expenses, IMPORTS,is
introducedto control the impact of import-controlregimes that firms face.
While greaterpenetrationof importedgoods in any particularsectorpressurizes domestic firmsto performbetter,whetherallowabilityof importsof raw
materialsand supplies by individualfirms does so is debatable.On the contrary,the existence of a quota system and importlicensing, which has been
the case in India (Marathe,1989), is expected to engenderrent-seekingand
the likely sign of IMPORTSis expected to be negative.
Finally,TIMEis an index variabletakingon the values between0 and5 for
each of the years 1988 to 1994, since the observationsbeing evaluatedbelong

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Table1. Regressionresults
Variable

Coefficient
estimate

t-statistic

Debt equity
Size

-16.675
8.591
-0.321
16.685
-8.385
-7.916
0.056
3.041
-1.116
-1.126
0.115
0.597
6.962
-0.005
-0.602
19.190
-9.889
59.327
0.500
60.911
1043

30.76***
4.44***
2.12**
2.47***

Age
Diversity
Group
Foreign
Exports
Advertising
Distribution
Marketing
Capitalintensity
Inventory
Liquidity
Sales growth
Excise
Imports
Time
Constant
R2
F
N

1.61*
1.23
0.38
1.63*
1.19
1.12
0.77
2.64**
1.47*
0.95
1.81**
1.10
4.18***
3.70***

***p<.01; **p<.05; *p<.10 (one-tailed).

to either of these years. Time effects are therebycontrolled,and whetherthe

reforms process has led to a structuralchange in performancepatternsof
Indian firms can also be tested. If, indeed, firms have become more profitable as a result of the opening-upof markets,then TIME and profitability
will display a positive relationship.Conversely,the unleashing of competitive forces can lead to a structuralprofitabilitydecline for firms. The issue
requiresempiricalvalidation.

4. Results
The regressionresultsareobtainedusing weightedleast squaresestimationto
correctfor the presenceof heteroscedasticity(Gujarati,1986) and are shown
in Table 1.
DEBT EQUITYis found to be negative and significant.The magnitudeof
the coefficientthatis estimatedis also substantial,and the significanceof the
relationshipis at the p i .001 level. These are counter-factualfindingswhich

298
go againstthe postulatesof receivedtheoryadvancedby financialeconomists
in the corporategovernancearea. Explanationsas to why the presence of a
greaterlevel of debt in the capital structureof firms have to be rooted in
the Indiancontext, and applicabilityof concepts of corporategovernanceto
transitioneconomies needs re-appraisalin light of institutionalfactors that
are commonly-notedin such economies, such as India. A detailed discussion of these findingsfollows separatelyin Section 5, afterthe resultsfor the
controlvariableshave been describedin this section.
Of the several control variablesintroducedinto the model, 9 of these are
significant,at a minimumof 10%level of significanceusing a one-tailedtest.
It is the relationshipof the significantcontrolvariables,and the implications
of the results for corporateperformanceanalysis in the Indiancontext, that
arediscussed. SIZEis positively relatedto performance,reflectingthe ability
of large firms in India to exercise power in productand factor markets.The
dataavailablehave not been adequatefor the purposeof constructingmarket
shareor concentrationvariableswhich more reflectthe marketstructurethat
firmsmay face; hence, following Shepherd(1986), SIZE is used as a surrogate. However,big firmsmay also enjoy scale economies; therefore,detailed
disaggregatedstudy of these effects is necessary.AGE is negative,implying
thatinertiacharacterisesolder firmsin India.Newer firms,on the otherhand,
seem to be more flexible in adaptingto the realitiesof the newly-competitive
marketplace.
DIVERSITY is positive and significant, implying that the utilization of
firms' resources in other business areas is conducive to overall firm-level
performance.Correspondingly,there may be an increase in organizational
variety engenderedby diversificationmoves as a result of which capability
spillovers may take place from the new business areas into the core business, with an impact on performance.GROUP is negative and significant,
implying that membershipof an industrialgroup is fraughtwith deleterious
consequenceson economic performance.
ADVERTISINGis positive and significant,and this is in consonancewith
industrialorganizationtheory.A higherlevel of advertisingspendingenables
productdifferentiationto take place, with consequentimpact on profitability. The sign for INVENTORYis as predicted.LIQUIDITYis positive and
significant,denotingboth the ability of firmsto be superiorworking-capital
managers,as well as gain, in profitterms,from lower interestcosts. EXCISE
is also negative and significant, implying that firms which play a role of
being tax collectors for the governmenthave muted incentives to be profitable commercialoperators.Also, in a relativelydemand-constrainedeconomy like Indiaa higherrateof excise dutyon productssold limits the margins
thatmanufacturerscan charge,given the inabilityof the Indiancustomersto

299
afford to pay more than a particularprice for the productson sale. Finally,
TIME is negative, the result implying that liberalizationmay be leading to
a structuralprofitabilitydecline for firmsin general.However,this aspect of
performanceneeds more disaggregatedanalysis.

5. Discussionand implicationsof principalfindings

In this section some explanationsare advancedin respectof the key findings
that are obtained.The supply of debt capital in India is almost fully in the
hands of the public sector, though equity capital is suppliedby privateindividuals, and every conceivablemajorinstitutionin the Indianfinancialsector
is owned by the government(Jalan, 1991). In 1956 the life insurancebusiness in Indiawas nationalized,followed by the nationalisationof the general
insurancesector in 1973. This created a government-ownedduopoly in the
insurancesector.Similarly,the largestmutualfund agency, the Unit Trustof
India, is fully owned by the governmentand other smallermutualfunds are
owned by the banks. While insurancecompanies and mutual funds are not
primarilylenders of debt, the objective is to highlight the pervasivehand of
governmentin the operationsof the financialsector of India.
In 1969, the principalcommercialbanks,making short-termworkingcapital loans to industry,were almost fully nationalized.Financial institutions
making long-termloans were established,de-novo, by the government.For
example, the IndustrialFinance Corporationof India was set up in 1948,
and the IndustrialDevelopment Bank of India in 1964. These are the two
majorsuppliersof long-termdebt to Indianindustry.Thereare also a number
of specialized long-termlenders, all owned by the government,such as the
IndustrialReconstructionBank of India, the Small IndustriesDevelopment
Bank of India and the ShippingCreditand InvestmentCorporationof India.
Apartfrom these centralgovernment-ownedfinancialinstitutions,almost
every majorIndianstate,therebeing 25 states in India'sfederalstructure,has
a State FinancialCorporationand a State IndustrialInvestmentCorporation.
These corporationsare also majorlong-termdebt suppliersto industry.The
only majorprivate-sectorfinancialinstitutionin Indiais the IndustrialCredit
and InvestmentCorporationof India;however,on its boardof directorsthe
governmenthas a very noticeable presence and for all practicalpurposesit
behaves like a state-ownedenterprise.In all Indianfinancialinstitutions,the
grantingof loans to the extent of often twice the level of equity capital, and
often much more, of the firmshas been the norm (Majumdar,1996b), unlike
in the U.S. where such high leverageratios are rarelynoted.
The financial sector in India is almost completely state-owned,with the
present empiricalresults supportingthe alternatehypothesis that there is a

300
negativerelationshipbetween leverage andcorporateperformance.Fromthe
point of view of policy-making,not only in the Indiancontext but also from
thatof manyothertransitioneconomies, thereis one majorimplication.India,
in commonwith manyothertransitioneconomies, is openingup herhithertoclosed marketsand industriesto large-scale entry by domestic and foreign
firms.Attemptsarebeing made to privatizecommercialand industrialIndian
state-ownedenterprises,as in other transitioneconomies, though not at all
very successfully. Yet, little attentionis being paid to reform of the financial sector, and this reform is fundamentalfor other micro-level reformsto
succeed.
Though a number of private foreign and domestic financial institutions
have enteredthe Indiancapital market,they have initially enteredas portfolio investorsin equity and have only lately been allowed to become suppliers
of debt. If the canons of corporategovernance,as commonly-understoodin
Westerneconomies, are to apply in India, as well as other transitioneconomies such as those of the United Kingdomand the United States, then a fundamentalpolicy-switch necessary is the privatizationof Indianstate-owned
financial institutions. Only then might the presence of debt in the capital
structureof firms have a disciplining impact on Indian managers.Yet, the
issue of transferringfinancial institutions' ownership to the private sector
has neverbeen voiced in the Indianreformsprocess. Thoughprivatizationof
state-ownedenterprisesis a majorissue in the reformof economies that are
in transition,the issue of financialsectorprivatisationhas hardlybeen raised.
Financialsector privatizationhas an impactin enforcinghard-budgetconstraintson firms, and with regardto the privately-ownedsupply of capitalto
Indian industrya contemporaryphenomenonwhich is occurringmay have
positive impact in the future. That phenomenonis the increasing presence
of institutionalinvestors in the capital marketsgenerally, and the increasing presence of institutionalinvestors has had a salutary impact in influencing managerialbehavior in the United States in the 1980s (Majumdar
and Nagarajan,1996). If the role of institutionsas a supplier of capital is
increasedover time, these institutionsmay be able to bringdisciplinarypressures to bear on firms' managersand enforce hard-budgetconstraints.
The repetition of the trend in India, where over time the supply of debt
capitalas well equity investmentsvia mutualfunds will become increasingly
concentratedin privateinstitutionalhands,both domestic and foreign, might
force discipline on the Indiancapital marketas well as on Indianfirms. An
empiricalexercise that can then be carriedout is to evaluatewhetherunexpected changes in the levels of debt suppliedby government-ownedinstitutions has a one-time effect on returnsvia the mechanismof an events study.

301
Such a study is not feasible using the presentdata set because the sources of
all corporatedebts are state-ownedfinancialinstitutions.
Additionally,foreign financialinstitutionshave enteredthe Indiancapital
marketin a substantialway. These foreign financialinstitutionsare well capitalized and can draw on the deep-pocketsof theirparentsfor resources.As
foreign financialinstitutionsexercise their financialmuscle in forcing firms
in Indiawhich use the capitalmarketas a sourceof funds to meet the standard
norms of behaviorthat are commonly accepted in the West, then firms' performanceis also likely to improve.The entryof foreign institutionalinvestors
into the Indiancapitalmarkethas considerableimplications,and over time it
is expected that these institutionswill develop into major suppliersof capital. This will be de-facto privatizationof the supply of debt capital in India,
a financialsectorreformwhich is needed.
Other than an agency reason, the evidence suggests that the capabilities
of Indianbanks and financialinstitutionsmay not be up to par, since a high
debt-equityratio is associated with low performance.The loan and project
appraisalskills of the government-ownedIndianbanks and financialinstitutions are likely to be called into question, since promoterswith inherentlyunsoundprojectsmay have obtainedlarge sums of money from these institutions. These sums, may have had to be lent because of political considerations, and banks and financialinstitutionsmay be merely serving as a conduit for the channel of government-largesseto specific parties. Also, even
if appraisalskills are at par, banks and financial institutionsmay have no
options but to continue funding, as an agency of government,because the
political consequences of calling in low-performingloans is likely to be
fraughtwith significantlynegativepolitical consequences.
With respect to how the financial sector is presently structuredin India,
two issues become important.The role of financial institutions' nominee
members' presence on the boards of firms which have significantborrowings, a standardpractice,is also likely to be questioned,since their presence
in highly-leveragedfirms may not matterin any critical way. Their role has
been to explicitly monitorthe performanceof highly leveragedfirms.Yet, it
is the highly leveragedfirmswhich are unsatisfactoryperformers.Simultaneously, the supervisoryabilities of the Departmentof Bankingin the Ministry
of Finance,which is a fully-fledgedgovernmentdepartmentwith a secretary
or additionalsecretaryat its head, or of the Reserve Bank of India's various
monitoringfunctions have to be called into question. Assuming that these
bodies have roles to play as overseers of the banking sector in the Indian
economy, those roles do not seem to have been fulfilled in any meaningful
mannerif the firmsin which the financialinstitutionsundertheircontrolhave
a largerexposureare ones which display low economic performance.

302
Nevertheless,therecan be a greatdeal of variationin the qualityof capabilities thatthe state-ownedbanksand financialinstitutionspossess. Theremay
be a numberof quite capable state-ownedfinancialinstitutionsand banks,
and a numberof these banks and institutionswhose performanceis considerably below average,given the very large numberof such institutionsthat
do exist in India. For example, 300 banks operateover 60,000 branchesin
India (Mistry, 1995); consequently,heterogeneityin banks' capabilities is
bound to exist. Thus, more detailed empiricalresearchwhich identifies the
relationshipsthat the explicit sources of loan capital in the corporatesector
have with profitabilityis warranted.Also, in the futurethe increasingpresence of foreign financial institutionsmay serve to enhance the capabilities
of all financialinstitutionsoperatingin the Indiancapitalmarketthroughthe
operationof a spillover process. Whetherthis phenomenonactually occurs
or not is, of course, an empiricalquestion. If it does, then Westernconcepts
of corporategovernancemay begin to be applicableto the Indiancontext.
The high cost of borrowingin the Indiancontextmay also, in part,account
for the resultsobtained.The cost of borrowingin Indiais phenomenallyhigh
by internationalstandards.Where investorsare presentlybeing offered rates
of interestof between 15%and 18%per annumby financialinstitutions,the
cost to borrowersof funds from banks and financialinstitutionsis considerably more, given the risk premiumand the administrativespreadthat are
addedon. Forhighly-leveragedfirmsto service suchhigh interestratesmeans
that the gross marginon sales has to be enormouslyhigh. The realizationof
such marginsin competitionwith firmswhich are less highly leveragedmay
not be feasible in the contemporaryIndianmarketcontext, where the liberalization of entry has simultaneouslyexacerbatedcompetitivepressuresfor
incumbents.The consequenceis thathighly-leveragedfirmsare considerably
less profitablethan firms with a greaterlevel of equity in their capital structure.
Withinthe frameworkof the debt literature,in this paperwe have studied
the narrowissue of whetherthe level of debt impactsfirms'profitability.The
MM propositionsrelate to firms' value, and in the context of Westerninstitutionalpracticesthe standardassumptionis thatcapitalmarketsare efficient
enough for investorsto not violate the no arbitragecondition.In India,however, the secondary marketfor shares is not efficient. The Bombay Stock
Exchange is the principal secondary market in India. It is over a century
old, accountsfor 70% of daily stock exchange turnoverin India,75% of the
total marketcapitalisationof sharesin Indiaandtradingis voluminous.6,000
sharesare listed, yet tradingin the sharesof 50 companiesaccountsfor 80%
of the marketactivity(Mistry,1995). A system of speculativeforwardtrading
by the brokercommunityaccountsfor the bulk of tradeswithin the Bombay

303
Stock Exchange and enables brokersto earn incomes at the expense of the
individual investors they represent.Marketrigging is endemic and Mistry
(1995: 190) remarksthat "brokerbehavior...isseverely inimical to the market's integrityandto the interestsof all othermarketparticipants."
Thus,if we
were to study the postulatesof the MM ideas as they relate to firms' values,
we will be unableto find empiricalsupportfor theirpropositionsin the Indian contextbecause of the institutionalcharacteristicsof the Indiansecondary
marketfor stocks, sharesand bonds.
Additionally,thoughequity marketshave been operatingfor over a century in India a genuine bond marketin tradinggovernmentand corporatedebt
issues, similar to such marketsin the developed world, has remainedundeveloped. The developmentof the fixed income instrumentstradingsegment
of the capitalmarkethas been stultifiedlargely as a consequenceof the governmentpre-emptinga large shareof bankingdeposits at below marketrates
of interest.Not only does the governmentpre-empta large shareof banking
deposits, but its borrowingin the capital marketsis not transparent.Therefore, conditionsfor a secondarydebt marketwhich is transparentin its operation to exist are vitiated.Controlledinterestrates and the absence of credit
risk differentiationhave furthercontributedto thatneglect. Propermarketsin
risk-managementand derivativeinstrumentshave not yet developed. Financial sector reform in India, so far, has been conspicuous in its omission of
the need to develop a wide, deep and liquid bond marketfor corporatedebt
issues.

6. Conclusion
Using contemporarydata,this paperhas investigatedthe relationshipbetween
leverage, or the level of debt in the capital structure,and performancefor a
large cross-section of Indianfirms, finding a negative relationshipwhich is
not in accordancewith the assumptionsof theory as commonly-acceptedin
Westerneconomies. In India,suppliersof debt are government-ownedfinancial institutions,and the postulates of agency theory,as applied to contemporary corporategovernance issues in the West, have to be re-assessed in
light of state-ownershipof financial institutions.The fact that suppliers of
debt capitalto firmsin India are state-ownedhas majorbehavioralramifications which impact on whetherthe presence of loan creditorsinduces managers in firms to strive for superiorcorporateperformance.Privatizationof
state-ownedIndian financialinstitutionsis suggested as a fundamentalpolicy change which may ensure that debt-holderscan exercise a disciplining
influenceupon Indianmanagersand ensure superiorcorporateperformance.
Correspondingly,the entry of foreign-owned financial institutionsinto the

304
Indiancapital marketmay also have a salutaryeffect on the performanceof
Indianfirms.

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