CHAPTER 5

Review of Literature

179
 CHAPTER 5

Business theory draws heavily from Economics and Social

sciences. Profitability and productivity are the two yardsticks against
+which the performance of any business organization is being measured.
Before the industrial revolution, business system was simple and the
organizations were relatively small. The advent of mechanization,
increase in the volume of business and invention of Company form of
organization required that the financial transactions of the business need
be more scientific and organized. The science of book keeping, which
was invented in 1494, was the obvious remedy to record, monitor and
control the commercial transactions of various businesses.
Book keeping and Accounting are the fore runners of Finance. In fact, the
science of financial management is based on Accounting and Economics.
Accounting is defined as the art of recording and summarizing business
transactions and of interpreting their effect on the affairs and activities of
an economic unit. l This definition given long back in 1955, is referring to
management's use of accounting data for quantifying and appraising of
the business activities. Another definition by a well known author is :
Accounting deals almost exclusively with data that can be measured and
reported in monetory terms.2 Business is concerned with money, and the
measure and reporting is thro accounting mechanism. Accounting has
often been called the language of business because people in the business
world - owners, managers, bankers, brokers, lawyers, engineers, and
investors use accounting terms and concepts to describe the events that
make up the existence of business of every kind.3

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 John Myer, a renowned authority on Financial Statements
Analysis, has referred that in the initial years of 20th century, the bankers
and securities exchange authorities were extensively relying on the
financial statements of the companies for analysis, monitoring and control
of the activities and performance of businesses. The history, principles
and financial statement analysis has been referred by another authority
also : Kennedy and McMullen.4
Literature on Economics also has a reference to accounting and
financial management. The aim of financial management has been linked
with (1) the field of basic economics, and especially micro economics
(use of scarce resource). (2) by examining the many and diverse activities
and decisions which occupy financial managers.
Long back (1957), EF Donaldson referred to the importance of
business and financial reporting. He highlighted that the economy
depends on the business organizations for goods and services. United
States believes in corporate world. The financial activities of business
enterprises of production and sale is of utmost importance. In his well
known publication (Corporate Finance, 1957) he has referred to all
important aspects of business finance like organization structure,
securities, production, capitalization, working capital, administration of
income, expansion and combinations (mergers), reorganization and
readjustments.
Another authority has aptly said that: Accounting is a systematic
means of writing the economic history of an organization.5 Here there is a
reference that the economic activity of any business enterprise is
involving money and accounting is concerned with record keeping of

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such monetary transactions of the business. The authority has referred
that invention and growth of corporations (company form of
organization) and need for keeping monetary records of growing and very
large businesses were the basic reasons for the phenomenal development
of accounting science and importance of financial statements as well as
its analysis. This data was useful to the owners, government, customers,
investors and the society. The important principles of verifiability,
objectivity, consistency and comparability were developed, so that the
statements become more reliable and useful. The authors have also
mentioned that in the initial period of twentieth century, the following
principles of management accounting were evolved and developed. (1)
Relevance. (2) Flexibility. And (3) Timeliness.
Another definition by a well known author can also be referred :
Accounting is score keeping, attention directing and problem solving.6
This authority states that accounting system provides information for
three broad objectives. (1) Internal reporting to managers for use in
planning and control of current operations. (2) Internal reporting to
managers for use in strategic planning, and (3) external reporting to
owners, government and other outsiders. As a score keeping activity, all
relevant data are generated by the system which becomes a guide for
attention directing and problem solving in different areas like inventory,
production, sales etc. The authors have referred to important aspects
accounting principles, importance of Annual Reports, measurement of
income, marginal costing and efficiency.
Robert Anthony, Professor of Accounting and Financial Control at
Harvard University has written many authoritative books on accounting

182
and financial management. He defines Accounting as a means of
collecting, summarizing, analyzing and reporting in monetary terms,
information about the business. This simple definition highlights the
importance of accounting and financial information in the business
enterprise. There is a reference to the following accounting principles and
scope of the field of accounting and finance.
Principles :
(1) Objectivity. (2) Going concern. (3) Realisation. (4) Matching
and constant rupee measurement. (5) Consistency. (6) Verifiability.
(7) Conservatism.(S) Disclosure. And Economic feasibility.
Scope :
(1) Accounting Concepts. (2) Records, measurement. (3) Financial
Statement Analysis. (4) Performance appraisal and control. (5) Behaviour
of costs in the organization. (6) Choices of decision making.
Another well-known publication on Financial Management,
Financial Decision Making By John Hampton (1983) covers authoritative
and lucid exposition on the subject covering : Financial accounting,
Financial Statements, Financial analysis, Leverage, Working capital,
capital Budgeting, valuation of the Firm, Mergers, acquisitions and
reorganization And Financial decisions.7
The fundamental behaviour of finance is based on two basic
variables of (a) risk and (b) uncertainty. Both refer to situations in which
future outcomes are imperfectly known. The term risk commonly denotes
only those future events in which the probabilities of alternative possible
outcomes are known. Objective probability is a measure of the relative
frequency of alternative events, and is strictly applicable only to those

183
events which are repetitive in nature, and so possess a frequency
distribution from which observations can be drawn and statistical
inferences can be made. Subjective probability may be interpreted as a
measure of the degree of ignorance or belief held with regard to the
outcomes of particular future events.The less perfectly the conditions of
the law of large numbers are satisfied, the more uncertain are subjective
probability estimates concerning future possible states of the world. The
term uncertainty is commonly used to denote the degree of ignorance
about the frequency distribution of a future event. Even with uncertainties
of investments and funds deployment for business, the firms have no
choice but to commit themselves to some decision. This is the reality of
basic financial behaviour.8
The basic objectives of Financial Management of (a) Liquidity and
(b) Profitability are discussed at length by this authority in the above
publication. It covers the discussion about functions leading to liquidity :
(1) forecasting cash flows. (2) rationing funds. (3) managing flow of
internal funds. The functions leading to profitability are : (1) cost control.
(2) pricing. (3) forecasting profits. (4) managing required return. The
financial tools have been discussed with the focus on (1) Use of tools for
measuring the effectiveness of actions (like ROI). (2) Use of tools for
measuring validity of decisions (like capital budgeting).
SC Kuchhal, noted Indian authority on Financial Management and
Professor of Finance, IIM, Ahmedabad wrote an authoritative publication
on Financial Management way back in 1969 which served as a valid
guide to corporates, banks, financial institutions, Professors, management
students and researchers. He defines Finance as a science of money. The

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finance functions are (1) Providing funds required by business. (2)
Finance is money, hence every business transaction involves money
(Finance) directly or indirectly. (3) Procurement of funds and their
effective use. Important finance functions referred by this authority are :
1) Establishing asset managing policies.
2) Determining the allocation of net profits.
3) Estimating and controlling cash flows and requirements.
4) Deciding the needs and sources of outside financing.
5) Negotiations for outside financing.
6) Checking upon the financial performance.
The scope of finance as discussed by Prof. Kuchhal covers :
1) Basics of Financial Management.
2) Corporate planning and financial Management.
3) Ratio analysis.
4) Cost Volume Profit analysis.
5) Analysis of operating and financial leverages.
6) Financial forecasting.
7) Short term and long term finance.
8) Capital budgeting.
9) Cost of capital.
10) Planning of capital structure.
11) Valuation.
12) Amalgamations and reorganization.9
The remarkable contributions by other well known authorities on
Financial Management include :

185
1) Brigham E F and Houston JF (Fundamentals of Corporate Finance,
1930 ).
2) HG Guthman (Analysis of Financial Statements, 1925).
3) Solomon E. (Theory of Financial Management, 1969).
4) Van Home JC (Financial Management and Policy, 1989 ).
5) Weston J. Fred et. Al. (Managerial Finance, 1981).
6) R A Foulke (Practical Financial Statements Analysis, 1976 ).
7) John Myer ( Financial statement Analysis, 1961 ).
8) H. Black & J. Champion (Accounting in Business Decisions,
1961).
9) HG Guthman & H. Dougall (Corporate Financial Policy, 1955).
10) Carl Moore & Robert Jadicke (Managerial Accounting, 1974).
11) Robert Anthony & Glen Welsch (Fundamentals of Management
Accounting, 1981).
11) Charles Horngren (Accounting for Management Control, 1974).
12) McMennamin Jim (Financial Management, 2000).
13) RM Srivastav ( Financial Decision Making, 1972 ).
14) Bhattacharya & Dearden (Accounting for Management, 1976 ).
15) PV Kulkarni (Financial Management, 1972 ).
16) Prasanna Chandra (Financial Management, 1980 ).
17) MY Khan & PK Jain (Financial Management, 1981 ).
18) IM Pandey ( Financial Management, 1978 ).
In the financial literature a lot of importance has been attached to
financial ratios for assessing the financial health of a firm. Financial
health will decide the repayment capacity of the debt sought by any
business enterprise. William Beaver10 studied important ratios of 79

186
Companies. These ratios were important ratios which decided the success
and failure of the concerned Companies. The important ratios identified
by this researcher were :
(1) Cash flow to total debt.
(2) Net income to total assets.
(3) Total debt to total assets.
(4) Working capital to total assets.
(5) Current ratio.
The failed firms had more debt and lower return on assets. They
had less cash but more receivables as well as low current ratio. The also
had less inventory.
In the Indian context, LC Gupta11 attempted a refinement of
Beavers method with the objective of building a forewarning system of
corporate sickness. A simple non-parametric test of measuring the
relative differentiating power of the various financial ratios was used. The
study covered cross section of companies falling under various industries.
Fifty six (56) ratios were tested for the period of 1962 to 1974, i.e. for
twelve (12) years. As per this study, it was found that the following five
(5) ratios have high degree of predictive power. These are :
(1) Earnings before depreciation, interest and taxes (EBDIT) to Sales.
(2) Operating cash flow (OCF) to Sales.
(3) EBDIT/Total assets including accumulated depreciation.
(4) OCF/Total assets including accumulated depreciation.
(5) EBDIT/(Interest + 0.25 Debt).
Among the balance sheet ratios, only two ratios were found to have
some power of predicting possible sickness. They were :

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(1) Net worth/Debt, including both short term and long term debt.
(2) All outside liabilities/Tangible assets.
An important outcome of the research was that weak equity base
can lead to sickness.
12
Another important research was carried out by E.I. Altman
which is referred to as Multiple Discriminant Analysis (MDA). After
studying 66 Companies, Altman concluded that a set of ratios can be
developed which has failure predictive power. Altman developed a
discriminant function, covering following ratios.
(1) Net working capital/total assets (percentage).
(2) Retained earnings/total assets (percentage).
(3) EBIT/total assets (percentage).
(4) Market value of total equity/book value of debt (Percentage).
(5) Sales/total assets (times).
The mixed result of these five ratios was Z score, on the basis of
which the firms can be classified either financially sound or otherwise.
Eltman found that a score above 2.675 was believed to be healthy. The
score below this, warranted overall financial weakness. In Eltmans
study, half of the firms became bankrupt.
Eltmans study was refined later on in 1977 which is more broad
and 70 % accurate13.
Many studies have taken place on the issue of methods, tools,
techniques and practices of business performance appraisal of companies.
This is critical, since this system plays a key role in developing strategic
plans and evaluating the achievements of the firm. Research has been
undertaken by premier business schools, consultant firms and others.

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Individual researchers from various fields of accounting, finance and
control, economics, strategy, operations management and others , are
exploring the subject and also trying to understand the drivers of
corporate performance, the linkages between them, and how to measure
their impacts on profitability.
David Otely has mentioned that the financial performance
measures serve three important ends : (1) They act as tools of financial
management. (2) They form a major objective of business organization.
(3) They act as a mechanism for motivation and control within the
organization.14
As referred by Bititci, Carrie and Turner, the business performance
measurement has variety of uses, like : (1) To monitor and control. (2) To
drive improvement. (3) To maximize the effectiveness of the
improvement effort. To achieve alignment with organizational goals and
objectives. (5) To reward and to discipline.
Also, as referred by Simmons,15 performance measurement is the
tool of balancing five major tensions within the firm : (1) Balancing
profit, growth and control. (2) Balancing short term results against long
term capabilities and growth opportunities. (3) Balancing performance
expectation of different constituencies. (4) Balancing opportunities and
attention. (5) Balancing the motive of human behaviour.
The shifts in performance (value) measurement can be summarized
as follows :

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 Sr. Period Performance Measurement Paradigm
No.
1 1920s Dupont Model, ROI
2 1970s Price/Equity Multiples, Earnings per Share
3 1980s Market to book value Ratios, Return on Equity, Return on
Net Assets, Cash flow, Quality management
4 1990s Economic value added, Market value added, EBIDTA,
CFROI, Total Shareholders Return, Balanced Scorecard,
Performance prism, Customer satisfaction
5 2000s EVA, Balanced Scorecard, Sustainability Group Index,
Global Reporting Initiatives, Environmental Performance
Metrics, Intellectual Asset Monitor.

Dr. Bob Frost and Ken Forbes16 had deep studies on the subject of
performance measurement and addressed the crucial questions like :
1) What is performance management ?
2) What is the science behind performance management ?
3) Where does performance improvement come from ?
4) What are the common challenges in performance management ?
Enterprise Performance Management System has now become an
important discipline in big enterprises to measure and monitor the
achievement of business goals.
Subhash Chander and Anjana Bedi conducted an empirical study of
significance of financial objectives (2004)17 where they studied the
performance of Top 500 Indian companies covering 8 industries as per
1998 CMIE data. The performance was analysed with reference to
following variables.
1) Book value of networth.
2) Market value per share.
3) Cash flow per share.

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4) Operating profit before interest and taxes.
5) Price earnings ratio.
6) Market rate of return.
7) Return on investment.
8) Net profit to Net worth.
9) Net profit margin.
10) Market share.
11) Earnings per share.
12) Total Assets.
13) Sales.
They observed:
(1) Maximising Sales, Return on Investment and operating profit
before interest and taxes have emerged as the most significant
financial goals. Surprisingly, goals having market related variables,
such as maximization of market rate of return, price-earnings ratio
and market value per share are the least preferred. Factor Analysis
has also shown that the Return on Investment is the most
significant factor to Companies in India.
(2) The assumption of pursuing the single financial objective has been
refuted by this study.
(3) The Companies are found to be postulating multiple financial
objectives.
(4) The nature of the industry to which a company belongs
significantly affects its perceived significance of different financial
goals.
A gist of their study is present in the following table.

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 Table : 5.1
Performance of Industries Covering Specific parameters

Industries
Financial
1 2 3 4 5 6 7 8
objectives
A. Book value of
3.25 3.33 4.00 4.00 2.67 4.70 4.20 3.88
Networth
B. Market value
3.50 2.33 3.67 3.64 4.00 2.80 2.50 3.58
per share
C. Cash flow per
3.75 3.33 5.00 4.19 4.17 4.50 4.00 4.41
share
D. Operating
profit before 4.25 5.00 5.00 4.36 4.50 3.70 4.40 4.79
interest and tax
E. Price earnings
3.00 2.67 2.67 3.58 3.00 3.20 3.11 3.50
ratio
F. Market rate of
3.25 2.33 3.67 3.50 3.33 3.30 2.88 3.36
return
G. Return on
4.67 5.00 5.00 4.75 4.33 4.30 4.40 4.88
investment
H. Net profit
4.24 4.67 5.00 4.75 4.33 4.30 4.40 4.88
margin
I. Net profit to
4.24 4.67 5.00 4.08 4.33 4.30 4.40 4.88
Net worth
J. Market share 4.50 4.00 3.67 3.55 4.50 4.00 4.22 .35
K. Earnings per
4.25 3.00 5.00 3.83 4.67 3.90 4.00 4.50
share
L. Total Assets 4.25 3.67 4.67 3.64 3.67 4.20 3.50 4.04
M. Sales 4.25 5.00 4.67 4.58 4.33 4.50 4.70 4.83

Note : Classification of Industries : (1) Investment and Finance. (2)

Cotton spinning. (3) Synthetic fibre, silk and woolen. (4) Electronics,
electric equipment and cables. (5) Metal alloys and metal products. (6)

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General Engineering. (7) Chemical dyes, pharmaceuticals, refineries and
plastics. (8) Miscellaneous.
Basil Moore (1968), referred to the basic reality about the growth
of business. He argued that shareholders benefit not from a high level of
profits per se, but rather from increases in the level of profits. They will
particularly be concerned that earnings and dividends for a firm grow
over time, so as to produce a higher yield on the historical value of their
own investment. In addition, in an expanding economy growth is
essential merely to maintain a firm's competitive market position vis--vis
its competitors. For both of these reasons shareholders are concerned
fundamentally about the growth prospects of their corporations, rather
than with the static profit maximization.18
The different theories of capital structure suggest that the firms' debt
equity choice is dependant on asset structure, new debt tax shields, growth,
bankruptcy risk, industry classification, company size, earnings volatility and
profitability. (Titman and Wessels, 1988).19Firms are heavily influenced by
market conditions and past history of security prices in choosing the debt and
equity mix (March, 1982). Apart from the use of traditional non-convertible
debentures, firms switched over to innovative instruments such as convertible
debentures in the early 1980s. However, with the liberalization and the new
Securities and Exchange Board of India (SEBI) guidelines, firms have
attempted to use innovative debt instruments such as triple option convertible
debentures, multiple option convertible debentures, zero interest bonds,
auction rated debentures, inflation Bonds, split coupon debentures, secured
premium notes, floating rate notes, foreign currency convertible bonds, and
securitized instruments. However, the pace of innovation has been very slow.

193
(Barua, Raghunathan, Varma and Venkatiswaran, 1994).20 The choice of
financial products is also dependant on firm specific characteristics. The most
important determinants of financial structure have been asset composition,
business risk, growth rate, earnings rate, industry class, debt service capacity
and corporate size. Financial leverage has been a significant factor considered
in financial structure decision (Johnson, 1997)21, and previous research shows
that financial leverage is influenced by factors such as operating leverage.
(Ferri and Jones, 1979),22 volatility of earnings (Cartannios, 198323, Bradley,
Jannel and Kim, 198424, Bradley and Smith, 1996, Titman and Wessels,
1988, Johnson, 1997 Pandey et al. 2000) Value of collateral assets (Johnson,
1997) non-debt tax shields (Saa Requejo, 1996)25, Profitability (Titman &
Wessels, 1988, Johnson, 1997), market to book ratio (Myers, 1974.,
Castannias, 1983, Bradley, Jannel and Kim, 1984, Bradley and Smith, 1996.,
Johnson, 1997) and firm size (Titman and Wessels, 1988., Mcconaughy and
Misra, 1996).26
Indian Industry prefers a lower level of debt equity in their capital
structure. This implies that there is a strong belief by corporates that
lower levels of debt will maximize the economic welfare of the owners
and consequently the value of the firm.
A study by MS Narsimhan, IIM, Bangalore of 208 companies
covering 8 years showed that there is a negative correlation between
growth rate of EBIT and debt levels. There is increasing dependence of
companies on the internal resources for their funding requirements. 27
It is generally accepted and believed that financial leverage is
beneficial and useful for maximizing return to the owners of the firm only
when favourable economic factors exist and the economy is booming.

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Since financial leverage is also known as a double edged sword, it can
produce the opposite result in adverse economic conditions. These facts
may justify the performance for switchings to lower debt-equity levels
1995 onwards.28
Singh and Hamid (1992)29 and Singh (1995)30 have analysed the
financing pattern of nine developing countries likes India, Korea, Jordan,
Pakistan, Thailand, Mexico, Malaysia, Turkey and Zimbabwe and found
that in all these developing countries' corporations rely in general, very
heavily on external funds and new issues of shares to finance their growth
of net assets. They have also concluded that there were important
differences between the two groups of corporations. Specifically, they
suggested that less developed Corporations used both external finance
and particularly equity finance to a much greater extent than their
counterparts in advanced economies. Their findings were almost reverse
of the Pecking Order pattern of finance observed for advanced country
corporations. Corbett and Jenkinson (1994,1997) have found that there is
no market based Anglo-US pattern of financing of industry. The
corporations in Germany, the United Kingdom and the United States are
internally financed with small or negative contributions from market
sources, while Japanese corporations are more externally financed with
both banks and markets contributing larger shares than in the former
group. They have also found that there is little evidence to support the
view that Germany is a bank financed system and that the UK or US are
market financed. Over the period of 1980s, all countries, except Japan,
have become more internally and less market financed.

195
 Love et. Al., (2005)31 have analysed the financing pattern of the
Indian Companies and found that while debt to asset ratios have been
relatively stable, nominal debt growth has slowed down in recent years.
Throughout the period of study (1994-2003), bank financing as a share of
total debt has increased, while borrowing from non-bank financial
institutions fell sharply. In terms of differences across firms, the finding
is of that debt levels increase with firm size. Smaller firms have
especially less debt relative to larger firms if they are young.
Furthermore, while the ratio of debt to assets has been relatively stable
for large firms, we observe a significant decline for smaller firms.
Pagano and Panetta (1998)32 have also found that the likelihood of
an IPO is positively related to the company's size, and the industry's
market-to-book ratio, Companies appear to go public not to finance future
investments, and growth, but rather to rebalance their accounts after a
period of high investment and growth. IPOs are also followed by a
reduction in the cost of credit, and an increased turnover in control. These
findings highlight some important differences between the role played by
the equity market in Italy (and likely in other continental European
countries), and in the United States. Hesuk and Smith (2000)33 found that
current industry market-to-book increases IPO probability, while lagged
market-to-book ratio decreases it. Sabine (2002)34 argued that the going
public decision is influenced by financing needs, the market mood per
industry, profitability, and size of the company. Financing needs,
profitability, and size indicate the necessity of going public. The market
mood indicates the opportunism by the company in the going public
decision. They found that size is negatively related to the likelihood of
going public, partly due to the size bias in the reference sample. Capital
expenditure is negatively related to the likelihood of going public.

196
Growth increases the possibility of listing. Return on assets is positively
related. They also found that the industry market-to-book ratio appeared
to be the most important of the probability of listing.
Time series analysis of the behaviour of private sector companies,
public sector companies and foreign companies covering the period 1966-
2000, for tapping the equity capital from the market is presented below :
Table : 5.2
Public Issues Behaviour of Companies (1966-2000)
Variables Public Private Foreign
1966- 1966- 1984- 1966- 1966- 1984 1966 1966- 1984
2000 1983 2000 2000 1983 2000 2000 1983 2000
Cons- -0.214 -0.322 0.11 0.082 0.48 0.221 0.26 (0.05 0.35 -0.17
tant (0.203 ) (0.089) (0.06) (0.136) (0.11) (0.11 6) 8) (0.059) (0.095)
TLB -0.133 -0.73 -0.02 -0.25 -0.27 -0.59 0.259 -0.44 0.093
(0.058 ) (0.13) (0.01) (0.08) (0.14) (0.19 ) (0.17 8) (0.16) (0.216)
SZ 0.021 -0.43 0.003 0.012 -0.02 0.007 -0.09 -1.15 0.004
(0.009) (0.04) (0.004) (0.005 ) (0.006 ) 0.003 ) (0.02 ) (0.541) (0.025)
PR -0.026 0.007 -0.06 -0.11 0.022 0.067 -0.11 0.05 -0.13
(0.018) (0.017 ) (0.024) (0.049) (0.027 ) (0.05 4) (0.04 ) (0.052) (0.059)
GR -0.04 0.041 0.05 0.013 -0.018 0.002 0.47 (0.01 0.058 0.002
(0.017 ) (0.024 ) (0.018) (0.011) (0.024 ) (0.00 9) 9) (0.053) (0.018)
LQ 0.05 0.021 -0.008 0.116 -0.138 0.042 0.028 0.016 0.19
(0.023 ) (0.031) (0.015) (0.108) (0.117 ) (0.02 ) (0.03 4) (0.009) (0.076)
CE -0.002 0.018 -0.044 -0.06 -0.12 0.021 0.101 -0.137 0.036
(0.021 ) (0.026 ) (0.042) (0.024) (0.047 ) (0.20 3) (0.07 1) 0.086) (0.076)
CB -0.17 0.16 0.171 -1.1 0.31 0.426 2.04 (0.22 1.12 1.06
(0.047 ) (0.05) (0.0223 (0.204) (0.14) (0.53 3) 3) (0.32) (3.33 )
NOB 35.00 18.00 17.00 35.00 18.00 17.00 35.00 18.00 17.00
R2 0.93 0.95 0.74 0.86 0.98 0.94 0.94 0.91 0.86
F 86.32 49.72 7.54 32.04 58.21 37.11 80.34 39.73 5.49
Value
P 0.156 0.127 -0.075 0.185 0.025 0.068 0.138 0.041 0.036
Value
Notes : TLB : Total long term borrowings. SZ : Size of the company. PR
GR: Growth rate. LQ : Liquidity. CE : Cost of Equity. CB : Cost
NOB : Number of observations. (1) The values in the parenthesis
are Probability values.

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 It was observed that total long term borrowings, size of the firm,
profitability, growth rate of the firm, and liquidity are the major
determinants of the equity capital financing in India. It has been found
that the variables like profitability, liquidity, and growth rate are
positively, and the variables like long term borrowings ratio, size of the
firm etc. are negatively related with the equity capital finance in India.
The time series model results show that the variables like total long term
borrowings, size of the firm and liquidity are statistically significant for
the determination of equity capital financing of the different types of
companies in India in the aggregate level. The period analysis shows that
the variables like total long term borrowings, size of the firm, growth rate
of the firm, and liquidity are statistically significant in panel data models
and also in the time series model in the aggregate level which means that
these are the major factors which affect demand for the equity capital of
the private corporate sector in India.35
A study by Opler, Saron and Titman (1997) highlight the
importance of corporate liability management for creating value for
shareholders. Their study covered analysis of optimal capital structure
(debt equity mix) in such a way that the sum of taxes paid by the firm and
the costs of financial distress are minimized.
Another study (1997) related to developing optimal asset allocation
strategy revealed that the objective of maximizing the utility of wealth.
There are relevant factors governing the development of an optimal
strategy as diffusion processes and assets as correlated Brownian notions.
A study of six industries for the period 1980-1996 by A.
Vijaykumar (Management Accountant. May, 1998) revealed that growth

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is found to be significantly associated with profitability. There is the
influence of size, return on net worth, retention of profits and long term
borrowings and net assets. There can be industry variations on account of
varying degree of competition, demand conditions and government
controls. However, profitability explains considerable part of the growth
of the firms.36
The composite profitability of a firm can be measured by the
method of multivariate analysis. Gross earnings ratio, gross profit ratio,
operating profit ratio and net profit ratio can help to study the profitability
in relation to sales. Gross surplus ratio and return on total tangible assets
can help to study the profitability in relation to total assets. Return on
capital employed (EBIT To CE) and cash flow plough back ratio can help
to study the effectiveness of capital employed. Return on shareholders'
equity studies the profitability in relation to shareholders' funds. Times
interest earned ratio can study the profitability of a firm from the point of
view of long term creditors. The high correlation existing between the
profitability ratio under each main head (margin on sales, return on total
assets and return on capital employed) are partly due to the common
elements found in both the ratios. Another reason for the high correlation
is that both ratios are influenced by the common economy-wide and
industry-wide factors. 37
A study was conducted by Economic Times of 348 companies
(which include Engineering companies also) for a period of 8 years. It
was found that the net profit growth rate is not substantially different
from growth rate of nominal GDP. The expectations during 2003 of
nominal GDP growth over the next 3 to 4 years are about 10 to 12 %,

199
with the real growth of about 6 to 7 %. And inflation of 4 to 5 %. The
dividend yield of sample companies is about 3.5 % having increased from
a less than 2 %, 5-6 years ego. Adding this to the expected earnings
growth, the expected stock market return then should be between 13.5 to
15.5 %. Hence, there is a need for a shift in the investor mental
programming of high return on equity investments.38
Aggregate tax provisions have declined by 25 % in 1997 compared
to 1996 even when 4 % rise in profits, because of tax planning avenues
helping private sector companies. (Economic Times study of 50
companies. November, 1997).
The growth in sales has been considerably lower at 9.90 % during
first half of 1997-98 against 17.60 % of the corresponding period of
1996-97. However, the net earnings increased to 9 % against 0.50 % on
account of sharp drop in interest rates, fall in corporate tax rates and fall
in manufacturing expenses. (ICICI study of 1619 companies. January,
1998). 39
The huge funds raised and invested in the corporate sector during
the initial years of liberalization were not utilized properly in average
terms. A study of 373 companies by CII in this reference may be referred.
Only 98 companies (like Bajaj Auto, BHEL, Hindustan Lever, Asian
Paints etc.) posted positive EVA considering the cost of capital and
RONW. Other companies have failed on both the counts. It is also
evident that share prices are not always influenced by financial
performance, but many a times by market whims.
Higher Dividend payout is not a solution. A dividend can cushion
stock price., but will not necessarily keep it from collapsing. Stocks are

200
risky investments, with dividend or with no dividend. As investor
attitudes gradually swing back into balance, stocks should resume their
traditional dual role of providing investor with a source of long term
capital growth and a steady stream of income from rising and suddenly
fashionable dividends. (Keith Black, 2003).
Miller and Modigliani (1961) have found dividend as irrelevant in
a world without taxes, transaction cost or other market imperfections and
added that the investment decision of the firm is not affected by the
dividends because investors can homebrew their own dividends by selling
a part from or borrowing against their portfolio. The firms that issue
dividends would incur flotation costs on new securities they have to issue
to keep their investment policy intact.40
Lintner analysed as to how companies decide payment of dividend
and concluded that firms have four important concerns. Firstly, the firms
have long run target dividend payout ratios. The payment ratio is high in
case of mature companies with stable earnings and low in case of growth
companies. Secondly, the dividends change follows shift in long form
sustainable earnings. Thirdly, the managers are more concerned with
dividend changes than on absolute level. Finally, managers do not intend
to reverse the change in dividends. (Lintner J. 1956).41
A study of 110 companies (Standard & Poors list) revealed that 90 %
of companies use dividends as a signal of their future earnings. They are very
reluctant to cut dividends, regardless of the purpose for such a cut. Even when
the companies initiate the stock buy back programme, they do not reduce the
dividends to support the repurchase. 75 % of the firms have actually increased
their dividend payments. (Lazo Shirley. 1999).42

201
 Baker et al. (2001) survey of 118 CFOs of NASDAQ listed firms
on 22 variables of the dividend policy found that Lintner's (1956) survey
results and model is valid.43
Managements of the firms believe that they do not have target
dividend payout ratio and dividend change follows the sustainable
increase in the level of earnings.44
A study of dividend payout ratio of 2535 Indian Companies by P.
Mohanty (1999) indicates that firms maintain a constant dividends per
share and have fluctuating payment ratio depending on their profits.
Raghunathan and Dass (1999) found that the top 100 and high
networth companies have maintained a stable dividend payout policy of
around 30 % during the period 1990 to 1999 in India.45
As per a study by Manoj Anand (2002), the management of
corporate India believes that dividend decisions are important as they
provide a signaling mechanism for the future prospects of the firm and
thus affect its market value. They do consider the investors' preference for
dividends and shareholder profile while designing the dividend policy.
They also have a target dividend payout ratio but want to pay stable
dividends with growth. Therefore, dividend policy does matter to the
CFOs and the investors.46
Kaplan (1934), Worthy (1987) and Brimson and Berliner (1987)have
suggested following for better cost management for improved performance.
1) Adopting cost based pricing.
2) Judging the cost of significant activities.
3) Charging technology costs.
4) Analysing value added and non value added costs.

202
 Harris and Pingle (1985) and Rubak (1995) studied the equations
of valuation which were based on the assumption that the leverage driven
value creation or value of the tax shields is the present value of the tax
shields discounted at the required return to the unleveled equity.
Myers (1974) assumed that the value of the tax shields is the
present value of the shields discounted at the required return to debt.
Modigliani and Miller (1963) calculated the value of tax shields by
discounting the present value of the tax savings due to interest payments
of a risk free debt at the risk free rate.
An empirical study was conducted by L. Sarda, A. Seetharaman
and MI Ahmad (2002) to study correlation of tax adjusted earnings, size,
growth and debt on firms value. The findings were : Debt advantage in
terms of market value turned out to be significant. The data covered by
study supported the theory advanced by Miller and Modigliani. Absence
of taxes on interest and dividend have significant implications for the
finance controller of companies for maximization of shareholder wealth.47
A study of capital structure decision was conducted by MS
Narsimhan and S. Vijaylakshmi (2003) covering 478 companies for the
period of 1989 to 2002. The findings were : (1) After 1991, the Indian
firms have been exposed to increased competition following the
economic liberalization. The business risk has consequently gone up and
has affected the profitability of Indian firms. (2) There was sharp decline
in ROCE. (3) The firms were found to be more liberal in dividend
payments. (4) The firms were inclined to increase debt after taking due
care of size, industry and payment impact on capital structure. 48

203
 A study of RPL-RIL merger was conducted for focusing on wealth
maximization for shareholders of RIL (Reliance Industries Ltd.) and also
the post merger corporate performance. It revealed (1) The results do not
support the capitalization hypothesis that bidders' gains are captured at
the beginning of merger programme. (2) The merger which could be
explained in terms of operational synergy, has not led to financial synergy
in the short run. The operating performance analysis reveals that
percentage changes in the post merger period with respect to EPS and PE
ratio showing negative changes. (Rajesh Kumar).49
A mail survey of 196 companies and in depth interviews of 16
company's executives (1996-2004) by Eric Laursen revealed that in the
area of working capital management, day's working capital and days sales
outstanding were important variables of working capital matrices.
Fuller and Farell (1987) have attempted to decide the strong form
of market efficiency into two distinct parts : he super strong form and
non-strong form. The three forms of market efficiency have been a
subject of intense research in the field of finance. (Efficient market
hypotheses (EMH) has been examined in three different forms : the weak,
semi strong and strong ).
Ball and Brown (1968)50, Beaver (1968)51 and Beaver et al.
(1980)52 examined the magnitude of price changes surrounding the
assessment of a firms' annual earnings. Their results showed that the
relation occurred quickly and, therefore, the EMH in the semi-strong
form holds ground. Dixit (1986)53 found that dividend was most
important determinant of share prices.

204
 Narayan Rao (1994)54, who examined the share prices responses to
some of the corporate financial policy announcements, reported that the
stock market is efficient in the semi strong form.
Barua and Raghunathan (1990)55, Sundaram (1991)56 and
Obaidullah (1991)57 cast doubt in the consistency of the observed price -
earnings ratio with fundamental factors like dividend growth and pay out
ratios.
The co-integration of macro economic variables and stock market
has been an extensive area of research in financial econometrics. In India,
the studies have been carried out by Lee (1992), Mukerjee and Naka
(1995), Poon and Tyler (1991) and Leigh (1997). The stock market, being
an important part of the financial system should have a systematic linkage
with fundamentals of the economy. The economic reason behind the logic
is the price of a stock necessarily reflects all the future cash flows depend
on many economic factors like GDP growth, price index (WPI), interest
rate, exchange rate fluctuations, global and domestic prices etc. 58
The macro-economic variables were considered for analyzing stock
prices in Indian market for 88 months from April, 1998 to July, 2003. The
variables considered were : WPI, exchange rate, IIP, foreign exchange
reserves, stock index, M 3, oil price index, real effective exchange rate,
91 day Treasury Bills yield as well as 10 year yields. It was found that
only two variables, of oil prices and exchange rate have correlation with
stock prices. Other factors are not relevant.59

205
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