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THE DEBT-EQUITY
CHOICE- AN EMPIRICAL
ANALYSIS OF INDIAN
COMPANIES
Presented By – Group 5
Introduction
 Debt-equity choice is one of the most important decisions in financing
policy.
 Static theory: It implies that firms have target debt ratio and that
firms try to move towards the target ratio.
 Pecking Theory: It argues that firms adopts a hierarchical order of
financing preference: internal financing preferred over external
financing.
 The important question facing companies in need of new finances is
whether to raise debts or equity capital.
 The majority of the studies in this area discuss the effects of leverage
on the value and profitability of the firm.
 Does use of debt create a value?
 Standard capital structure of firm includes retained earnings, debts
Capital Structure has a great impact in understanding the behavior of firms with
respect to their choice among the use of debt or equity.
Which actually explain the mix of securities and financing sources used by
corporation to finance real investment and focused on the proportions of debt vs.
equity observed on the liabilities side of corporations’ Balance Sheet.
Tread off Theory: States that firms seek debt levels that balance the tax
advantages of additional debt against the costs of possible financial distress. It
also predicts moderate borrowing by tax-paying firms.
Pecking order Theory: States firm’s tendency is to borrow, rather than issuing
equity, when internal cash flow is not sufficient to fund capital expenditures. Thus
the amount of debt will reflect the firm’s cumulative need for external funds
Free cash floe Theory: States that dangerously high debt levels will increase
value, despite the threat of financial distress, when operating cash flow
significantly exceeds its profitable investment opportunities.
Literature Review
Study by Booth et al.: debt ratios in developing countries seem to be affected
in the same way and by the same types of variable that are significant in
developed countries.
Study by K.Lakshmi(2008): The higher the institutional investors’
shareholding the lower was the level of debt for the sample firms.
Study by D.Dutta & B.Agarwal(2009): Redeeming signal about the Indian
corporate behavior which found out to show more dependence on their
internally generated funds than on external sources of finance.
Study by G.Shanmugasundaram(2008): States that Indian companies are
shifting from high debt to high equity over the period clearly indicating
consistency with the static “Trade off Theory”.
Literature Review
Objective of the study
 The present study analyzes the financing pattern of 300 Indian private
sector companies comprising of 20 different sectors for the period 1999-
2000 to 2007-2008, duly grouping them under the basis of their region,
size, age and nature.
Research Methodology
 Primary data : Data has been collected rom sampled companies.
 Secondary data: moneycontrol.com, periodicals, Govt. Reports, RBI
Bulletins and various books.
 Sample size: 300 companies from a heterogeneous set of 20 different
sectors.
 For our study purpose data has been taken from top 15 companies of each
sector.
 Applied Methods: Cash Flow Analysis, Ratio analysis and correlation
analysis
Objective of the study & Research Methodology
DATA ANALYSIS
15%
32%
53%
Classification of companies
according to age
Very Old
Old
New
Year of
Incorporation
Age
Group
No. of
companie
s
% to
Total
Sample
Prior to 1947 Very Old 44 14.67
1947-1980 Old 95 31.67
After 1980 New 161 53.66
Total 300 100
12%
45%
28%
15%
Classification of companies
according to region
Eastern
Western
Southern
Northern
Region/
Group
Easter
n
Wester
n
South
ern
North
ern
Total
No. of
Compan
ies
34 135 85 46 300
% of
Total
Sample
11.33 45 28.33 15.34 100
DATA ANALYSIS
25%
33%
42%
Classification of companies
according to size
SMALL Below Rs. 100
Crore
MEDIUM Rs.100 Crores
to Rs.500 Crore
LARGE Above Rs. 500
Crore
Size of the
Company
Total Assets as
on 31st
March
2008( Rs. In
Crores )
No. of
companies
% to Total sample
SMALL
Below Rs. 100
Crore
75 25
MEDIUM
Rs.100 Crores
to Rs.500
Crore
98 32.67
LARGE
Above Rs. 500
Crore
127 42.33
TOTAL 300 100
30%
45%
15%
10%
Classification of companies
according to sector/ Industry
Agro Based
Manufacturing Industries
Textiles Manmade, Food
Processing, Edible Oil,
Cotton Textiles, Paper,
Sugar,
Mineral Based
Manufacturing Industries
Chemicals, Cement,
Fertilizer, Construction &
Housing, Electric
Equipment,
Pharmaceuticals, Plastic,
Industrial
Group
Name of the Industry/Sector
No. of
Compani
es
Percenta
ge to
Total
Sample
Agro Based
Manufacturing
Industries
Textiles Manmade, Food
Processing, Edible Oil, Cotton
Textiles, Paper, Sugar,
90 30
Mineral Based
Manufacturing
Industries
Chemicals, Cement,
Fertilizer, Construction &
Housing, Electric Equipment,
Pharmaceuticals, Plastic,
135 45
Service
Industries
Computer Software, Hotel,
Transport
45 15
Plantation
Industries
Rubber, Tea & coffee, 30 10
Total 300 100
Findings & Observation
 The average debt-equity ratio of sample companies during the study period
was 1.12 which is slightly higher than generally accepted norms of 1:1.
 An average of 60.54% total funds are raised from internal sources where as
external sources contribute only 39.46%.
 Issue of share capital had never been a source of long term finance for
corporate sector.
 The correlation between investment in tangible fixed assets and debt equity
ratio shows that the sample companies utilizes a major portion of debt
finance in Tangible fixed assets.
 The average debt-equity ratio is 1.24 and the southern region is 0.97.
 Increment in the size of the investment is mostly financed by debt incase of
northern region companies and through equities incase of other region
companies.
Conclusion
 Barring to a few exceptions like small and medium sized companies
in size group and agro based companies and plantation companies in
industrial groups it was found that companies prefer mostly internal
funds as compared to external funds.
 Small sized companies are relies more on debt capital as compare to
large size companies.
 The average debt-equity ratio of small size companies were found to
be more than 3:1 where as incase of large sized companies it is 1 : 1.
 The average debt-equity ratio of manufacturing companies were
more than double of the average debt-equity ratio of service sector
companies.
 A result of debt dominated capital structure the Indian corporates
are exposed to a vey high degree of total risk.
Thank You

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Debt equity

  • 1. THE DEBT-EQUITY CHOICE- AN EMPIRICAL ANALYSIS OF INDIAN COMPANIES Presented By – Group 5
  • 2. Introduction  Debt-equity choice is one of the most important decisions in financing policy.  Static theory: It implies that firms have target debt ratio and that firms try to move towards the target ratio.  Pecking Theory: It argues that firms adopts a hierarchical order of financing preference: internal financing preferred over external financing.  The important question facing companies in need of new finances is whether to raise debts or equity capital.  The majority of the studies in this area discuss the effects of leverage on the value and profitability of the firm.  Does use of debt create a value?  Standard capital structure of firm includes retained earnings, debts
  • 3. Capital Structure has a great impact in understanding the behavior of firms with respect to their choice among the use of debt or equity. Which actually explain the mix of securities and financing sources used by corporation to finance real investment and focused on the proportions of debt vs. equity observed on the liabilities side of corporations’ Balance Sheet. Tread off Theory: States that firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. It also predicts moderate borrowing by tax-paying firms. Pecking order Theory: States firm’s tendency is to borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. Thus the amount of debt will reflect the firm’s cumulative need for external funds Free cash floe Theory: States that dangerously high debt levels will increase value, despite the threat of financial distress, when operating cash flow significantly exceeds its profitable investment opportunities. Literature Review
  • 4. Study by Booth et al.: debt ratios in developing countries seem to be affected in the same way and by the same types of variable that are significant in developed countries. Study by K.Lakshmi(2008): The higher the institutional investors’ shareholding the lower was the level of debt for the sample firms. Study by D.Dutta & B.Agarwal(2009): Redeeming signal about the Indian corporate behavior which found out to show more dependence on their internally generated funds than on external sources of finance. Study by G.Shanmugasundaram(2008): States that Indian companies are shifting from high debt to high equity over the period clearly indicating consistency with the static “Trade off Theory”. Literature Review
  • 5. Objective of the study  The present study analyzes the financing pattern of 300 Indian private sector companies comprising of 20 different sectors for the period 1999- 2000 to 2007-2008, duly grouping them under the basis of their region, size, age and nature. Research Methodology  Primary data : Data has been collected rom sampled companies.  Secondary data: moneycontrol.com, periodicals, Govt. Reports, RBI Bulletins and various books.  Sample size: 300 companies from a heterogeneous set of 20 different sectors.  For our study purpose data has been taken from top 15 companies of each sector.  Applied Methods: Cash Flow Analysis, Ratio analysis and correlation analysis Objective of the study & Research Methodology
  • 6. DATA ANALYSIS 15% 32% 53% Classification of companies according to age Very Old Old New Year of Incorporation Age Group No. of companie s % to Total Sample Prior to 1947 Very Old 44 14.67 1947-1980 Old 95 31.67 After 1980 New 161 53.66 Total 300 100 12% 45% 28% 15% Classification of companies according to region Eastern Western Southern Northern Region/ Group Easter n Wester n South ern North ern Total No. of Compan ies 34 135 85 46 300 % of Total Sample 11.33 45 28.33 15.34 100
  • 7. DATA ANALYSIS 25% 33% 42% Classification of companies according to size SMALL Below Rs. 100 Crore MEDIUM Rs.100 Crores to Rs.500 Crore LARGE Above Rs. 500 Crore Size of the Company Total Assets as on 31st March 2008( Rs. In Crores ) No. of companies % to Total sample SMALL Below Rs. 100 Crore 75 25 MEDIUM Rs.100 Crores to Rs.500 Crore 98 32.67 LARGE Above Rs. 500 Crore 127 42.33 TOTAL 300 100 30% 45% 15% 10% Classification of companies according to sector/ Industry Agro Based Manufacturing Industries Textiles Manmade, Food Processing, Edible Oil, Cotton Textiles, Paper, Sugar, Mineral Based Manufacturing Industries Chemicals, Cement, Fertilizer, Construction & Housing, Electric Equipment, Pharmaceuticals, Plastic, Industrial Group Name of the Industry/Sector No. of Compani es Percenta ge to Total Sample Agro Based Manufacturing Industries Textiles Manmade, Food Processing, Edible Oil, Cotton Textiles, Paper, Sugar, 90 30 Mineral Based Manufacturing Industries Chemicals, Cement, Fertilizer, Construction & Housing, Electric Equipment, Pharmaceuticals, Plastic, 135 45 Service Industries Computer Software, Hotel, Transport 45 15 Plantation Industries Rubber, Tea & coffee, 30 10 Total 300 100
  • 8. Findings & Observation  The average debt-equity ratio of sample companies during the study period was 1.12 which is slightly higher than generally accepted norms of 1:1.  An average of 60.54% total funds are raised from internal sources where as external sources contribute only 39.46%.  Issue of share capital had never been a source of long term finance for corporate sector.  The correlation between investment in tangible fixed assets and debt equity ratio shows that the sample companies utilizes a major portion of debt finance in Tangible fixed assets.  The average debt-equity ratio is 1.24 and the southern region is 0.97.  Increment in the size of the investment is mostly financed by debt incase of northern region companies and through equities incase of other region companies.
  • 9. Conclusion  Barring to a few exceptions like small and medium sized companies in size group and agro based companies and plantation companies in industrial groups it was found that companies prefer mostly internal funds as compared to external funds.  Small sized companies are relies more on debt capital as compare to large size companies.  The average debt-equity ratio of small size companies were found to be more than 3:1 where as incase of large sized companies it is 1 : 1.  The average debt-equity ratio of manufacturing companies were more than double of the average debt-equity ratio of service sector companies.  A result of debt dominated capital structure the Indian corporates are exposed to a vey high degree of total risk.