Dynamic Adjustment towards capital structure

1. Dynamic Adjustment Towards Target Capital
Structure: Evidence From Indian Companies
By
Sulagna Mukherjee, Jitendra Mahakud, 2010
Department of Humanities and Social Sciences, IIT Kharagpur,
Kharagpur, India

2. PURPOSE OF THE STUDY
• To study the Dynamics of Capital structure in context of Indian
Manufacturing companies
• To examine the existence of Optimal Capital Structure
• To estimate the Speed of adjustment
• To examine factors that affect the adjustment speed.

3. BACKGROUND
• A fundamental issue in corporate finance involves understanding how firms choose
their capital structure
• Target capital structure describes the mix of debt, preferred stock and common
equity which is expected to optimize a company's stock price. As a company raises
new capital, it will focus on maintaining this target or optimal capital structure
• The optimal capital structure for a company is the one which proffers a balance
between the idyllic debt-to-equity ranges thus minimizing the firm's cost of capital.

4. LITERATURE REVIEW
• A fundamental issue in corporate finance involves understanding how firms choose their
• capital structure.
• There is no unique view that explains the capital structure decision of the firm.
• The literature on capital structure has focused on four main theories to explain corporate leverage ratios
• (a)Trade-off theory,
• (b)Pecking order theory,
• (c)Market-timing theory and inertia theory
• The trade-off theory of corporate capital structure assumes that firms strive to maintain an optimal capital
structure that balances the costs and benefits associated with varying degrees of financial leverage.
• This optimal level is achieved by making trade-off between the gains from debt or equity to loss from them.

5. LITERATURE REVIEW
• According to Welch (2004) the dynamic trade-off theory of capital structure has argued that
every firm has target leverage and there is always a difference between the observed and
target leverage due to the presence of market imperfections and adjustment costs.
• With the empirical success of partial-adjustment models to measure the speed of
adjustment, the literature has begun to examine the factors affecting of the speed of
adjustment to the target capital structures (Faulkender et al., 2008; Flannery and Hankins,
2007; Byoun, 2008)
• There is limited work done related to dynamic trade off theory of capital structure in the
context of Indian corporate sector (Rajbhandary, 1997; Bhaduri, 2002; Mahakud and Bhole,
2003)

6. RESEARCH GAP
• This paper is first of its kind to study both the determination of target
capital structure and the speed of adjustment to target capital structure in the
context of Indian companies.

7. METHODOLOGY
• This paper specifies a partial-adjustment model and uses the generalized
method of moments technique to determine the variables which affect the
target capital structure and to find out the factors affecting the adjustment
speed to target capital structure.

8. DATA
• Our sample targets all the companies available in the PROWESS data base
maintained by Centre for Monitoring the Indian Economy (CMIE)
• We have identified nine major industry sub-groups within the manufacturing
industry. We have found 891 companies which have the continuous data for
the period of 1993-94 to 2007-08

9. MODEL
1. ΔD/Ei,t = (1- λ)ΔD/Ei,t-1 + λβΔXi,t + Δεit ( Equation 5)
2. D/Ei,t = (1- k)D/Ei,t-1 – Z’itΦ D/Ei,t-1 + (k + Z’itΦ) ( α + βXi,t) + εit (Equation 10)
• We have used the dynamic panel data method and more specifically the generalized method of
moments (GMM) technique as suggested by Arellano and Bond (1991). They prove that GMM
estimation provides consistent parameter estimates by utilizing instruments We have estimated
Equations (5) and (10) separately to measure the adjustment speed to target leverage and
determine the factors which affect the speed of adjustment to target capital structure.

17. FINDINGS
• It is found that
• Firm-specific variables like
• (i)Size,
• (ii)Tangibility,
• (iii)Profitability, and
• (iv)market-to-book ratio were found to be the most important variables
• These variables determine the target capital structure across the book and market leverage.
• The following factors determine the speed of adjustment to target leverage for the Indian manufacturing companies like
• (i)Size of the company,
• (ii)Growth opportunity and
• (iii)The distance between target and observed leverage

18. CONCLUSIONS
• We can say the factors which affect the target capital structure and
the speed of adjustment to target capital structure have been varied
across countries but some common firm-specific factors like size,
growth, tangibility and profitability play the important role in
determining the optimal capital structure and variables like the
distance between target and observed debt ratio, size and growth
have been more influencing factors for determination of speed of
adjustment to target leverage for all the countries.