Determinants of

Capital Structure: An
Empirical Study of
Indian Manufacturing
Companies
Financial Management II Report

Determinants of Capital Structure: An Empirical Study

of Indian Manufacturing Companies
Introduction
Companies have been struggling with capital structure for more than four
decades.
Despite decades of intensive research, and hundreds of papers after Modi
gliani and Millers seminal work, surprisingly there is lack of consensus ev
en today among the finance experts on this basic issue of corporate financ
e. In practice, it is observed that finance managers use different combinati
ons of debt and equity. Academicians and practitioners alike have found it
difficult to find out how a firm decides its capital structure in the perfect ca
pital markets
the west as well as in the imperfect capital markets, as in India. This has l
ed to an upsurge in research on company finance, particularly aimed at un
derstanding how companies finance
their activities and why they finance their activities in these specific ways.
A practical question therefore is: What determines the capital structure?
This report undertakes study of firm level data of nearly 200 major
manufacturing companies listed in BSE, taken from 6 different sectors and
attempts to identify main determinants of capital structure for the period
of one year. Our purpose of this exercise is to verify whether any
particular theory can characterize Indian corporate behaviour in
determining capital structure. The central issue we will address is to
examine empirically the existence of inter-firm and inter-industry
differences in the capital structure of Indian firms and identify the possible
source of such variation in capital structure. Efforts will be made to find
out the factors that determine the financing pattern of capital structure of
Indian manufacturing companies
Capital structure represents the proportion in which various long-term
capital components are employed. Over the years, these decisions have
been recognized as most important decisions that a firm has to take. This
is because of the fact that capital structure affects the cost of capital, net
profit, earning per share, and dividend payout ratio and liquidity position
of the firm. These variables coupled with a number of other factors
determine the value of a firm. So, capital structure is a very important
determinant of the value of the firm.
Modigliani and Miller were the first people to try to determine the ideal
capital structure and value of firm.In their research they concluded that
the value of the firm is self-determining of capital structure and that the
value of an unlevered firm is equal to that of a levered firmbased on the
assumption of absence of taxes. This assumption was considered

Determinants of Capital Structure: An Empirical Study

of Indian Manufacturing Companies
unrealistic and in their subsequent research Modigliani and Miller took tax
into consideration and concluded that because of tax shield on debt as a
factor, the value of a levered firm was more than the value of an
unlevered firm and that this value was equal to the value of the tax shield.
According to Jensen and Mackling, the optimal capital structure is
obtained by trading off the agency cost of debt against the benefit of
debt. Here, Jensen and Mackling first identified disputes between
shareholders and managers because of managements ownership being
less than 100% of the equity. Jensen proposed that this problem could be
reduced by increasing the percentage of shares owned by the manager or
by increasing debt in the capital structure. This would result in the
reduction of the amount of unused cash available to managers. This would
eventually benefit debt financing. Agency models have shown a positive
relation between leverage and firm value, regulatory abidance, probability
of defaults, value at the time of liquidation, freely available cash flows and
the significance of managerial reputation. Leverage is expected to be
negatively correlated with interest coverage, growth opportunities, and
possibility of reorganization following default.
Besides, a lot more work has been done on this problem till now, but a
formal model, showing the mechanism for determining an optimal
structure in an imperfect market, is yet to be developed.
Research methodology
Scope of the study
The proposed research is intended to examine the trend and pattern of
financing the capital structure of Indian companies. The central issuewe
will address is to examine empirically the existence of interfirm and inter
industry differences in the capital structure of Indian firms andidentify the
possible sources of such variation in capital structure in order to find out
the factors that determine the financing pattern of capitalstructure of
Indian companies, particularly in the private sector.
Source of the data
For our study purpose, only secondary data is used which is sourced from
the website www.moneycontrol.com.
Techniques used for Analysis
The data collected from the financial statements of the companies are
analysed with the help of the correlation analysis.

Determinants of Capital Structure: An Empirical Study

of Indian Manufacturing Companies
Limitations of the study
Some of the limitations of this study are that we took only data of one
year and we assumed that the nearly 200 companies across 6 sectors are
representative of whole Indian companies.
Determinants of capital structure
Capital structure of a firm is determined by various internal and external
factors. External factors that affect the capital structure of a firm include
taxpolicy of government, inflation rate, and capital market condition. In
thissection we discuss some of the internal factors that we consider to
affect the capital structure of a firm with reference to capital structure
theories.
Current Ratio:
The current ratio is a liquidity ratio that measures company's ability to pay
short-term and long-term obligations. Current ratio considers the total
assets of a company (both liquid and illiquid) relative to that companys
total liabilities.
The formula for calculating a companys current ratio is:
Current Ratio = Current Assets / Current Liabilities
The current ratio is called current because it incorporates all current
assets and liabilities. The current ratio is also known as the working
capital ratio.
Debt to Equity Ratio:
Debt to Equity Ratio is a debt ratio used to measure a company's financial
leverage. It is calculated by dividing a companys total liabilities by its
stockholders' equity. The Debt to Equity ratio indicates how much debt a
company is using to finance its assets relative to the amount of value
represented in shareholders equity.
The formula for calculating Debt to Equity ratios is:
Debt to Equity Ratio = Total Liabilities / Shareholders' Equity
Long term debt to Equity Ratio:
Long term Debt to Equity ratio is a way to determine a company's
leverage in risk analysis. It is calculated by taking the company's long-

Determinants of Capital Structure: An Empirical Study

of Indian Manufacturing Companies
term debt and dividing it by the total value of its preferred and common
stock. The greater a company's leverage, the higher the ratio.
The formula for calculating Long term Debt to Equity Ratios is:
Long term Debt to Equity Ratio = Long-term debt / (Preferred stock +
Common stock)
Operating Income:
Operating income is the amount of profit realized from a business's
operations after taking out operating expenses. Operating expenses
includes cost of goods sold (COGS) or wages and depreciation. Operating
Income is synonym for earnings before interest and taxes.
The formula for calculating Operating income is:
Operating Income = Gross Income - Operating Expenses - Depreciation&
Amortization
Net Debt:
Net Debt is the sum of all short term debt, and notes payables, Long Term
debt and preferred equity minus the total cash and equivalents and short
term investments
Cost of debt (COD):
Cost of debt is the effective rate that a company pays on its current debt.
Cost of debt can be measured by either before- or after-tax returns. Cost
of debt is one part of the companys capital structure, which also includes
the cost of equity.
Data analysis
We started the analysis of the collected data by grouping them into
respective industries. As different industries behave differently this would
give better results. Next we tried to establish correlation between capital
structures (Current ratio, Long term debt to equity ratio, and debt to
equity ratio) with its determinants which were explained above. An
attempt has been made to analyse and interpret the trend and pattern
structure of each group of sample companies. The required data is
obtained by aggregating the data ofsample companies belonging to a
particular group. Log functions are taken to account for the differences in
the small ratios and large investment and debt amounts.
Findings & observations

Determinants of Capital Structure: An Empirical Study

of Indian Manufacturing Companies
It is found that there is a strong correlation on operating income and total
assets on Debt to Equity ratio, Long term Debt to Equity ratio. The cost of
debt has also high correlation with Debt to Equity ratio as well as Long
term Debt to Equity ratio. It has a significance level of 99% in some cases.
These are the some of the major correlations that are found in the
analysis. The other results are attached in the excel files.
Conclusion
Barring to a few exceptions,it was found that companies mostly prefer
internal funds as compared to external funds. When it comes to external
funds, the companies seemed to raise more funds through debt capital as
compared toequity, may be due to the reason of easy and availability of
cheap debt capital. The debt to equity ratio is observed to be different for
different industries, which is to be expected considering the different
types of business risk associated. To sum up, Indian companies prioritize
their sources of financing(from internal financing to equity) according to
the law of least effort, or of least resistance, preferring to raise equity as a
financing means oflast resort. Hence internal funds are used first, and
when that is depleted debt is issued, and when it is not sensible to issue
any more debt,equity is issued. Equity capital as a source of fund is not
preferred across the board. This shows that somewhere or other, the
financing patternof Indian private sector companies is in line with the
packingorder theory.
References
1. Brealey, and Myers, Principles of Corporate Finance, 6th ed., McGraw
Hill.
2. A study on determinants of capital structure in India AnshuHandoo,
Kapil Sharma.
3.Jagannath Panda, andAshok Kumar Panigrahi,Determinants Of Capital
Structure: An Empirical Study Of Indian Companies.