Chapter III

Survey of Literature

3.1

Introduction

In a perfect and efficient capital market the value of the firm is

determined by its capacity to generate return on its investments in its
assets but not by the types of securities used to raise capital (Modigliani
and Miller, 1958). When imperfections exist in the financial markets,
financing becomes important and affects the value of the firm (Durand,
1961 ). We can identify and hypothesise the relationship between the
dependent and independent variables on the basis of the survey of
literature which is given below.

3.2

Capital Structure, Cost of Capital and Value of the Firm

Let us explain the concepts, identify the components and elaborate

how to measure capital structure, cost of capital and value of the firm.

3.2.1 Concept, Components and Measurement of Capital Structure

Concept of Capital Structure

Financial management revolves around the creation and disposition/

allocation of a pool of fund. The disposition of the pool of fund amounts
to use of fund for the purposes of procuring fixed assets and financing net
working capital. On the other hand, financing the pool of fund involves
raising resources by issuing different types of securities from various
sources. The holders of different securities have equitable claims,
commensurate with the risk assumed by them, on the assets or future cash
flows of the firm. These equitable claims on assets or cash flows are
known as equities.
The

use

of long-term

loans,

debentures

and

bonds

creates

contractual obligations of paying fixed returns periodically during the

33

tenure of these securities and repaying the principal amount at the end of
the tenure. These are called external equities.
The use of equity shares and retained earnings does not create such
contractual obligations. These are called internal equities.
Preference shares fall in the category of external equities so far as
payment of dividend and repayment of principal are concerned. A firm
has to pay dividend on preference shares, if profit is earned, periodically
during the tenure of these securities and has to repay the principal amount
at the end of the tenure. Even if the firm fails to earn a profit or earns
insufficient profit, the dividend on preference shares gets accumulated
and when it earns sufficient profit it has to pay accumulated plus current
dividends on preference shares first before distributing any dividend to
the equity shareholders. But the claims of the preference shareholders are
met after the claims of the external equities (i.e., debtholders) are fully
met. So preference share is a hybrid security. It has the features of both
debt and equity share.
So the use of external equities creates fixed claim on the cash
inflows of the firm and they get priority over the equity shareholders in
the matter of distribution of income in case of a going concern and
distribution of assets in case of liquidation of the firm.
The combination of external and internal equities which are used in
creating the pool of fund of the firm is known as its capital structure. So
capital structure represents the proportions of various securities used in
financing the pool of fund of the firm.
Van Horne (2002) defines capital structure as the proportions of
debt instruments and preference share capital and equity share capital on
the company's balance sheet. Being hybrid securities preference shares
can be treated as debt. But preference share capital has been included in
the shareholders' equity in the "Finances of Public Limited Companies"
published in the bulletins of the Reserve Bank of India. Due to this
reason preference share capital has been included in the shareholders'
equity in our study.

34

Clerkson and Elliott (1970) state that the capital fund (referred to
as pool of fund in our study) shows the long-term financial strength of
the firm.
The balance sheet of a company shows the amounts of long term
capital raised by issuing ordinary and preference shares, long term debt
instruments and by retaining earnings. The total value of these funds
equals the sum of fixed assets and net working capital. Thus the net asset
of the firm is financed by long-term capital.
Creation of pool of fund

Disposition of pool of fund

(Sources)

Equity Share Capital,

(Uses)

Retained Earnings,

Pool
Of

Preference Share Capital

Fund

--~

Fixed Assets

--.

Net Working Capital

Long-term Loans,
Debentures, Bonds etc.

Components/ Sources of Long-Term Capital

A company can raise long term capital by issuing equity shares,

preference shares, long term debt instruments (like debentures, bonds,
long term loans etc.) or by retaining profits. These are called the
components of capital structure. These components can be grouped into
debt and shareholders' equity which represents share capital (including
preference share capital) plus retained earnings.

Measurement of Capital Structure

The capital structure of the firm is measured by the debt to capital

employed ratio where debt represents the value of long-term debt and
equity represents the value of shareholders' equity (including preference
share capital) and capital employed represents the value of long-term debt
plus shareholders' equity.

35

The average market values of the securities remaining outstanding

during the year can be considered for this purpose. Where market values
are not available book values can be taken as market values. Where
market values are considered the value of shareholders' equity is
represented by the market value of the equity shares outstanding. When
book values are considered it is represented by the book values of equity .
share capital plus retained earnings.

3.2.2 Concept, Components and Measurement of Cost of Capital

Concept of Cost of Capital

Cost of capital is not an out-of-pocket cost but the opportunity

costs of the investors of the firm. Since a firm is owned by its
shareholders and the goal of the managers, acting on their behalf, is
assumed to be maximization of shareholders' wealth, cost of capital
should be measured from the standpoint of its shareholders. The concept
of cost extends to debt as well as shareholders' equity. Each and every
source of capital has its own cost even though in case of retained
earnings no direct cash outlay is involved.
It is difficult to measure the expectations or opportunity costs of a

large, diverse and constantly changing group of investors. Even though,

as Donaldson (1972) argues, the firm should find a standard (i.e., the rate
of return expected by shareholders) based on shareholders' modus
operandi and it should return the funds to its shareholders if it fails to
find projects that can generate comparable

returns.

An investor's

expectation about the rate of return from an investment has two

dimensions viz., the rates of return that the investment opportunities,
available to him, are expected to generate and the risks associated with
those opportunities.
In a perfect capital market, in order to operationalise the concept of
cost of capital, the market price of a security can be regarded as a
function of the return expected by the investors. Market forces act in such

a way that equilibrium rates

of return for

36

various securities are

determined. Thus the opportunity cost of capital for a particular security

represents the rate of return that equates the future expected benefits
accruing to the supplier of capital with the present market price of that
security.
Durand [1952] states that the cost of capital is not an out-of-pocket
cost but an opportunity cost which represents the minimum rate of return
that the new investment must earn without making it disadvantageous to
its shareholders or owners given the objective of the firm to maximize the
investment value or the discounted value of an expected income stream.
Solomon (1955) argues that cost of each component of capital can
be measured from the standpoint of the firm's shareholders and defines
cost of capital as the minimum marginal rate of return that is required to
justify the active investment of the available funds.
Modigliani

and

Miller

( 195 8)

argue

that

the

market

value

maximization approach of financial management provides the basis for an

operational definition of cost of capital and the theory of investment.
Under this approach any investment project and its financing plan are
worth undertaking if these raise the market value of firm's shares. If the
marginal cost of capital to the firm is lower than the marginal rate of
return on investment then the project is worth undertaking.
Thus cost of capital can be defined as the minimum rate of return
the firm must earn on its investment in order to leave the market value of
its equity shares unchanged.

Components of Cost of Capital

The capital structure of a firm may consist of four components and

funds from each of these sources can be raised but for a cost. The overall
cost of capital is the weighted average cost of each component of capital.
Thus the overall cost of capital consists of cost of equity share capital,
cost of retained earnings, cost of debt and cost of preference share
capital. Let us define each of these costs.

>

Cost of equity share capital

37

Donaldson (1972) defines cost of equity share capital as the

opportunity cost that at least equals the rate of return on the common
shareholders' best investment opportunities.

Cost of retained earnings

Solomon (1955) argues that the cost of retained earmngs is an

imputed cost that equals the cost of equity fund derived externally
assuming that shareholders are in zero tax brackets and there are no
underwriting and floatation costs. Management harms the interests of its
shareholders if it fails to generate a rate of return, on internally derived
funds, that at least equals the expected rate of return of its equity
shareholders. In that case it should distribute the earnings to its equity
shareholders as dividends.

Cost of debt
Solomon (1955) argues that the real cost of debt to the borrower

includes the out-of-pocket interest charge that can be explicitly measured

and two other implicit charges viz., the constraints (like dividend
restriction etc.) and the risk of default and its consequences. Since it is
difficult to quantify the implicit charges and the interest is a taxdeductible expense so the after tax interest may represent the explicit cost
of debt to the firm.

Cost of preference share capital

According to Pandey (2005) cost of preference share capital is a

function of the returns expected by the investors. Preference shares have

the same features as those of debt instruments with a few exceptions. It is
not legally binding on the firm to pay preference dividend periodically
but in case of cumulative preference shares if dividend is not paid for any
year for want of sufficient profit the accumulated arrear dividend has to
be paid when sufficient profit is earned before distributing any dividend
to equity shareholders. But non-payment of preference dividend does not
cause bankruptcy. Preference dividend is an appropriation of profit and
hence not tax-deductible.
38

Measurement of Cost of Capital

Pandey (2005) defines the cost of each component as the investors'

required rate of return which should be adjusted for taxes for arriving at
the cost of each

sour~e

of capital to the firm.

Although it is very difficult to measure the rate of return (i.e., the

implicit cost of capital) expected by the investors on their investment but
if we assume that the securities issued by firms are traded in a perfect
capital market and investors are rational, the market price of a security
reflects the present value of the future returns expected by the investors.
According to Pandey (2005) the opportunity cost of capital can be
determined by the following formula:-

CFn
C~ + CF2 +------+--(1 + k)n
(1 + k) (1 + k) 2

where,
Po = capital supplied by the investors or the market price of a security at
time t=O,
CF,
k

= returns

expected to accrue to the investors at the end of time t,

= cost of capital to the firm or the rate of return expected by the

investors.
Since the overall cost of capital is the weighted average of the cost
of each component of capital let us first see how the cost of each
component can be measured.

Cost of equity share capital

Solomon (1955) argues that in the long run, the holder of a share of

common stock is the owner of a stream of returns from that holding and
so the holder is concerned with the impact of policy on the future returns
per share. He proposes to estimate cost of equity share capital by dividing
management's best estimate of average future earnings per share with the

39

current market price per share if the proposed capital expenditure is not
made, assuming that there are no underwriting and flotation costs and
management

Is

acting

in

the

best

interest

of the

firm's

equity

shareholders. On behalf of its equity shareholders, management should

accept only those projects, based on a criterion (i.e., cost of capital) that
benefits its equity shareholders.
Donaldson

( 1972)

argues

that

defining

and

measunng

the

expectation of a large, diverse and changing group of equity shareholders

is very difficult. Quantitatively the cost of equity share capital can be
measured by analyzing the relationship between the price the market is
willing to pay for the stock and the returns the stock ownership confers
viz., dividends and capital gains (indicating growth opportunities). But
the market price at a given point of time is affected by various factors.
Because of these reasons Donaldson ( 1972) argues that there is no
satisfactory operational measure of cost of equity share capital.
Assuming that the firm is operating in a perfect and efficient
capital market in which investors behave rationally and the management
acts in maximizing the market value of shareholders' equity, according to
Gordon and Shapiro ( 1961 ), the explicit cost of equity share capital
represents the current dividend rate (i.e., current dividend divided by
current market price) plus the rate at which the dividend is expected to
grow.
Cost of equity share capital can be measured by the following two
approaches:-

a. Dividend capitaJization approach

In a perfect capital market in which investors are also rational and
management acts in the best interests of the investors, the market value of
the equity shares reflects the present value of the future expected returns
discounted by the market capitalization rate or .the rate of return expected
by the equity shareholders. Thus cost of equity share capital equals the

expected dividend yield plus capital gain rate reflecting the expected rate
of growth in market price, earnings and dividends.
In case of a single-period model"

40

Pr=DIV0 (1+g)+ ~
0
(l+ke)
(l+ke)
Or

k =DIVo(l+g)+~-Po
' e
Pr
p
0

Or,

ke

DJV0 (l+g)

Po

+g

In case of a multi-period model-

= DIV0 (1+ g)+-------+ DIV0 (1+ g)n

(l+ke)

(l+ke)n

i DIV (1 + ~)'
0

(1 + ke)

t=l
When n ~ oo, we can derive-

k =DIV0 (l+g)+g
e
p
0
where,
Po= market price per equity share at time t=O,
P 1 = market price per equity share at time t= I,
kc = cost of equity share capital,
DIV 0 = dividend per share at time t=O,
g = annual rate of growth in market price, earnings and dividends.
According to Pandey (2005) this equation is based on the following
assumptions:

The market price of equity shares (P 0 ) ts a function of expected

dividends,

The initial dividend is greater than zero,

The rate of dividends grows at a constant rate g,

Dividend pay-out ratio is a constant,

41

The market capitalization rate (ke) is greater than the rate of growth
in dividends (g).
But it is difficult to estimate dividends and the rate of growth

10

earnings and dividends.

b. Capita) Asset Pricing Mode) (CAPM)

An investor, who is investing money at present,

IS

actually

sacrificing present consumption of value in favour of future consumption.

Again, different securities have different degrees of risk. So the investor
expects compensation for time and risk. The expected rate of return of a
security can be given as follows:
Expected rate of return (k) =Risk-free rate of return (Rr) + Premium
for risk.
Government bonds or treasury bills have no risk of default and
variability in return. The rate of return on these securities can be taken as
the risk-free rate and as compensation for time. The amount of risk
premium depends on the riskiness of the security assuming that the
investors are risk averse.
The risk of a security consists of systematic and unsystematic risks.
Unsystematic or unique risk arises from the uncertainties which are
unique to individual securities. This risk can be eliminated through
diversification without any cost and so the investor should not be
compensated for this risk. Systematic risk arises from the economy-wide
uncertainties which cannot

be reduced through diversification.

So

investors should get premium only for systematic risk. The risk of an
individual security, in CAPM, is stated as the volatility of that security's
return vis-a-vis the return of a well-diversified market portfolio, and is
measured by

p.

So

Pmeasures

only the systematic risk of a security.

The following assumptions have been made under the CAPM

(Fischer and Jordan, 2002):~

Investors make investment decisions on the basis of risk and return.

Securities can be infinitely divisible,

Investors can short sell shares without any limit.

42

>>>>-

Transactions in shares by a single investor cannot affect prices.

There are no transaction costs.
There is no personal tax.
Investors can borrow and lend any amount of funds at an identical
riskless rate.

>-

Investors have identical expectations about future returns from

securities.
Under the CAPM, the required rate of return on equity share capital

can be given by the following formula:kc = Rf + (Rm - Rf ) ~i

where,
kc = Cost of equity share capital,
Rf = Risk-free rate of return,
Rm= Rate of return on a well-diversified market portfolio,
~i

= Beta of security i,

/3

. = Cov( Ri' Rm)

2

(jm

rim()i

Cov(Ri,Rm) = Covariance between the return on security

and market

portfolio m,
cri = Standard deviation of returns on security i,
crm= Standard deviation of returns on market portfolio m,
rim= Correlation co-efficient between the return on security i and market
portfolio m,
crm 2 ::oVariance of returns on market portfolio m.
Here, market portfolio is represented by a well-diversified share
price index like BSE Sensex which is a 30 share index.

>-

Cost of retained earnings

43

Solomon ( 1955) argues that cost of equity share capital derived

externally may be taken as the cost of retained earnings under certain
conditions.

);>

Cost of debt
The after-tax interest charge can be taken as the explicit cost of

debt and is measured by the following formula: -

Dn
+---(1 +kd)n
Where,

Do = capital supplied by the investors or the market price of a debt

instrument at time t=O,
I = interest payable at the end of each year during the tenure of the
security,
kct = cost of debt to the firm,
= repayment of principal to the investors at end of time t=n,

Dn
T

= rate

of tax on corporate income.

Assuming that the firm will continue to use debt and the existing
debt instruments will be replaced with new ones when these instruments
fall due, we can get the explicit cost of debt by the following formula: -

D _ 1(1-T)
0k
'

when n-+ oo

1(1-T)

Or,

);>

Cost of preference shares

Since preference dividend is not a tax-deductible expense so the

explicit cost of preference capital can be measured by the following

formula: -

44

Where,

PFo =capital supplied by the investors or the market price of a preference

share at time t=O,
DIV P = preference dividend payable at the end of each year during the
tenure of the security,
kp

cost of preference share capital to the firm,

PFn =repayment of principal to the investors at end of time t=n

Assuming that the firm will continue to use preference share capital
and the existing preference shares will be replaced with new ones when
these shares fall due, we can get the explicit cost of preference share
capital by the following formula: -

when n ---+ oo

Overall cost of capital

The overall cost of capital can be defined as the weighted average

cost of each component of capital and this represents the average rate of
return expected by all the investors. This can be measured by the
following formula: -

E
D
PF
k=-k +-k +-k
V e V d V p
where,
k =overall cost of capital,
E = market or book value of common shareholders' equity,

45

market or book value of debt,

PF= market or book value of preference share capital,

V

total value of the firm == E + D + PF

Where market values are taken, the value of shareholders' equity is

represented by the market value of equity shares and where book values
are considered, this is represented by the book value of equity shares plus
retained earnings.

3.2.3 Concept, Components and Measurements of Value of the Firm

Concept of value of the firm

A firm raises long-term capital by issuing different types of

securities. The sum of the market values of those securities represents the
market value of the firm. A firm can issue security, by collateralizing its
assets, on which it commits itself of paying fixed return periodically and
repaying the principal at the end of the tenure of the security. This type
of security is called debt instrument. Shleifer and Vishny (1997) argue
that debt instruments are easy to value where there are abundant
collaterals. Again, a fairly certain stream of returns, in case of highly
rated debt instruments, accrues to the debt holders. Since future returns
that are expected to accrue to the debt holders are fairly certain and the
rate of return expected by them is also contractual and fixed so the value
of debt securities is also stable. So according to them, the debt holders
need only to be concerned about the value of the collaterals for
safeguarding their investment value and not with the value of the entire
firm.
Shleifer and Vishny (1997) argue that although its shareholders
own the firm but they are not promised any return on their investment in
the firm and since they have no specific claim on the assets of the firm
they have no right to pull the collaterals. Since they are the residual
claimants they bear the highest proportion of all the risks the firm faces.
Because of these reasons the common shareholders' welfare should be
maximized for inducing them to part with their funds for more risky

46

investments. In a perfect capital market where investors act rationally and

the management of the firm also acts in safeguarding the interests of all
security holders, the market value of a security represents the present
value of the future returns that are expected to accrue to the investors,
discounting the future returns at the rate of return expected by the
investors.
Van Horne (2003) argues that the objective of a firm should be to
create value for its common shareholders and this value is represented by
the market price of its common or equity shares. Since its common
shareholders own a business entity maximization of shareholders' wealth
provides a rational economic criterion for the efficient allocation of
resources and running a business in the society.

Components of the value of the firm

The sources used by the firm for raising its long-term finance can

be divided into debt, preference share capital and common shareholders'

equity. So the value of the firm consists of three components.

Measurement of the value of the firm

The value of the firm (V) represents the sum total of the value of

equity shareholders' funds (E), preference share capital (PF) and debt
(D). So the value of the firm can be measured as follows: V

);;>

E + PF + D

Common Shareholders' equity

The market value of the equity shares outstanding during a year can

be taken as the value of common shareholders' equity for that year. In the
absence of market value, book value of the equity share capital
outstanding plus average retained earnings during that year will represent
the same.

);;>

Preference share capital

47

The market value of the preference shares outstanding during a year

can be taken as the value of preference shareholders' equity for that year.
In the absence of market value, book value of the preference shares
outstanding during that year will represent the same.

Debt
The sum of the market values of long term debt instruments like

debentures, bonds, long-term loans etc. outstanding during a year

represents the value of the debt for that year. In the absence of market
values book values can be considered.

3.2.4 Relationships among These Variables

The value of the firm represents the present value of all future
returns accruing to all the investors of the firm. The investors consist of
the subscribers of various instruments issued by the firm like debt
instruments, preference shares and equity shares. Since retained earnings
would otherwise be distributed to the equity shareholders and should be
reflected in the price of those shares, this is a part of the common
shareholders' equity.
The future returns expected to accrue to a particular class of
securities holders are capitalized at a rate expected by that class of
investors. The future returns and the rate of returns expected by the debt
holders and preference shareholders are contractual and stable and so are
the values of those securities. Thus if the value of the firm is maximized
then the value of the shareholders' equity can also be maximized
assuming that the management is acting in the best interest of its
shareholders besides meeting the fixed claims and safeguarding the
interests of the debt holders and preference shareholders.
The wealth of the shareholders can be maximized, given a rate of
return on investment, if the overall cost of fund with acceptable risk is
minimized. Clerkson and Elliott (1970) state that different types of costs
and risks with varying degrees are associated with each component of
capital. These costs and risks associated with long-term debt differ
48

substantially from those associated with equity financing. Since capital

structure decisions deal with raising of funds from various sources these
decisions aim at minimizing the cost of fund with acceptable level of risk
in order to maximize the wealth of the shareholders of the firm.

3.3

Relationship

between

Financial

Market

Development,

Institutional Factors and Corporate Finance

In a perfect financial market, an equilibrium price (or, interest) is

reached when demand for fund and supply of fund match. So, at the
equilibrium rate of interest, the demand and supply of funds are cleared.
A perfect and efficient financial market is expected to allocate funds to
the most productive uses. The underlying assumptions of perfect and
efficient financial market are as follows:
~

There is a large number of investors.

} All investors are rational.

} Information is available at free of cost to all investors and all
investors are well-informed.
~

All financial assets are infinitely divisible.

All investors have the same subjective probability distribution

about the future benefits that are expected to accrue to them.

} There are no transactions costs and taxes.

A perfect market is expected to achieve efficiencies with respect to
informational asymmetry, valuation of securities, hedging of possible
future risks, allocation of resources and operation of the system. In a
perfect

capital

market,

capital

structure

decisions

do

not

matter

(Modigliani and Miller, 1958).

But a perfect financial market, in its theoretical form, hardly exists
in this world. Moreover, financial markets are regulated and controlled by
the governments. But the extent of regulation and control differs from
country to country and from time to time in case of the same country.
The level of financial market development, institutional and legal
structures, net tax advantage of debt income over dividend or capital
gain, growth rate of the economy, concentration of ownership, market for
49

corporate control and other country-specific factors influence the choice

of finance exercised by the economic entities to a large extent (Report on
Currency and Finance 1999-2000, Reserve Bank of India). Booth et. al.,
(200 1) identify stock market value to Gross Domestic Product, liquid
liabilities to Gross Domestic Product, rate of growth in real Gross
Domestic Product, inflation rate and Miller tax term as the independent
macro-economic proxy variables and corporate level aggregate debt ratios
as dependent variables for assessing the influences of macro-economic
and institutional development on corporate financial

leverage.

The

relationships of these factors with corporate finance are discussed

below:-

Growth rate of the economy

The firms operating in a growing economy find enough growth

opportunities. These firms would select only those projects which are
highly profitable. So profitability of these firms is expected to be high
and these firms are expected to retain more to finance new projects. In
the absence of adequate internal finance firms would raise debt first, then
issue convertible debentures and issue equity shares as the last alternative
(Myers, 1984).

Net tax advantage of debt over equity

The trade-off theory of capital structure supports the use of debt

upto a limit because unlike dividend on equity, interest on debt is tax

deductible. Joseph et. al. (2002) find no direct relationship between debt
financing and tax rate. But higher the tax rate higher is the value of
interest tax-shield other things remaining the same. As the effective tax
rate falls interest tax-shield also falls making debt financing unattractive.
Joseph et. al. (2002) find that, during 1988-96, share of debt finance falls
with the fall in the effective tax rate, which supports the theory. But
Joseph et. al. (2002) argue that decline in the share of debt financing
occurs due to equity market boom.

50

In an efficient capital market investors would only be concerned

with risk and return associated with their investments. And this return
should be the return in the hands of the investors net of all taxes,
corporate as well as individual. Unlike dividend, interest is a tax
deductible expense and taxed only in the hands of the investors. So long
as the net tax advantage of debt is positive in the economy firms may
increase the use of debt in order to take advantage of the cheaper debt all
other things remaining constant. Conversely if the net tax advantage of
debt is negative firms may increase the use of equity. Thus financial
leverage is expected to vary directly with the net tax advantage of debt.

Bank-based vs stock market-based financial systems

With respect to orientation, there are two extreme forms of

financial systems - bank-oriented and market-oriented systems. In a

bank-oriented economy, in the absence of a well-developed stock market,
firms would have to rely on funds from banks when internally generated
funds

are

inadequate

to

finance

the

profitable

new

investment

opportunities. On the other hand, Booth et. al., (200 1) argue that with the
development of the equity capital markets, firms might find it viable to
depend on the equity share capital and make less use of debt. Rajan and
Zingales (1995) argue that orientation of the financial system (whether
bank-oriented or market-oriented) does not affect leverage but influence
the choice of financing between public (bonds and equities) and private
(bank loans). Rajan and Zingales (1995) argue that where banks provide
equity as well as debt finance or where debt as well as equity markets are
developed, firms may not borrow beyond a point and in those cases
orientation of the financial system does not affect the leverage.
Demirguc-Kunt and Maksimivic ( 1996) argue that leverage depends
on the level of stock market development. At the initial level of stock
market development, the quality of information, monitoring and control
of large firms improve significantly and reduce the costs of both external
equity as well as external debt. The aggregation of information by market
about the prospects of the large firms reduces the cost of monitoring of

51

the investors and the financial intermediaries. So firms are induced to

issue new equity. But this also induces the lenders to lend more and
consequently the

debt-equity

ratio

increases. But as stock market

develops further firms substitute debt with equity, internal as well as

external, and consequently leverage falls.

Ownership of banks and financial institutions

In a bank and financial institutions dominated capital market the

ownership pattern of these institutions influences the dependency on debt.

Majumder (1997) argues that the ownership and control of banks and
financial institutions by the Government lead to poor monitoring and
governance of these institutions. This results in lack of efforts on the part
of these institutions to enforce good corporate governance of the firms
which depend heavily

on funds

borrowed from these institutions.

Privatisation and decontrol of these institutions are expected to make

them accountable to their own investors and in that case they are
expected to exert effort to enforce good corporate governance of their
borrowers. This would also benefit the minority shareholders of those
borrowing firms.
So, where financial institutions and banks are subjected to capital
market disciplines and control, these institutions are expected to have
sufficient incentives to monitor and discipline their borrowers.

Market for corporate control

Where a market for corporate control exists, firms may depend on

debt

and

encourage

inter-company

holdings

and

such

other

arrangements to concentrate the ownership of firms in the hands of a few

in order to ward off any hostile takeover threat. Rajan and Zingales
(1995) argue that where a market for corporate control exists, a strong
pressure forces firms to depend more on debt and as firms increase debt
the future cash flows are committed to paying interest making the firms
unattractive to raiders.

52

Law relating to liquidation

Titman and Wessels ( 1988) argue that firms maintain low debt
ratios where liquidation of a firm is costly to the suppliers, workers and
customers. The suppliers of debt are also expected to exert pressure to
contain the proportion of debt in that case.

Concentration of ownership

Friend and Lang (1988) find that leverage decreases as the level of
management's

shareholding

increases

even

when

there

exist

non-

managerial principal stockholders.

3.4

Review of Theoretical Literature

The modern theory of corporate finance and investment starts with

the celebrated paper of Modigliani and Miller (1958) where they show,
under the following assumptions, that the cost of capital and value of the
firm are independent of its capital structure or financial leverage:};>

The stream of income available to shareholders extends indefinitely

into the future. The mean value of the stream of income over time
represents a random variable subject to a subjective probability
distribution. The probability distributions of the expected income
of all investors are identical.

);>

Firm distributes all its net profits to its shareholders. Retained

earnings, if any, are regarded as issued and fully subscribed
common shares.

);>

Firms can be divided into equivalent risk classes. This also implies
that within a group, firms are perfect substitutes for each other.

);>

Securities are traded in a perfect capital market.

);>

There is no tax.
On the basis of these assumptions they provide the following

propositions:-

53

Proposition 1: The market value (V) of any firm is independent of its

capital structure and is given by capitalizing the expected income (EBIT)
at the rate k appropriate to its risk class. So, in equilibrium, they getV = E + D = EBIT I k, where, E and D represent the market value

of equity shares and debt respectively.

This follows that k= EBIT IV and so the average cost of capital (k)
of a firm is entirely independent of its capital structure.
Proposition II: The expected rate of return on investment m common
stock (kc) is equal to the average cost of capital (k) plus a premium for
financial risk equal to debt-equity times of the spread between k and the
rate of interest (i.e., cost of debt) (kd). So they get-

ke

k + (k - kd) DIE

Proposition III: A firm that acts in the best interest of its shareholders
accepts only that investment opportunity which generates a rate of return
which is at least equal to its cost of capital.
So Modigliani and Miller (1958)

argue

that

substitution of

expensive equity with cheap debt does not yield any effect on the value of
the firm since the overall cost of capital remains constant because the
favourable effect of cheap debt is nullified by an exactly unfavourable
effect of expensive equity. So, Modigliani and Miller (1958) argue that
financial innovation does not matter.
On

the

basis

of the

costlessly

enforceable

'me-first

rule'

assumption which protects the characteristics of the payoffs on the firm's

outstanding debts, Fama (1978) argues that maximising the combined
wealth of the shareholders and debtholders is the only criterion that is
consistent with a stable equilibrium and the market, in its capacity as a
price setter, can provide incentives for firms to choose this criterion.
Fama (1978) argues that, in equilibrium, the market value of the firm is
always the value implied by an optimal capital structure irrespective of
the capital structure chosen by the firm. So according to Fama ( 1978), the
value of the firm is independent of its financing decisions.
But in reality capital structure decisions do matter due to various
imperfections.

54

Durand

( 1961)

severely

criticizes

the

assumptions

on

which

Modigliani and Miller's propositions rest. He argues that the assumptions

are extremely restrictive and are difficult to apply operationally. He
argues that the effectiveness of arbitrage depends on the possibility of
exchange of securities of two companies but perfect substitution of
securities is not always possible. Secondly, a demand loan on personal
account of the investor is not a perfect substitute of a corporate bond due
to limited liability of investors in case of the later. Thirdly, market
restrictions, institutional arrangements and legal measures restrict margin
trading. Thus buying shares by borrowing funds is restricted. Fourthly, if
a long-run equilibrium, at which shares are sold at book value, is not
achieved,

Modigliani

&

Miller's

assumption

to

regard

retention

equivalent to fully subscribed issue of common stock, does not hold good.
But in real world shares are hardly traded at book value.
We have divided the literature survey section into theoretical and
empirical works. The theoretical works are followed by the empirical
evidences.
The main approaches to capital structure theories are described as
follows:

Trade-off Theory
Trade-off theory can be presented with the help of following
assumptions:

Firm can raise funds from various sources which can be broadly
divided into debt and equity.

The use of these sources has costs as well as benefits.

Interest on debt is tax deductible.

Use of debt is associated with the possible financial distress and

agency costs.

The greater the level of debt higher is the probability of financial

distress and agency problem.

Each and every firm has its own peculiarities or attributes.

Managers act in the best interests of firm's shareholders.

55

Investors are rational.

Capital markets are perfect.

The investments and business risk of the firm are given.

On the basis of these assumptions, this theory predicts that a firm

IS

expected to select that capital structure which trades off the benefits

(i.e., present value of interest tax shield) of debt with the possible
financial distress and agency costs (i.e., present value of expected
financial distress and agency costs), after considering its own attributes.
This capital structure maximizes the value of the firm and is the optimal
capital structure of that firm. The value of the firm is maximized when
the overall capitalization rate or cost of capital is minimized given the
return on investment in the assets of the firm.
VL = Vu + {teD- (CF + CA)}

where,
V L = value of levered firm,
V u = value of unlevered firm,
teD =present value of expected debt tax shield,
CF = present value of the possible financial distress costs,
CA =present value of the possible agency costs,
Trade-off theory explains why profitable firms having stable and
tangible assets tend to have high optimal debt-equity ratio. This is
because the tax benefit associated with debt tends to be high and the costs
of financial distress and agency costs tend to be low. On the other hand,
unprofitable firms having risky and intangible assets tend to have low
optimal debt-equity ratio because the tax benefit of debt tends to be low
and the financial distress and agency costs tend to be high (Chandra,

2002).

Agency Theory
The emergence of large-sized joint stock compames paved the
separation of ownership and management. These firms are owned by a
well-dispersed large number of shareholders called principals. These
firms are managed by managers who act as agents of the shareholders. A

56

firm can raise funds by issuing equity and debt instruments. The
objectives of debt holders may be to have fixed but secured returns, the
goals of equity shareholders may be to have risky but maximum returns
and managers may aim at increasing their own benefits at the cost of the
shareholders.
Jensen and Meckling (1976) identify two types of conflicts.
Assuming that managers do not hold I 00% of the equity of the firm,
conflict arises between shareholders and managers. The managers cannot
capture the entire gain which arises out of their value increasing
activities but bear the entire cost of these activities and consequently
they are interested in increasing their own benefits instead of maximising
shareholders' wealth. Jensen and Meckling (1976) predict that larger is
the fraction of equity owned by the managers, lower is the possibility of
loss of value due to this type of conflict. Given the total absolute
investment in the firm and absolute investment in equity owned by the
managers, the fraction of equity owned by managers increases with the
increase in the proportion of debt.
The second type of conflict arises between debt holders and equity
shareholders. The managers, acting in the best interests of the equity
shareholders, would seek to undertake risky projects so that the wealth of
the shareholders increases (in the event of success of the projects) at the
expense of the debt holders who have to bear the loss in the event of
failure of the projects. In short, shareholders enjoy the upside potential
but debt holders suffer the downside risk associated with the risky
projects. In order to protect their interests, debt holders would seek
restrictive covenants which would restrict the operational flexibility of
the managers resulting into inefficiency. Debt holders would also seek to
monitor the adherence of the firm to the covenants. The loss of value due
to inefficiency and cost of monitoring will be borne by the shareholders.
Jensen and Meckling (1976) predict that an optimal capital structure can
be arrived at by trading off the agency cost of debt and the benefits of
debt.

o
Jensen (1986) argues that the conflicts of interests between

shareholders and managers over dividend payout policies are severe

57

where firm generates substantial free cash flow which is left with the firm
after funding all profitable projects available to the firm during any given
planning period. Managers will have the incentive to increase their
perquisite or use free cash flow sub-optimally to maximise 'corporate
wealth' instead of 'shareholders wealth'. Managers can also increase
dividend payment or repurchase stock but they may not be able to
maintain high rate of dividend payment m future. Consequent cut m
dividend payment may be punished by capital markets by a large
reduction in share price. Jensen (1986) argues that debt can be an
effective substitute for dividends and can motivate managers to be
efficient in order to service the debt. Thus, Jensen (1986) argues that in
case of firms generating large cash flows but have low growth prospects
or may shrink, debt reduces the agency costs of free cash flow by
reducing the cash flow available for spending at the discretion of
managers. This 'control effect' is a potential determinant of capital
structure.

Market Timing Theory

Baker and Wurgler (2002) explain the equity market timing theory
on the basis of the following assumptions:~

Capital markets are inefficient and segmented.

Managers believe that they can exploit the 'mis-pricing' of

equity. shares by investors by timing the issue of shares.

Managers

act

in

the

best

interest

of

the

ongoing

shareholders.
~

The possibility of 'mis-pricing' of shares at different times

by irrational investors exists.

On the basis of these assumptions this theory predicts that firms are
expected to issue equity shares when market value of shares is high as
compared to their book value or past market value and repurchase shares
when market value is low. By exploiting the temporary fluctuations in the
market prices, market timing benefits the ongoing shareholders at the
expense of new and departing shareholders. Baker and Wurgler (2002)
argue that capital structure is determined by the cumulative effect of the
58

past attempts of the firm to time the equity market and so optimal capital
structure does not exist according to this theory.

Models based on financial signalling

Being insiders managers know more about the firm than outsiders.
Managers use capital structure changes to convey information about the
profitability and risk associated with investments undertaken by the firm.
Increase in leverage increases the possibility of bankruptcy and the
possibility of imposition of penalties, through contracts, on managers if
bankruptcy occurs. So, managers are expected to issue debt when they
have good reason to believe that the project is profitable and sound.
Again, managers, acting in the best interests of the current shareholders,
will issue shares if shares are overvalued and raise debt if shares are
undervalued (Myers and Maj luf, 1984 quoted in Myers, 200 I). Investors
are also expected to know this and treat equity issue as 'bad news' and
debt issue as 'good news' and react accordingly. Thus changes in capital
structure of a firm give signal to the market. The greater the

as~mmetry

of information between insiders (i.e., managers) and outsiders (i.e.,

investors) the greater the possibility of share price reaction to a financing
announcement (Van Horne, 2003, p- 278).
Let us consider the 'pecking order theory' which is based on
asymmetry of information.

Pecking Order Theory

Myers ( 1984 ), while presenting this theory, makes the following
assumptions:);>

Managers act in the best interest of the existing shareholders of the

firm.

);>

Firm has assets-in-place and a new growth opportunity which needs

to be financed.

);>

Managers know the real worth of the assets-in-place and the new
opportunity.

);>

Investors do not know the real worth of the existing assets or the
new opportunity but the subjective probability distribution of those
59

values is same for all investors. Excepting this capital market

IS

perfect in its semi-strong form of efficiency.

So under this theory there exists the problem of asymmetric
information. The investors can overvalue or undervalue the real worth of
the assets-in-place and the new investment opportunity. Managers acting
in the best interest of the existing shareholders will not issue shares when
assets-in-place or growth opportunity is undervalued, rather they will
issue secured debt which passes either no value or minimum value to the
new investors when inside information is revealed to them. An overvalued
firm may issue shares only when the overvaluation is higher than the
expected loss of wealth of the existing shareholders arising out of the
expected fall in prices which may happen if the new investors bring down
the prices when they come to know the real worth of the assets-in-place
and the growth opportunity. The new investors also know the intensions
of the managers and so they will refuse to buy the overvalued securities
or force the firm to reduce the price of the securities. In that case, firm
may reject a project having positive net present value (NPV) which is an
opportunity cost to the existing shareholders. In order to overcome this
problem, Myers (1984) argues that firms always prefer internal finance.
When external finance is required to be raised, firms issue secured debt
first then they issue convertible debt and equity shares are issued as the
last resort. So, according to Myers ( 1984) the amount of debt represents
firm's cumulative need for external finance. So, according to this theory,
optimal capital structure does not exist.
This theory was first established by Gordon Donaldson ( 1961 ). It
explains why profitable firms borrow less because they don't need much
external finance. On the other hand, less profitable firms borrow more
because, in their cases, internally generated funds are inadequate to meet
the

requirement

of

funds

to

finance

the

profitable

investment

opportunities and so they raise external funds in which case debt is

preferred over external equity.

3.5

Review of Empirical Literature

60

Since an efficient and perfect capital market in its theoretical form

hardly exists in reality financing decisions matter even in the developed
economies. The macro-economic, institutional and legal frameworks
governing an economy also influence the financing choices of the firms.
The review of the following empirical works based on Indian as well as
foreign experiences, helps to understand why financing decisions matter.

Let us start with the review of the foreign empirical literature:

Harris and Reviv ( 1991) survey a number of literatures and find a

large number of potential determinants of capital structure. This survey
of literatures indicates that leverage increases with fixed assets, non-debt
tax shields, growth opportunities and firm size and decreases with
volatility,

advertising

expenditures,

research

and

development

expenditures, bankruptcy probability, profitability and uniqueness of

product. But this survey fails to identify the factors which are important
in different contexts. This implies that different predictions can be made
on the basis of different models in a particular situation. Despite
differences, Harris and Reviv (1991) find that all models predict increase
in stock prices on announcement of leverage increasing capital structure
changes.

Titman and Wessels ( 1988) find that the uniqueness of a firm (that
produces a unique product) is highly negatively related to the long-term
debt ratios. They argue that where liquidation of a firm is costly to the
suppliers and workers (since they have job specific skills and technology)
and customers (since they may find it difficult to service the unique
products from alternative sources), firms maintain low debt ratios. They
also find a negative relationship between short-term debt ratios and the
size of the firm. They argue that small firms find it difficult to raise longterm funds due to high transaction costs. Moreover, the performance of
sma11 firms is highly sensitive to the temporary economic downturns
which do not significantly affect the large firms. They find a negative

61

correlation

between

profitability

and

debt

to

market

value

of

shareholders' equity ratio.

Hovakimian et. al., (200 1) find that in the long run, firm tends to
move towards its target debt ratio. They find that more profitable firms
have lower debt ratio due to retention of profit but these profitable firms
are expected to raise debt than equity or repurchase equity than debt to
offset the effect of retention. They also find that firms with higher
current share price relative to book value or past share price or earnings,
are expected to issue equity than debt. They argue that higher share prices
are expected to be experienced by those firms which have better growth
opportunities.

Friend and Lang (1988) find that leverage decreases as the level of
management's

shareholding increases even when there exists non-

managerial principal stockholders who have sufficient investment in the

firm to warrant the effort for monitoring and influencing the management
to use optimum a!llount of debt that maximises the value of the firm.
However, Friend and Lang (1988) find that corporations with nonmanagerial large stockholders have significantly higher leverage than
corporations with no principal stockholders. This suggests that nonmanagerial large stockholders might exert effort to make coincide the
interests of managers and public stockholders.

Baker and Wurgler (2002) find that, in an inefficient and segmented

market, low leverage is associated with firms which raise equity capital
when their market valuations are high and high leverage is associated
with those firms which raise equity capital when their market valuations
are low. They find a strong and persistent negative correlation between
leverage and the historical market valuations of the firm. They also find
that the influence of this independent variable on leverage is stronger
than the influence of other variables which affect the capital structure
choice. Baker and Wurgler (2002) argue that the main objective of equity
market timing is to exploit the 'mis-pricing' of shares by the investors
62

and this is an important feature of capital structure decisions, which

benefits the ongoing shareholders at the expense of the new and departing
shareholders assuming that managers act in the best interests of the
ongoing shareholders.

Huang and Ritter (Forthcoming), usmg firm-level data for the

period 1964 to 2001, find, using equity risk premium, that U.S. firms use
external equity financing when cost of equity share capital is low. They
also find that historical cost of equity share capital has long-lasting effect
on firms' capital structure.

Stock market liberalisation

allows

sharing

of risks

between

domestic and foreign investors resulting in reduction in cost of equity

capital (Stulz, 1999 quoted in Henry, 2000). Holding future expected cash
flows constant, decrease in cost of equity would result in an increase in
equity price index. Moreover, projects which had negative net present
value before liberalisation would become profitable after liberalisation
due to fall in cost of equity capital (Henry, 2000). Stulz (1999) (quoted in
Henry, 2000) argues that domestic price per unit of risk is greater than
the global price of risk. Henry (2000) finds a fall in the aggregate cost of
equity capital following liberalisation and integration of a country's stock
market with the global market.

Davis and Stone (2004), using corporate-level data for the year
1999, find that emerging market corporate sector depend more on external
financing and specifically on finances from banks and has higher debtequity ratio than the corporate sector of the industrialised countries.

Rajan and Zingales (1995) undertake a study to show that the

determinants of capital structure of the US based firms are similarly
related to capital structure of the firms based at other G-7 countries. This
study also analyses the major institutional differences across the G-7
countries and their probable influence on the capital decisions. Rajan and
Zingales (1995) specifically examine the effect of accounting practices,
63

tax rates, bankruptcy laws, market for corporate control and bank verses
market-oriented financial system on the firm-level determinants of capital
structure. This study covers the period 1987 to 1991 and focuses on nonfinancial corporations. Raj an and Zingales ( 1995) find that despite the
institutional differences the variables that are correlated with leverage in
the USA appear to be similarly correlated in other industrialized
countries although the regression coefficients vary across countries.
Moreover, the theoretical explanations drawn from the experience of the
USA seem not to be strong in explaining the observed correlations
between variables in other countries. Rajan and Zingales (1995) consider
tangibility of assets (measured by fixed assets to total assets ratio),
growth opportunity (measured by market to book ratio), size of the firm
(measured by log of sales) and profitability (measured by earnings before
interest, tax and depreciation to book value of assets) as the firm-level
determinants of capital structure.

Booth et. al., (200 1) analyze the capital structure choices of firms
belonging to ten developing countries having different macro-economic
conditions, institutional and legal frameworks and diverse culture. Their
study covers the period from 1980 to 1990. They find that the firm
specific variables that are found to be relevant for capital structure
choices in the developed countries seem to be similarly correlated in the
developing countries. But the magnitudes of correlations of those
variables with leverage are found to vary widely among countries
indicating the weaknesses of their explanatory powers and probably
indicating the importance of the country specific factors in explaining the
capital structure choices. Booth et. al., (2001) consider average tax rate,
asset tangibility, profitability (measured by earning before tax to total
assets), business risk (measured by standard deviation of return on
assets), growth opportunities (measured by market to book ratio) and size
(measured by log of sales/1 00) as the determinants of capital structure.

Demirguc-Kunt and Maksimovic (1996b) examine the effect of

financial market development on the financing choices of firms. The
64

aggregated firm-level data for a sample compnstng of thirty developed

and developing countries, from 1980 to 1991, is used for this study.
Demirguc-Kunt

and

Maksimovic

(1996b)

examine

what

extent

of

variation in the debt-equity ratio within these countries is explained by

the level of financial market development, macro-economic factors, the
differences between the tax treatment of debt and equity incomes and the
firm-specific factors. Taking all the countries together, Demirguc-Kunt
and

Maksimovic

(1996b)

find

statistically

significant

negative

correlation between stock market development and leverage and a

statistically significant positive correlation between the size of the
banking sector and leverage. But after controlling the effect of firm-level
determinants of financial

structure Demirguc-Kunt and Maksimovic

( 1996b) find that in case of developing economies, as the stock market

develops, large firms become more levered but the small firms do not get
affected significantly. But in case of developed economies, as the stock
market develops further, firms substitute long-term debt with equity and
consequently leverage falls. Demirguc-Kunt and Maksimovic (1996a) find
that corporate debt-equity ratios initially increase by 10% when less
developed stock market doubles but decrease by 25% when stock market
quadruples. Demirguc-Kunt and Maksimovic ( 1996b) argue that the initial
development of stock market facilitates aggregation of information by the
market about the prospects of large firms only since it is cost effective
for the market to gather and disclose information on those firms whose
stocks are traded frequently and in large volumes and quite naturally they
attract the interests of the analysts. Demirguc-Kunt and Maksimovic
(1996b) argue that at the initial stage, as stock market develops, the
quality of information, monitoring and corporate control improves
significantly, which induces the lenders to lend more although debt does
not increase at the cost of equity but equity issues complement the bank
loans and debenture/ bonds issues. As stock market develops further firms
start substituting debt with both internal as well as outside equity and
consequently debt-equity ratio falls.

65

Using aggregate firm-level data for a sample of twenty-one

emerging markets from 1980-1997, Agarwal and Mohtadi (Forthcoming)
find that stock market development reduces financial leverage while
credit market development increases it. They find that foreign direct
investment reduces financial leverage in the short-run but in the long-run
it does not have significant influence. They also find that domestic
investment is significantly positively related to long-run debt-equity
ratio.

Desai, Mihir A., Foley C. Fritz and Hines, James R. Jr. (2006),
using firm-level data for the period 1982 to 1999 of U.S firms operating
abroad, find that foreign subsidiaries of American multinational firms,
located in politically risky (which indicate higher business risk for the
subsidiaries) countries have higher financial leverage than other foreign
subsidiaries of the same multinational parents. American multinational
firms are also more likely to share ownership of their foreign subsidiaries
located in politically risky countries with local partners. They argue that
in order to mitigate the political risks, even when external financing is
costly, American multinational firms shift some of the risks to foreign
capital providers and foregoes some of the benefits of high level of
financial leverage. These multinational firms also reduce their domestic
financial leverage.
The data used in these studies are old and are not very relevant.
Moreover, the Indian financial system had been repressed before the early
1990s. Since the early 1990s, the financial sector reforms in India have
been initiated with the intention to unshackle the financial system from
the clutches of the bureaucrats of the Government. Our study aims at
examining the financing choices of the Indian companies in the changed
scenario.

Empirical literatures based on Indian works are summarized below:

Bhole and Mahakud (2004) find a negative correlation between

leverage and cost of debt but the regression coefficients for the pre and
66

post liberalization periods are not significant but it is statistically

significant for the whole period only. The correlation between leverage
and cost of equity (measured by dividend to share .capital) is found to be
positive and significant during the entire and the pre-liberalisation
periods but not significant during the post-liberalisation period. The size
of the firm is found to have significantly positive correlation with the
leverage during all the periods. It is found that profitability is negatively
correlated and growth rate is positively correlated with leverage although
the regression coefficients are not significant. The collateral value of
assets is positively correlated with leverage and significant for the whole
period but the relationship is not significant during the pre- and postliberalisation periods. Liquidity is found to be significantly negatively
correlated with leverage. Non-debt tax shield is found to be negatively
correlated with leverage but the regression coefficient for the postliberalisation period is not significant. They describe 1984-85 to 1991-92
as

pre-liberalisation

liberalisation period.

period

and

1992-93

to

1999-2000

Bhole and Mahakud (2004)

argue

as

post-

that size,

liquidity, cost of debt, collateral value of assets, cost of equity and nondebt tax shield are the major determinants of capital structure in India.
This study does not specifically examine the effect of economic reforms
on the determinants of capital structure of firms and explain their
behaviour.

Majumder

(1997)

finds

significantly

negative

relationship

between the debt-equity ratio, the principal explanatory variable, and

profitability (measured by profit to sales ratio), the dependent variable.
The period of study is 1988 to 1994. This finding does not support the
accepted theory developed on the basis of the experiences of the
capitalist societies and the political and economic environment of the
west. In India, the institutions which supply debt, both short-term as well
as long-term, are mainly owned and controlled by the government and
have been very liberal with their lending decisions, poor in monitoring
their borrowers and recovering loans. On the other hand, they are not
subjected to discipline by their owners, he argues. These institutions are
67

also encouraged to lend in order to meet the policy goals of the

government. In some cases, they lend funds to large corporates on
political considerations too. The absence of a market for corporate
control helps Indian firms to avoid the capital market discipline and
control. These institutional factors which are different from those of the
west, strongly affect the behaviour of firms. Mazumder (1997) argues that
the entry of foreign institutional investors and privatization of the state
owned Indian financial institutions may improve the role of debt in
ensuring

supenor

corporate

performance.

This

study

specifically

examines the role of Indian institutional lenders in ensuring the efficient

utilisation of resources and protecting the interests of the minority
shareholders.

Pandey (200 1) finds significant announcement effect associated

with

takeovers

in

India

but

post

announcement,

these

gains

are

substantially eroded implying that private benefit of control rather than

potential economic value of the firm is the main driver of market for
corporate control in India.

Joseph et. al., (2002) find that Indian firms were heavily dependent
on external sources since internally generated funds were insufficient to
meet the funding requirements of new investment opportunities. During
the pre-liberalization period, due to the dominance of credit market, firms
were highly dependent on loans from banks and developmental financial
institutions. The significance of the stock markets has been increasing
since the mid 1980s. During the initial years of financial market reforms
(i.e., during the early 1990s), due to increase in flows of funds to the
stock markets from domestic and foreign sources, firms were tapping the
market with equity issues. However, bank credit again picked up in
subsequent years. As the dominance of the stock markets increases, the
importance

of the

equity

shareholders

(specially

the

institutional

shareholders) is bom1d to increase in monitoring and disciplining firms.

The competition in the market for corporate control can provide the
ultimate discipline in a market dominated economy. Joseph et. al., (2002)
68

argue that in bank-dominated Indian economy, both the credit and stock
markets will play important roles in monitoring and disciplining firms
and in improving corporate governance of these firms. The study covers
the period 1971-72 to 1995-96. But after this period significant changes
have taken place in the Indian financial system and efforts have been
made to improve the corporate governance practices in India. Our study
will cover the changes that have been made in recent times also.

69