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Cost of Capital, Optimal Capital Structure, and Value of Firm: An

Empirical Study of Indian Companies

Raj S Dhankar and A jit S Boora

Academicians and practitioners alike havefound it difficult to resolve the issue ofoptimal capital structure in the perfectcapital markets of the West as well as in theimperfect capital markets, as in India. Thispaper examines whether there exists anoptimal capital structure in Indiancompanies, both at the micro and the macrolevel and whether financing decisions affectthe value of a firm.

Raj S Dhankar is an Associate Professor,

Faculty of Management Studies, University

of Delhi and Ajit S Boora is an Associate

Professor, SBM Institute of Management,

Rohtak.

Introduction

During the last 50 years or so, the role of financialmanagement has undergone a tremendous change. Theownership structure, size of business firms, securitymarkets, financial system and instruments have greatlychanged. As a result, the role of a finance manager hasbecome far more important than merely a fund raiser.The finance manager is expected to maximize theeconomic welfare of the owners, which is represented bythe market value of the firm. To achieve this objective,one has to take a number of decisions, the most importantbeing the investment, financing and dividend decisions.

Do changes in capital structure affect the value of afirm? This question has been puzzling the minds of boththe finance managers and academicians for the last 40years, especially since the publication of the path breakingarticles by Franco Modigliani and Merton Miller. In aperfect capital market, their irrelevancy model is perfectlyvalid and is supported by all. But, in case of an imperfectmarket, the views differ greatly and, as a result, till date,no universally accepted model has been developed onthis crucial issue. In India, no significant work has beendone in this regard. This paper makes a humble attemptto empirically test whether there exists an optimal capital

structure in Indian companies, both at the micro and themacro level. The paper also tries to examine whether thefinancing decisions affect the value of a firm.

The paper is divided into four sections. Section 1deals with the review of literature and objectives of thestudy; section 2 explains the research methodology;section 3 shows the empirical results and section 4 givesthe conclusions.

Review of Literature

Sound financing decisions of a firm basically should leadto an optimal capital structure. Capital structure repres-

ents the proportion in which various long-term capitalcomponents are employed. Over the years, these decis-ions have been recognized as the most importantdecisions that a firm has to take. This is because of thefact that capital structure affects the cost of capital, netprofit, earning per share, dividend payout ratio andliquidity position of the firm. These variables coupledwith a number of other factors determine the value of a

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firm. So, capital structure is a very important determi-nant of the value of a firm.

Franco Modigliani and Merton Miller (hereaftercalled M -M) were the first to present a formal model onvaluation of capital structure. In their seminal papers(1958,1963), they showed that under the assumptions ofperfect capital markets, equivalent risk class, no taxes,

100 per cent dividend-payout ratio and constant cost ofdebt, the value of a firm is independent of its capitalstructure. When corporate taxes are taken into account,the value of a firm increases linearly with debt-equity(D/E) ratio because of interest payments being taxexempted. M-M'S work has been at the centrestage ofthe financial research till date. Their models have beencriticized, supported, and extended over the last 35 years.

David Durand (1963) criticized the model on theground that the assumptions used by M-M are unrealistic.Solomon (1963) argued that the cost of debt does notalways remain constant. When the leverage level exceeds

the accepted level, the probability of default in interestpayments increases thus raising the cost of debt. Stiglitz(1969,1974) proved the validity of the M-M model underrelaxed assumptions whereas Smith (1972), Krause andLitzenberger (1973), Baron (1974,1975), and Scott (1976,1977), supported the M-M model, but only under theconditions of risk free debt and costless bankruptcy.When bankruptcy has positive costs, there exists anoptimal capital structure which is a trade-off betweentax advantage of debt and bankruptcy costs.

This trade-off theory was challengedby Miller (1977).He argued that bankruptcy and agency costs are toosmall to offset the tax advantage of debt. But when

personal taxes are taken into account, this advantage iscompletely offset by the disadvantage of personal taxrnte. Thus, in equilibrium, the value of a firm isindependent of its capital structure, even when themarket is imperfect. But Miller's model was rejected byDeAngelo and Masulis (1980). They argued that even ifbankruptcy, agency and related costs are ignored,introduction of non-debt tax shields is enough for a firmto have an optimal capital structure. And even if thesecosts are taken into account, an optimal capital structureexists, irrespective of availability of non-debt tax shields.Masulis (1980,1983), Brennen and Schwartz (1978), andJensen and Meckling (1976) also advocated the existence

of an optimal capital structure in an imperfect market,while using different mechanisms. Besides, a lot morework has been done on this problem till now, but aformal model, showing the mechanism for determiningan optimal capital structure in an imperfect market, isyet to be developed.

On the basis of the major work done by M-M and

30

This model clearly advocates the existence of anoptimal capital structure which is a trade-off betweentax advantages and disadvantages of leverage. However,M-M (1966) again proved their irrelevancy hypotheseis.But the study by Davenport (1971) supported the tradi-

tional view.In the Indian context, one comes across two works,

one by Sharma and Rao (1969) and the other by Pandey(1992). The former tested the MM model using cross-sectional analysis for engineering companies, whereinthe value of a firm was found to be independent of itscapital structure after allowing for tax advantage. Butthe results could not be generalized as the sample was

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homogeneous. The other work by Pandey (1992) obser-ved that the M-M theory is not fully valid under Indianconditions. He concluded that, initially, cost of capitaland value of a firm are independent of the capitalstructure changes, but they rise after a certain level. Allthese studies have helped understand the dynamics ofthis crucial issue better but have not been able to come to

a definite conclusion as to how firms determine theiroptimal capital structure. So, the present study wasplanned to make another attempt to resolve thiscontentious issue. It may be pointed out that the studyhas not included the effect of factors like agency andbankruptcy costs, as they are difficult to measure in theIndian scenario.

Objectives

The basic objective of this study is to find out if thereexists an optimal capital structure either at the microand/or at the macro level in Indian private sectorcompanies. If yes, how do companies determine it? Inaddition, it has the following sub-objectives: Does change

in capital structure affect the cost of capital? Are capitalstructure and dividend policy correlated? Does capitalstructure of companies differ significantly?

Research Methodology

For conducting the study, a sample of 26 widely heldIndian private sector companies from top 300 large scalecompanies was taken. The sample is not homogeneousas the companies are taken from 15 different industrygroups. It is a multi-period study covering the periodfrom 1981-82 to 1990-91. The study used both primaryand secondary data. The main source of secondary datawas the Bombay Stock Exchange Directory. Primary data

were collected through a mailed questionnaire. In all,100 questionnaires were mailed but the response ratewas about 26 per cent. Hence, a sample of 26 companieswas taken. Most of the respondents were above the levelof Finance Manager. The responses were ranked on thebasis of relative weightage given to various factors bythe respondents.

Measure of Variables

The variables used in the study are as follows:

1) Capital structure (C):

C = Sum of the book values of various components ofcapital structure

2) Market value of equity (E):

E = Number of shares outstanding at the end of an

accounting year X Average market price per

share

where,

Number of shares = Total equity capital/Face

value per share

Average price = Mean value of monthly highand low price/share duringthe accounting year.

3) Value of firm (V):

V = Market value of equity + Book value ofpreference share and debt1.

4) Cost of capital (Ka):

Kp.P + Kd.D + Ke.EKa =

P + D + E

where,

Kp = Cost of preference capital2

Kd = Cost of debt capital3

Ke = Cost of equity capital

4

P, D = Book value of preference and debt capital

respectively

E = Market value of common equity capital

wherein, Ke = Rf + B (Rm-Rf)

where,

Rf = Risk free rate5

B = Beta coefficient6

Cov (Rj,Rm)

Var (Rm)

where,

Rm = Return on market portfolio

Rj = Return on common stock

Var (Rm) = Variance of return on market portfolio

1. Preference share and debt are taken at book valuesbecause there is no significant yearly fluctuations in theprices of these sources of capital.

2. Preference dividend/price of preference share.

3. Interest (1 - T)/Total debt.

4. Calculated by using Capital Asset Pricing Model.Frequency of variables is on an annual basis.

5. Risk free rate is taken as 10 per cent.

6. It represents the systematic risk associated with "a

security.

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;i) Leverage (L):

L = Debt to total capital ratio, i.e. L = D/ (D+E) = D/C

6) Dividend payout ratio (D/P):

Equity dividend paid

D/P =

Net profit - Preference dividend

In the absence of a well developed model on capitalstructure problem, Karl Pearson's bivariate correlationcoefficient was used to find the relationship among thevariables. The value of r for the pooled data representsa correlation between average change in D/C ratio(change in capital structure) on the one hand, and totalmarket value of firms, average Ka and average D/Pratio, respectively, on the other (Tables 1,4,5). Consideringthe nature and objectives of the study, we thought itproper to use the bivariate correlation technique. As amatter of fact, most of the earlier studies in this area haveused a similar technique. The correlation results weretested by using student's t-test; f-test has been used to

test the significance of difference in inter-company capi-tal structure.

Empirical Results

Optimal Capital Structure : There is no definiterelationship between change in the capital structure andthe value of a firm (Table 1). Out of 26, only 6 companiesshow statistically significant relationship (3 showingnegative and 3 showing positive values). Further, noneof the sample companies was found to be highly levera-ged. Except for ICICI, the maximum value of D/C ratiofor a company was 0.714. For ICICI, it was 0.916 whichis normal for a financial institution. These insignificantand inconsistent results at the micro level can be attributedto the fact that capital structure is not the only determinantof market price of a company's share and its value andthat there are other factors as well which do affect theirvalues. Incidentally, this was confirmed during thecourse of our discussions with company executives(Tables 2 and 3).

Table 1: Coefficient of Bivariate Correlation (r) bet-

ween Change in Capital Structure and Valu e

of the Firm

8 DCM 0.668 0.0919 Escorts 0.477 -0.015

10

11

12

Godfrey Philips

Goodyear Grasim

Industries

0.488

0.283

0.431

0.226 -

0.682 **

0.746 *

13 HEG Ltd. 0.410 0.838 *14 ICI Ltd 0.494 -0.137

15 ICICI 0.916 -0.467

.16 Kelvinator 0.534 -0.206

17

18

Kinetic Engg.

Kirloskar Brothers

0.438

0.684

0.079 -

0.37519 Mukand Ltd 0.563 0.131

20 Nestle 0.384 0.459

21

22

23

Ranbaxy Laboratories

Rathi Alloys Ltd SPIC

0.688

0.714

0.569

-0.239

0.280 -

0.29824 SRFLtd 0.437 0.273

25 TELCO 0.583 -0.626**

26 TISCO 0.512 -0.796 *

Pooled data 0.666# 0.706**

* and ** represent the significance of results at 1 per centand 5 per cent level respectively.

# 0.666 is the weighted average D/C ratio of all thecompanies for ten years.

Table 2 : Determinants of Share Prices

Rank Determinant

Management of the company

Dividend policy

Role of bulls and bears Capital structure

Government policies Takeover bid by others

Cost of capital

Table 3 : Other Factors which Affect the Value of aFirm

Nflme o/ the Company D/C Ratio r

1 Amrit Banaspati Co. 0.536 0.3482 Apollo Tyres 0.765 -0.146

3 Asea Brown Boveri 0.580 -0.3074 Atlas Cycle Industries 0.582 0.014

5 Ballarpur Industries 0.358 0.049

6 Bata India 0.474 0.903 *

7Blue Star 0.446 -0.052

Rank

1

2

3

4

5

6

Factor

Operating results

Business risk

Economic conditions

Promoters

Tax rates and structures

Political conditions

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Since a majority of the factors are non-measurable asthey are qualitative in nature, it is not possible to segregatetheir effects. Therefore, an exact relationship betweencapital structure and value of a firm cannot be establi-shed. This conclusion is further strengthened by thehighly volatile behaviour of the stock markets. One ob-serves that 22 companies showed coefficient of variance(C V) greater than 50 per cent. The average C V for all thecompanies was 62.11 per cent which is quite high. Fur-ther, in general, variations in values were not found tobe significantly associated with the financial performan-ce of the companies. So, the market price of the stock isnot the true index of a company's performance. The va-riations in stock prices of a company may also representthe effects of qualitative factors. These factors canundervalue or overvalue these prices at the micro levelas a result of which they may not be the true

1indices of a

company's performance.

However, at the macro level, the relationship bet-ween change in capital structure and value of a firm was

found to be highly positive and statistically significant(r = 0.706) (Table 1). These results are totally differentfrom those obtained at the micro level. The reason isquite clear, because when we take the aggregate figures,the positive and negative effects of the external andqualitative factors on individual shares neutralize oneanother and we get a closely approximate true value ofthe share prices. That is why we get a highly positivecorrelation between the two at the macro level.

The above results clearly show that in imperfect

market, at the macro level, an optimal capital structuredefinitely does not exist. It is not possible to determine it

exactly, because of the difficulty faced in the measure-ment of qualitative factors and other problems. These

results fully support the views expressed by Brighamand Gopanski (1985) when they observed, "Unfortuna-

tely, it is almost impossible to test the leverage effectsempirically, because (1) future earnings are impossibleto measure and (2) most real world leverage changes are

accompanied by asset changes which may be changingthe firm's risk class. Thus, empirical tests have not pro-

duced conclusive results. However, the evidence doesgenerally support the contention that some benefits

from leverage do exist, at least if the firm does not exceedreasonable limits of debt."

Capital Structure and Cost of Capital : In general,

change in capital structure and cost of capital were foundto be negatively related, as 81 per cent of the companies

showed negative relationship (Table 4), thus, supportingthe theory that cost of capital decreases with increase in

debt level because cost of debt is less than that of equityand interest payments are tax exempted. Furthermore,

since the cost of capital is measured using historical data,the weighted average" cost of capital is bound to go downwith increasing debt, other things being equal. But therelationship is not statistically significant. It means that,in general, changes in capital structure are not acco-mpanied by proportionate changes in cost of capital.The statistically insignificant values of r'can be explai-

ned by the following reasons:

* Indian companies have no specific model ormechanism to compute the specific costs of capital,particularly the cost of equity capital and the averagecost of capital. This became clear, when ,in responseto the question, "how do you compute the cost ofcapital?", none of the companies suggested a definite/specific mechanism.

* Cost of capital is not the only determinant of thecapital structure, though it is one of the mostimportant determinants. Since the effects of otherdeterminants cannot be segregated, so, an exact

relat ionship between the two could not beestablished.

* Cost of debt in India is quite high as compared to

that in the developed countries.

Table 4: Coefficient of Bivariate Correlation (r)between Change in Capital Structure andCost of Capital

Name of the Company r

12

3

Amrit Banaspati Co.Apollo Tyres Asea

Brown Boveri

-0.217

0.621**

0.0954

56

Atlas Cycle IndustriesBallarpur IndustriesBata India

-0.550**

-0.108-0.325

7 Blue Star -0.3148 DCM 0.069

9 Escorts -0.1661011

12

Godfrey PhilipsGoodyear GrasimIndustries

-0.100-0.131

-0.156

13 HEGLtd -0.17714 ICI Ltd -0.23915 ICICI -0.14816 Kelvinator -0.5431718

Kinetic Engg.Kirloskar Brothers

0.043-0.227

19 Mukand Ltd. 0.37520 Nestle -0.436

21

22

23

Ranbaxy Laboratories

Rathi Alloys Ltd.

SPIC

-0.256

-0.117-0.411

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24 SRF Ltd. -0.34425 TELCO -0.176

26 TISCO -0.216

Pooled data -0.245

* and ** represent the significance of results at 1 per centand 5 per cent level, respectively.

Capital Structure and Dividend Policy : At the microlevel, no definite and consistent relationship existsbetween change in capital and dividend policy (Table 5),as 14 companies showed positive values of r whereas 12companies showed negative values. The relationshipwas statistically significant in case of 3 companies only.These inconsistent results could be attributed to twomain reasons:

* The Indian companies do not apply any dividendmodel or theory while deciding the D/P ratio.When asked, all the companies replied in negative.

* Dividend policy and dividend payout ratio are

influenced by a number of factors (Tables 6 and 7),and most of these factors are not measurable as theyare qualitative in nature. Hence, their effect cannotbe segregated. As a result, it was not possible toestablish an exact and definite relationship betweenthe two. Furthermore, it is also evident from thesetables that the single most important factor is theopinion of the directors, and the shareholders havevery little say in dividend policy matters. Also, theIndian companies have no specific criteria fordeciding the retention ratio. Generally, it is quitehigh. This fact, too, was confirmed in the study, asthe average retention ratio turned out to be 69.04

per cent.Though the relationship between capital structure

and dividend payout ratio is not statistically significant,it does tell that as degree of leverage increases, dividend

payout ratio also increases moderately. This is becauseof the fact that EPS increases with leverage as long as thecompany is solvent.

Differences in Inter-company Capital Structure : The

differences in the capital structure of companies, whetherbelonging to the same group or not was statistically

significant as f value was 6.174 at 1 per cent significantlevel. This is because of the fact that capital structuredepends on a number of factors whose magnitude varies

from company to company. This was confirmed byexecutives when they were asked, "What are the determi-

nants of your existing capital structure?" (Table 8).

* One way ANOVA test was applied on the mean values

of D/C ratio of all the 26 companies. Detailed results

available on request.

Table 5 : Coefficient of Bivariate Correlation (r) bet-ween Change in Capital Structure andDividend Payout Ratio

Name of the Company r

1 Amrit Banaspati Co. 0.081

2 Apollo Tyres 0.756*

3 Asea Brown Boveri -0.110

4 Atlas Cycle Industries 0.074

5 Ballarpur Industries 0.057

6 Bata India -0.089

7 Blue Star 0.366

8 DCM -0.512

9 Escorts -0.039

10 Godfrey Philips -0.469

11 Goodyear 0.141

12 Grasim Industries -0.428

13 HEG Ltd. -0.632**

14 ICI Ltd. -0.17915 ICICI 0.702 *

16 Kelvinator 0.389

17 Kinetic Engg. 0.093

18 Kirloskar Brothers 0.41519 Mukand Ltd. 0.775*

20 Nestle -0.337

21 Ranbaxy Laboratories -0.511

22 Rathi Alloys Ltd. 0.211

23 SPIC -0.441

24 SRF Ltd. 0.270

25 TELCO -0.480

26 TISCO 0.090

Pooled data 0.368

* and ** represent the significance of results at 1 percentand 5 per cent level, respectively.

Table 6 : Determinants of Dividend Policy

Rank Deteminant

1 Board of Directors Opinion

2 financial needs of the company

3 Growth of the company

4 New security issues

5 Liquidity

6 Restriction in loan agreement

7 Desires o shareholders

8 Legal restrictions

9 Investment opportunity

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Table 7: Factors AffectingDIPRatio Decision

Rank Factor

1 Operating results

2 Business risk

3 Economic conditions

4 Promoters

5 Tax rates structures

6 Political conditions

Table 8 : Determinants of Capital Structure

Rank Factor

1 Cost o capital

2 Dividend policy

3 Market conditions

4 Earning stability

5 Nature of industry

6 Government rules

7 Size of the company

8 Restrictions by fis

9 Industry norm

10 Management decisions and policies

Leverage : Except for ICICI, average values of debt tototal capital ratio (D/ C) of the sample companies rangedfrom 0.2831 to 0.7139. So, none of the companies was

found tobe excessively leveraged, as over the years, a D/E ratio of 2:1 (i.e. D/C ratio of 0.67) was the norm fixedby the government and its agencies. For ICICI, it was0.916 which is also not high because the norm fixed bythe World Bank and the RBI for financial institutions is0.923. The mean value of D/C ratio for all the companiesin the sample was 0.666 (Table 1).

Conclusions

No significant relationship was found between change

in capital structure and the value of a firm, at the microlevel. This is because of the fact that the value of a firm

is affected by a multiplicity of factors and capital structureis just one of them. Many of these factors like the reputa-tion of promoters, management of the company, econo-

mic and political conditions, role of bulls and bears,government policies, etc., are not measurable as they are

qualitative in nature. Because of this problem, their

effect cannot be segregated, and hence, an exact relation-ship between change in capital structure and value of afirm could not be established. However, at the macrolevel, the relationship was statistically significant at 5 percent level of significance (r = 0.706). The above factorsmay result in undervaluation or overvaluation of sharesat the micro level but when we take the aggregate, their

positive and negative effects neutralize one another. So,the market value at the macro level acts as the true indexof financial performance of all the companies. Theresults clearly advocate the existence of an optimalcapital structure at the macro level but in the absenceof a model on capital structure, it is not possible todetermine its exact range. However, the 'r' value of0.706 for a weighted average D/C ratio of 0.666 is highand statistically significant. What it implies is that ahigher level of debt in the capital structure of these firmswill not affect their values adversely. As a matter of fact,the additional debt will help increase their values.

Companies were found to differ significantly in

capital structure irrespective of whether they belong tothe same industry group or different groups. This isbecause of the fact that the magnitude of the effect ofdeterminants of capital structure vary from company tocompany. In general, change in capital structure andcost of capital were found to be negatively related, butthe results were not statistically significant. These resultssuggest that though cost of capital decreases when leve-rage increases, this decrease is very moderate and notproportional to debt level. Probably, it is for this veryreason that most of the companies are not high leveraged.The relationship between change in capital structureand dividend policy was not found definite and statisti-

cally significant. Further, it was also found that Indiancompanies do not employ a specific model for computingthe cost of capital and have no scientific model fordetermining their target capital structure. Thus, it couldbe concluded that like perfect capital markets of thewest, in India, too, wherein the capital markets areimperfect, companies have no definite way of deter-mining their optimal capital structure.

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