Managerial Managerial Finance Agency theory, theory, capital structure and firm performance: some Indian evidence Varun Dawar
Ar ti c le i n fo rm ati on : ) T P ( 5 1 0 2 r e b m e v o N 6 0 8 0 : 9 1 t A g n u p m a L f o y t i s r e v i n U s s e n i s u B d n a s c i m o n o c E f o y t l u c a F y b d e d a o l n w o D
To cite this document: Varun Dawar , (2014),"Agency theory, capital structure and firm performance: some Indian evidence", Managerial Finance, Vol. 40 Iss 12 pp. 1190 - 1206 Permanent link to this document: http://dx.doi.org/10.1108/MF-10-2013-0275 Downloaded on: 06 November 2015, At: 19:08 (PT) References: this document contains references to 70 other documents. To copy this document:
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) T P ( 5 1 0 2 r e b m e v o N 6 0 8 0 : 9 1 t A g n u p m a L f o y t i s r e v i n U s s e n i s u B d n a s c i m o n o c E f o y t l u c a F y b d e d a o l n w o D
MF 40,12
Agency theory, capital structure and firm performance: some Indian evidence
1190
Varun Dawar
Received 6 October 2013 Revised 30 January 2014 Accepted 6 February 2014
IMT (Institute of Management Technology) Ghaziabad, Ghaziabad, India Abstract Purpose – Based on the agency theory, the purpose of this paper is to empirically investigate the impact of capital structure choice on firm performance in India as one of the emerging economies. Design/methodology/approach – Fixed effect panel regression model is used to analyse ten years of data (2003-2012) on the sample units, to find the relation between leverage and firm performance after controlling for factors such as size, age, tangibility, growth, liquidity and advertising. Findings – Empirical results suggest that leverage has a negative influence on financial performance of Indian firms, which is in contrast with the assumptions of agency theory as commonly received and accepted in other developed as well as emerging economies. Consequently, postulates of agency theory have to be seen with different perspective in India given the underdeveloped nature of bond markets and dominance of state-owned banks in lending to corporate sector. Practical implications – The findings of the paper will enable the practitioners and analysts to understand as to why, in the bank-dominated debt financing system in India, leverage is negatively associated with firm performance. Originality/value – The results of the study enrich the literature on capital structure and agency costs issues in several ways. Keywords India, Capital structure, Agency theory, Firm performance, Emerging economy Paper type Research paper
Managerial Finance Vol. 40 No. 12, 2014 pp. 1190-1206 r Emerald Group Publishing Limited 0307-4358 DOI 10.1108/MF-10-2013-0275
1. Introduction The theory of capital structure and its association with firm performance and value has been an important issue in corporate finance literature ever since the publication of the seminal paper of Modigliani and Miller (1958). Modigliani-Miller (MM) propagated that in a perfect capital market free of taxes, transaction costs and other frictions, capital structure is irrelevant in determining firm value. They showed that the choice between debt and equity financing has no material effect on the firm value and consequently management should not be concerned about the proportion of debt and equity that constitute the capital structure of the firm. This led to a plethora of research on the topic (both theoretical and empirical) with researchers examining the robustness of the MM model in the light of realistic assumptions relating to market frictions and the information asymmetries. Although various alternative capital structure theories have been developed during the last 50 years so as to determine the optimal capital structure and its impact on firm value, they differ in their relative emphasis. For instance, while trade-off theory suggests an optimum debt level or target level in terms of balance between tax savings and bankruptcy cost, pecking order theory (Myers and Majluf, 1984; Myers, 1984) assumes hierarchy of financial decisions under which firm resort to external financing only in absence of internal financing. Similarly agency theory of debt (Jensen and Meckling, 1976) talks about agency costs which arise on account of conflict between managers and shareholders. Agency costs theory, identified by Jensen and Meckling (1976), has its genesis in the idea that the interests of the company’s managers and its shareholders are not perfectly
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aligned. The conflict between managers and shareholders, on account of separation of ownership and control, arise as managers tend to maximize their own utility rather than the value of the firm. Consequently, issuing debt may lower agency costs and affect firm performance by disciplining or encouraging managers to act in the best interests of the shareholders rather than indulge in discretionary behaviour (Grossman and Hart, 1982; Jensen, 1986; Harris and Raviv, 1991 for overviews). While there is a vast amount of literature examining the choice and impact of capital structure decisions on firm performance over the past few decades (Taub, 1975; Miller, 1977; Stulz, 1990; Roden and Lewellen, 1995; Champion, 1999; Ghosh et al., 2000; Gleason et al., 2000; Simerly and Li, 2000; Hadlock and James, 2002; Berger and Bonaccorsi di Patti, 2006; Rao et al., 2007; Margaritis and Psillaki, 2007, 2010; Weill, 2008; Ebaid, 2009; Nunes et al., 2009; Sadeghian et al., 2012), empirical evidence has been mixed and contradictory with regards to debt adding positive or negative value to the firm. Also most of the studies examining the implications of capital structure on firm performance exist in developed markets (USA, UK and Canada) with little empirical evidence regarding the same in emerging markets, particularly India. As against the capitalistic nature of political and economic environment and dominance of privately owned financial institutions in the west, financial landscape of emerging market like India is dominated by state-owned enterprises (wherein Indian Government is the majority shareholder) who controls majority share of the corporate funding. Consequently it becomes necessary to examine whether the behaviour and performance implications of capital structure choices on firm performance (with the assumptions of agency theory) as commonly received and accepted in case of developed markets is valid in emerging market of India or needs to be reassessed in the light of what data might reveal. Tests of the agency cost theory typically have been based on regressions of various measures of firm performance on various indicator of leverage plus some control variables. Elaborating on the above argument of agency issue this study reason and empirically investigate the relationship between debt level and financial performance of set of listed Indian companies during the period 2003-2012. To measure firm performance, we use two accounting-based measures of firm performance namely, return on assets (ROA) and return on equity (ROE). The study further controls for differences in firm-related or industry-related factors by including variables such as firm size, firm age, tangibility, sales growth, liquidity and advertising. The results of the study enrich the literature on capital structure and agency cost issues in several ways. First, we find that there is negative influence of capital structure on financial performance of Indian firms (measured by ROA and ROE). The result is in contrast with the postulates of agency theory as evidenced in other developed as well as emerging economies. We argue that tenets of agency theory as applied in other markets have to be seen in different light in case of India where bond markets are yet to flourish and major source of corporate funding rests with the banking sector. The underlying assumption behind the agency theory is that suppliers of debt capital incentivise or discipline the managerial discretionary behaviour so as to mitigate the agency conflicts and ensure superior firm performance. However, in India suppliers of debt capital being primarily state owned are subject to minimal disciplining influence by their owner-principal (government). Consequently, they have reduced incentives for subsequent monitoring and disciplining their debtor firms. Debtor firm managers, aware of this inconsequential presence of the lenders, continue to pursue discretionary behaviour instead of striving for superior corporate profitability
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thereby resulting in negative association between leverage and performance. Second, we find that while firm size, tangibility, liquidity and advertising are positively related to firm performance, firm age tends to have a negative influence on the same. The rest of the paper is organized in the following way: Section 2 discusses literature review; Section 3 discusses the measures of firm performance and exogenous variables; Section 4 describes the data and empirical model; Section 5 details the empirical result and Section 6 concludes with summary of findings. 2. Literature review Ever since publication of the seminal paper of Jensen and Meckling (1976) as regards the agency costs, there has been a great deal of empirical work with several studies in almost all countries (wherein private capital plays a major role in the economy) examining the relationship between financial leverage and firm performance. Under the agency cost hypothesis, separation of ownership and control in firms creates conflicts of interest between the firm’s shareholders and managers. This is because managers often indulge in investing the firm’s resources in projects that enhances their own personal benefits rather than maximize the firm value (Jensen, 1986). Similarly the firm managers are averse to giving up control of the firm and often tend to resist liquidation despite it being in the best interests of shareholders (Harris and Raviv, 1988). Consequently, use of leverage in capital structure can mitigate agency costs by constraining or encouraging managers to act more in the interests of shareholders by regulating the choice of investment (Myers, 1977), the amount of risk undertaken (Jensen and Meckling, 1976) and the conditions under which firm can resort to liquidation (Grossman and Hart, 1982; Williams, 1987; Harris and Raviv, 1990). Thus increasing leverage can mitigate agency costs and have a positive effect on profitability and consequently firm performance. A number of empirical studies provide evidence suggesting this positive relationship between debt level and firm’s performance. For example, Taub (1975) examines the factors influencing the firm’s choice of a debt-equity ratio for a set of US companies and find significant positive association between debt and profitability. Similarly Grossman and Hart (1982) and Williams (1987) finds that high leverage reduces agency costs and increases firm value by encouraging managers to act more in the interests of equity holders. Roden and Lewellen (1995) find significant positive association between profitability and total debt as a percentage of the total buyout-financing package in their study on leveraged buyouts. Similar results are documented by Hadlock and James, (2002) for a set of companies in USA and by Lara and Mesquita in case of Brazilian companies. Margaritis and Psillaki (2010) investigates the relationship between efficiency, leverage and ownership structure using a sample of French manufacturing firms and finds that higher leverage is associated with improved efficiency over the entire range of observed data. While increased leverage in the capital structure reduces the agency conflicts between shareholders and managers, it can bring with it the commitment for future cash outflows resulting in higher expected costs of financial distress, bankruptcy and/or liquidation. Jensen and Meckling (1976) suggest that effect of leverage on total agency costs cannot be monotonic. At low levels of leverage, while increase in debt reduces agency conflicts through positive incentives for managers, at higher levels losses increase on account of negative net present value projects leading to likely situation of bankruptcy and distress. Thus, when bankruptcy and distress become more likely, further increases in leverage can result in higher total agency costs leading
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to a negative effect on profitability and firm performance. A number of studies provide empirical evidence supporting this negative relationship between debt level and firm’s performance or profitability. For example, while Kester (1986) reports negative relation between leverage and profitability in case of USA and Japan, Rajan and Zingales (1995) report such results in case of G-7 countries (USA, Japan, German, France, Italy, UK and Canada). Gleason et al. (2000) report negative relationship between capital structure and performance in case of set of European retail firms. Similar results are reported by Booth et al. (2001) for a set of ten developing countries including Brazil, Mexico, South Korea, Zimbabwe and Malaysia among others. The findings indicate that agency costs of debt are significantly large in developing countries compared to that in developed markets. Goddard et al. (2005) finds evidence of negative relation between firm’s gearing ratio and its profitability for a set of manufacturing and service sector firms in Belgium, France, Italy and UK. Rao et al. (2007) examines the relationship between capital structure and financial performance of Omani firms and find a negative association between the level of debt and financial performance. They argue that the negative association can be attributed to the high cost of borrowing and the underdeveloped nature of the debt market in Oman. Similarly Nunes et al. (2009) confirms the negative relationship in case of set of firms in Portuguese service industries. Similarly some studies report both positive as well as negative effects of leverage on firm performance. For instance, Simerly and Li (2000) find that debt has a negative impact on competitiveness as the imposition of covenants limits the firm ability to make decisions. However, as debt increases, corporate governance can change from internal to external control thereby having a positive impact on firm’s profitability. Similarly Berger and Bonaccorsi di Patti (2006) finds that for a set of banking firms in USA while higher leverage or a lower equity capital ratio is associated with higher profit efficiency, at higher levels of debt there are offsetting effects from the agency costs of debt. Margaritis and Psillaki (2007) investigates the relationship between firm efficiency and leverage for a set of New Zealand firms and find that while relation is positive at low to mid leverage levels, it becomes negative at high leverage ratios. While the evidence in developed markets with regards to relationship between financial leverage and firm performance has been mixed and contradictory, a few studies investigated this relationship in emerging markets. For instance, Majumdar and Chhibber (1999) examine the relationship between capital structure and performance for a sample of Indian firms and find the relation to be negative. Similarly Chiang et al. (2002) finds negative relation between capital structure and performance of Hong Kong firms belonging to property and construction sector. Abor (2005) examines the relationship between capital structure and profitability of firms listed on the Ghana Stock Exchange during a five-year period and finds the relation to be positive and negative in case of short-term and long-term debt, respectively. Abu and Abdussalam (2006) examine the relationship between firm structure and profitability in case of Jordan listed firms and finds significant positive relation between the two. Kyereboah-Coleman (2007) investigates the relationship between capital structure and firm performance using a set of microfinance institutions in sub-Saharan Africa and finds the relation to be positive. Abor (2007) extends his previous studies to small and medium-sized enterprises in Ghana and South Africa and reports negative relation between debt (both long-term and short-term) and performance. Zeitun and Tian (2007) study the relationship between capital structure and performance of a set of Jordan firms and shows that debt level is negatively related with both accounting and market measures of performance. Ebaid (2009) using three accounting-based measures of financial performance (i.e. ROE, ROA
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and gross profit margin (GM)), finds that capital structure choice decision, in general terms, has a weak-to-no impact on firm’s performance. David and Olorunfemi (2010) study the impact of capital structure on corporate performance in case of Nigerian Petroleum Industry and find positive relation. Onaolapo and Kajola (2010) study of the impact of capital structure on firm’s financial performance using sample of 30 non-financial firms listed on the Nigerian Stock Exchange and find that leverage has a negative impact on firm’s profitability (measured by ROA and ROE). Sadeghian et al. (2012) investigates the relationship between capital structure and firm performance in Tehran using a combination of accounting (ROA, ROE) and market measures (Tobin’s Q ) and finds the relation to be negative. Shubita et al. extends Abor (2005) findings by examining the effect of capital structure on profitability of the industrial companies listed on Amman Stock Exchange and report significantly negative relation between debt and profitability. The Indian context In India, corporate bond market, unlike developed and other Asian counties, is relatively underdeveloped both in terms of depth and liquidity and is still to gain traction compared to equity markets which have grown leaps and bounds since liberalization in early 1990s. Although there have been efforts on the part of government to open up debt segment for foreign financial institutions through increased investment limits (currently investment limit for foreign investors in Indian corporate debt is $51bn)[1], response of foreign investors has been lukewarm with major portion of the same remaining unutilized. While world over, debt markets (especially corporate bond segment) have become much larger in size compared to traditional banking and equity sources of financing, in India corporate funding is primarily met by banks, particularly state-owned banks (wherein Indian Government is the majority shareholder) who control majority of the bank lending in terms of market share. Like most banking systems in developing countries, the banking system in India is characterized by the coexistence of different ownership groups, public (state owned) and private and within private – domestic and foreign. State-owned banks owe their existence to the various phases of the nationalization carried on by the Government of India (GOI) during the last 60 years. While private sector banks as well as the foreign banks were allowed to coexist with public sector banks, their activities continued to be highly restricted through entry regulation and strict branch licensing policies. As a result state-owned banks have continued to dominate the banking business in India accounting for almost 77 per cent [2],[3] of the deposits and 73 per cent (see footnote 2) of credit disbursed in terms of market share. Currently there are 26 state-owned banks, 20 private banks and 41 foreign banks operating in the Indian banking industry. While all commercial banks in India (state owned, private and foreign) are regulated by the country’s Central Bank, the Reserve Bank of India (RBI), management of state-owned banks falls under the purview of the Department of Banking in the Finance Ministry of GOI, which directly appoints the managing directors of these banks and determines the constitution of the Board of Directors. Given its proprietary interests, the GOI has its representatives on the Board of Directors and there is a considerable degree of government intervention in the day-to-day operational decisions of these banks that has seriously limited their operational autonomy. Resultantly studying the relationship between capital structure and firm performance in case of an emerging market like India assumes significant importance as it can shed further light on role of state-owned suppliers of debt capital in
disciplining or incentivizing the managerial discretionary behaviour as against the prior evidence emanating from privately owned institutions in developed economies.
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3. Measures of firm performance and exogenous variables Measures of firm performance The empirical literature employs a number of different measures of firm performance to test its relationship with capital structure. These measures include accounting based ratios from balance sheet and income statements such as ROA, ROE, asset turnover, etc. (Demsetz and Lehn, 1985; Gorton and Rosen, 1995; Mehran, 1995; Majumdar and Chhibber, 1999; Ang et al., 2000; Singh and Davidson, 2003; Fleming et al., 2005; Abor, 2005; Ebaid, 2009; Sadeghian et al., 2012), stock market returns and their volatility (Cole and Mehran, 1998; Welch, 2004), measures such as Tobin’s Q , which mixes market values with accounting values (Mehran, 1995; Himmelberg et al., 1999; Zhou, 2001; Abor, 2007; Sadeghian et al., 2012) and finally measures of profit efficiency i.e., managerial efficiency computed using a profit function (Berger and Bonaccorsi di Patti, 2006). In the present study, we use a similar approach and use commonly used accounting based ratios such as ROA and ROE to measure firm profitability or performance. Financial leverage To assess the impact that leverage has on corporate profitability (or performance), we use following two ratios as the principal explanatory variables:
(1) short-term debt (STD) to total assets; and (2) long-term debt (LTD) to total assets. Exogenous or control variables In explanations of profitability or performance, we include a vector of control variables to account for firm-related or industry-related factors and also to minimize specification bias in the model. These are firm size, firm age, tangibility or asset structure, sales growth, liquidity and ratio of advertising, distribution and marketing expenses to total operating expenses. To control for the differences associated with firm size, we include the size variable in the model measured by the log of total assets of the firm. This is in line with prior research which suggests that size of the firm may have an influence on its performance owing to differences in operating environment, access to the markets, diversification of business and information asymmetry (Ferri and Jones, 1979; Myers and Majluf, 1984; Rajan and Zingales, 1995; Ramaswamy, 2001; Frank and Goyal, 2003; Ebaid, 2009; Sadeghian et al., 2012). Similarly firm age, measured as the number of years since inception to the date of observation, is included as a control variable. Given that older firms are able to achieve experience-based economies and can avoid the liabilities of newness (Stinchcombe, 1965), positive relation is posited between age and firm performance. We further introduce tangibility (asset structure) as a control variable, calculated as ratio of net fixed assets to total assets. Prior research predicts that tangibility can have conflicting effects on profitability. Given that tangible assets are easily monitored and provide good collateral, they tend to mitigate agency conflicts (Himmelberg et al., 1999; Booth et al., 2001). Conversely, firms with high levels of intangible assets tend to have more investment opportunities in the long term and consequently negative association between tangibility and profitability (Rao et al., 2007; Zeitun and Tian, 2007; Weill, 2008, Nunes et al., 2009). Sales growth, measured as rate of change in sales between the observation year and the preceding years, can have
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a positive effect on performance as companies are able to generate higher profits from their investment (Margaritis and Psillaki, 2010; Zeitun and Tian, 2007; Nunes et al., 2009). We further include liquidity, measured in terms of quick assets ratio or ratio of cash to current liabilities, as another control variable since it helps control for industry-related, firm-specific and business cycle factors. Lastly, ratios of advertising, distribution and marketing expenses to total operating expenses is included to control for both industry-related and firm-specific factors. In some cases, firms resort to heavy spend on advertising, distribution and marketing expenses to garner higher market share and consequent higher impact on profitability. The variables therefore tend to capture firm level predilections. In other cases industry characteristics or settings may warrant higher spend on advertising, distribution and marketing activities; thereby industry-related effects are controlled to some degree. 4. Data and empirical model Sample and data The study uses the list of S&P BSE 100 index companies as its sample. The list consists of 100 companies representing diverse sectors of the economy. The index is calculated by the Bombay Stock Exchange (BSE) using free float capitalization weighted method and represents about 80 per cent of the free float market capitalization of the stocks listed on BSE. To construct the data sample, historical data have been taken from “prowess” database of the Centre for Monitoring Indian Economy (CMIE) for ten financial years from 2003 to 2012 for analysis. Out of 100 companies we exclude banks and non-banking finance companies as per usual practice as their financial characteristics are quite different from others. Resultantly, the sample size gets reduced to 78 companies representing almost all the major sectors of Indian economy except banking and finance sector. Table I provides the distribution of the sample by industry. Empirical model To capture the relationship between leverage and firm’s performance, we formulate the following regression model (Table II): ROAit ¼b0 þ b1 LTD i t þ b2 STD i t þ b3 SIZE i t ;
;
;
þ b4 AGE i t þ b5 TANG i t þ b6 GROW i t þ b7 LIQ i t þ b8 ADV i t þ ui t ;
;
;
;
;
ð1Þ
;
ROE it ¼b0 þ b1 LTD i t þ b2 STD i t þ b3 SIZE i t ;
;
;
þ b4 AGE i t þ b5 TANG i t þ b6 GROW i t þ b7 LIQ i t þ b8 ADV i t þ ui t ;
;
;
;
;
ð2Þ
;
where ROAi,t is the return on assets of firm i at time t ; ROE i,t the return on equity of firm i at time t ; LTD i,t the total long-term debt to total assets for firm i at time t ; STD i,t the total short-term debt to total assets for firm i at time t ; SIZE i,t the size of firm i at time t ; AGE i,t the age of firm i at time t ; TANG i,t the tangibility of firm i at time t ; GROW i,t the growth in sales of firm i at time t ; LIQ i,t the quick ratio of firm i at time t ; ADV i,t the advertising, distribution and marketing expenses to total operating
Industry name
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Agriculture Capital goods Chemical and petrochemical Consumer durables Diversified FMCG Healthcare Housing related Information technology Media and publishing Metal, metal products and mining Oil and Gas Power Telecom Textile Transport equipments Transport services
ROA ROE LTD STD SIZE AGE TANG GROW LIQ ADV
% of firms 1 8 3 1 1 12 9 9 6 1 12 9 10 4 1 12 1
Return on assets has been computed as ratio of net profit to average total assets at the end of each financial year from 2003 to 2012 Return on equity has been computed as ratio of net profit to average total equity at the end of each financial year from 2003 to 2012 Long-term debt to total assets has been measured by dividing the book value of long-term debt by the book value of total assets at the end of each financial year from 2003 to 2012 Short-term debt to total assets has been measured by dividing the book value of short-term debt by the book value of total assets at the end of each financial year from 2003 to 2012 Natural log of the book value of total assets at the end of each financial year from 2003 to 2012 has been used as proxy for size Firm AGE has been measured as the number of years since inception to the date of observation Tangibility has been calculated as ratio of net fixed assets to total assets at the end of each financial year from 2003 to 2012 GROW denotes sales growth. It is defined as growth of sales and is measured for the i th firm at time t as under: Grow ¼ Salesi Salesi(t 1) /Salesi(t 1) Liquidity has been measured by quick assets ratio or ratio of cash to current liabilities at the end of each financial year from 2003 to 2012 Calculated as ratio of advertising, distribution and marketing expenses to total operating expenses at the end of each financial year from 2003 to 2012
expenses of firm i at time t ; b0 the common y -intercept; b1-b8 the coefficients of the concerned explanatory variables; m i,t the stochastic error term of firm i at time t . Research methodology The study uses panel data regression methodology to conduct the analysis as it takes into effect systematic differences between the firms as compared to OLS regression methodology which assumes that model parameters remain constant across all firms. Under panel data regression methodology, there are two types of data models: fixed effect methodology (FEM) and random effect methodology (REM). FEM model takes
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Table I. Industry distribution of the sample
Table II. Variables definition and explanation
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into account the individuality of each firm or cross-sectional unit included in the sample by allowing the intercept to vary for each firm but still assumes that the slope coefficients are constant across firms. REM is theoretically the opposite of the FEM and assumes that the variables are uncorrelated and appropriately can apply random effects when performing the regression. Moreover, the REM disregards the need for generating dummy variables and instead uses a disturbance term in correspondence with the error term. To determine whether to use FEM or REM for the data set, Hausman (1978) specification test is conducted. The Hausman test statistic is asymptotically distributed as w2 and is based on the Wald criterion. The Hausman test assumes the null hypothesis that there is no correlation between the individual effects and the regressors and hence REM should be used. In case the null is rejected, implying correlation between the individual effects and the regressors, FEM is preferred over REM. Accordingly we formulate the following hypothesis: H0. Null hypothesis – there is no correlation between the individual effects and the regressors. H1. Alternate hypothesis – there is correlation between the individual effects and the regressors.
The results of the Hausman test in our study (Table III) reject the null hypothesis at 5 per cent significance level, thereby supporting the use of FEM over REM in all cases. 5. Empirical results Descriptive statistics This section presents the various estimation results and discusses the implications of the empirical findings. The summary statistics of the dependent and explanatory variables over the sample period are presented in Table IV, reflecting the average values of the dependent and the independent variables. Table V shows the correlation matrices among all the variables along with variance inflation factors (VIF). The VIF values affirm the absence of multi-collinearity among the variables considered since the values are well within the acceptable limits (VIF 45 indicate multi-collinearity as per Gujarati, 2003). Additionally we conduct Ramsey RESET test (Table VI) for the model misspecification and the results suggest no apparent non-linearity in the regression equations. Regression results Tables VII and VIII present the results of regression using FEM to test the relationship between capital structure and firm’s profitability measured by ROA and ROE (Models 1 and 2). As shown in these tables, the results indicate a significant negative
Table III. Hausman test
Specification: Model 1 (ROA) w2-statistic Probability Specification: Model 2 (ROE) w2-statistic Probability Note: **Significant at 5 per cent level
20.17** 0.004 15.06** 0.035
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Variable
Min.
Max.
SD
ROA ROE LTD STD SIZE AGE TANG GROW LIQ ADV
0.200 1.590 0.000 0.000 3.310 2.000 0.000 0.710 0.010 0.000
0.510 1.800 0.870 0.570 7.130 117.0 0.730 980.68 13.430 0.460
0.089 0.210 0.200 0.080 0.681 26.994 0.174 39.025 1.410 0.088
Notes: Sample of 9,780. Observations, 2003-2012
ROA ROA ROE LTD STD SIZE AGE TANG GROW LIQ ADV
1 0.77 0.43 0.23 0.48 0.01 0.26 0.03 0.13 0.42
ROE
1 0.24 0.17 0.37 0.08 0.14 0.01 0.14 0.37
LTD
1 0.13 0.12 0.28 0.03 0.00 0.25 0.18
Specification: model 1 (ROA) F -statistic Log likelihood ratio Specification: model 2 (ROE) F -statistic Log likelihood ratio
STD
1 0.1 0.3 0.09 0.00 0.47 0.15
SIZE
1 0.2 0.22 0.01 0.27 0.53
AGE
1 0.09 0.07 0.16 0.02
TANG
1 0.05 0.31 0.35
GROW
1 0.02 0
LIQ
1 0.29
ADV
VIF
1
1.23 1.05 1.19 1.17 1.20 1.03 1.04 1.00 1.07 1.18
0.065 0.172
Probability Probability
0.4924 0.4469
0.126 0.242
Probability Probability
0.5881 0.5156
relationship between debt (both short term and long term) and firm profitability (in case of both ROA and ROE); the coefficient of debt being negative and statistically significant at 5 per cent level, which suggests that an increase in debt is associated with decrease in profitability (or performance). This results thus implies that an increase in short-term and long-term debt position is associated with a decrease in profitability. Firm size is positively and significantly related to profitability (or performance) suggesting that large firms in India enjoy economies of scale and are able to exercise considerable influence in product and factor markets. Firm age exhibits negative and significant association with profitability (or performance) suggesting that newer firms are able to score over older firms in adjusting/adapting to changing competitive product and factor market place. Tangibility is found to be positively and significantly
Capital structure and firm performance 1199
Table IV. Descriptive statistics
Table V. Correlation matrices and variation inflation factors (VIF)
Table VI. Ramsey regression equation specification error test (RESET)
MF 40,12
ROAit ¼ b0 þ b1 LTD i t þ b2 STD i t þ b3 SIZE i t þ b4 AGE i t þ b5 TANG i t þ b6 GROW i t ;
;
;
;
;
;
þ b7 LIQ i t þ b8 ADV i t þ mi t ;
;
;
Dependent variable: ROAit Explanatory variable ) T P ( 5 1 0 2 r e b m e v o N 6 0 8 0 : 9 1 t A g n u p m a L f o y t i s r e v i n U s s e n i s u B d n a s c i m o n o c E f o y t l u c a F y b d e d a o l n w o D
1200
Table VII. Regression result of capital structure and performance measured by ROA
Coefficient
0.29 0.26 0.04 0.07 0.05 0.00 0.05 0.11 0.44 0.41 0.92 2.56 0.97 84.90 0.00
LTD STD SIZE AGE TANG GROW LIQ ADV R 2 Adjusted- R 2 SE of regression Mean dependent variable SD dependent variable F -statistic Prob( F -statistic)
t -statistics
Prob.
9.63** 8.87** 2.61** 2.43** 3.75** 0.93 2.56** 3.2** Durbin-Watson Akaike info. criterion Schwarz criterion Hannan-Quinn criterion
0.00 0.00 0.00 0.00 0.00 0.35 0.00 0.00 1.9 2.66 2.96 2.53
Note: **Significant at 5 per cent level
ROE it ¼ b0 þ b1 LTD i t þ b2 STD i t þ b3 SIZE i t þ b4 AGE i t þ b5 TANG i t þ b6 GROW i t ;
;
;
;
;
;
þ b7 LIQ i t þ b8 ADV i t þ mi t ;
Dependent variable: ROE it Explanatory variable
Table VIII. Regression result of capital structure and performance measured by ROE
LTD STD SIZE AGE TANG GROW LIQ ADV R 2 Adjusted R 2 SE of regression Mean dependent var. SD dependent var. F -statistic Prob. ( F -statistic)
;
;
Coefficient
0.22 0.20 0.07 0.01 0.03 0.00 0.04 0.44 0.34 0.30 0.56 1.85 0.51 73.38 0.00
t -statistics
Prob.
5.68** 4.46** 6.01** 2.56** 2.55** 0.37 2.49** 4.59** Durbin-Watson Akaike info criterion Schwarz criterion Hannan-Quinn criterion
0.00 0.00 0.00 0.00 0.00 0.17 0.00 0.00 2.0 2.55 2.51 2.53
Note: **Significant at 5 per cent level
related to firm profitability (or performance) suggesting that tangible assets are easily monitored and provide good collateral and thus they tend to mitigate agency conflicts between shareholders and creditors. Sales growth shows no significant relationship with profitability (or performance). Liquidity has a positive and significant association
) T P ( 5 1 0 2 r e b m e v o N 6 0 8 0 : 9 1 t A g n u p m a L f o y t i s r e v i n U s s e n i s u B d n a s c i m o n o c E f o y t l u c a F y b d e d a o l n w o D
with profitability (or performance) signifying the benefits of superior working capital management and gains accruing on account of lower interest cost. Finally advertising show a positive and significant effect on profitability (or performance) suggesting that higher advertising spend can generate higher profits on account of product differentiation (in line with industrial organization theory). In summary, the results shown in Tables VII and VIII indicate that after controlling for factors such as firm size, firm age, tangibility, sales growth, liquidity and advertising, capital structure has a negative influence on financial performance of a set of listed Indian firms. This evidence is in contrast with findings in developed (Taub, 1975; Grossman and Hart, 1982; Williams, 1987; Roden and Lewellen, 1995; Champion, 1999; Ghosh et al., 2000; Hadlock and James, 2002; Margaritis and Psillaki, 2007, 2010) as well as emerging economies (Abor, 2005; Kyereboah-Coleman, 2007) which document a positive impact of capital structure on firm’s performance. The above evidence is not in accordance with the postulates of agency theory as commonly accepted in other developed as well as emerging markets. In India, given the underdeveloped nature of the corporate bond market, reliance on traditional sources of financing has been excessive. Consequently, the suppliers of debt capital in India, unlike developed economies, are primarily banks particularly state-owned banks who control a major share of the lending. This dominance of state-owned suppliers of debt capital plays an important role in determining whether presence of loan creditors disciplines managers towards superior firm performance. State-owned banks in India have not been able to incentivise or discipline the managerial discretionary behaviour so as to mitigate the agency conflicts and bring it in congruence with the best interests of shareholders. Unlike privately owned institutions, which are subject to strict monitoring by their suppliers or owner principals, state-owned banks in India do not face any such market discipline by their owners (government). Instead they have often served as a vehicle for channelling government considerations to favoured parties under the garb of industrial advancement or development. Consequently, state-owned banks have reduced incentives for increasing monitoring of their debtor firms as they are not likely to be penalized for making bad loans decisions by their owners (government). This lack of monitoring incentivizes debtor firm managers to pursue discretionary behaviour which have negative performance consequences. The above empirical evidence is further substantiated by the fact that the bad assets (non-performing asset) of state-owned banks stands at a level of 4.1 per cent (as per cent of gross advances) compared to just 2 per cent in case of private sector banks (Table IX). Unlike private sector banks where presence of institutional investors had an impact in influencing managerial behaviour and bringing in disciplinary pressures to enforce hard budget constraints, in case of state-owned banks vesting of ownership
Capital structure and firm performance 1201
Trends in non-performing assets – bank group-wise State-owned banks Private sector banks Gross NPAs (in INR Billion) Gross NPAs as per cent of gross advances (%) 2011-2012 2012-2013
1,650
210
3.30 4.10
2.10 2.00
Source: RBI Report on Trends and Progress of Banking in India – 2012-2013
Table IX. Trends in non-performing assets – bank group-wise
MF 40,12
) T P ( 5 1 0 2 r e b m e v o N 6 0 8 0 : 9 1 t A g n u p m a L f o y t i s r e v i n U s s e n i s u B d n a s c i m o n o c E f o y t l u c a F y b d e d a o l n w o D
1202
in the hands of government department (who holds all the shares on behalf of government) has failed to keep a check on profligacy or lack of effort on discretionary managerial behaviour in debtor firms. This further brings forth an important issue of role of government nominee members on the board of debtor firms. Given their unsatisfactory role in monitoring the performance of debtor firms consequently leading to increasing NPA’s, there is a need to revisit the monitoring capabilities of government nominees to ensure any meaningful disciplining influence on Indian managers. Second, project appraisal and credit analysis skills of state-owned banks needs to be overhauled as promoters of economically unviable projects may have obtained large loans from these institutions on account of political considerations and subsequently failed to honour the commitments. These issues have been voiced by RBI in its report on Trends and Progress of Banking in India (see footnote 2) wherein they had directed state-owned banks to take adequate steps to strengthen their risk management systems, credit appraisal and sanction process, post-sanction monitoring and follow-up and have a robust MIS mechanism for early detection of incipient weaknesses/distress and for taking steps for remedial measures and recovery of bank’s dues. Similarly apex banking lobby Indian Bank’s association (IBA) have continuously raised concerns on instilling better governance practices by state-owned banks while monitoring debtor firms. 6. Summary of findings and conclusion A vast literature investigates the relationship between capital structure and performance since the seminal work of Modigliani and Miller (1958). While most of these studies explore the relationship in the developed countries, little is empirically known about such implications in emerging economies such as India. The present study investigates the impact of capital structure choice on performance of listed firms in India as one of the emerging economies. Based on a sample of large cross-section of Indian firms and using two accounting-based measures of financial performance (ROA, ROE), the results indicate that capital structure negatively impact the firm performance. This is not in accordance with the assumptions of agency theory as commonly received and accepted in other developed as well as emerging markets. Consequently, postulates of agency theory have to be seen with different perspective in India given the underdeveloped nature of bond markets and dominance of state-owned banks in lending to corporate sector. As against privately owned institutions in developed economies, state-owned nature of lending in India has impacted the way in which presence of loan creditors induces managers towards striving for superior corporate performance. State-owned suppliers of debt capital (state-owned banks) have not been able to exercise considerable disciplining influence on Indian corporate managers who have continued to indulge in discretionary behaviour with negative performance consequences. For future research sectoral analysis can be incorporated so as to explore whether relationship is any different given the specific attributes particular to an industry. Finally given that relationship between leverage and firm performance can assume non-linearity, the same can be studied using quantile regression estimates. Notes
1. Securities and Exchange Board of India (SEBI). 2. RBI Report on Trends and Progress of Banking in India – 2012-13. 3. http://articles.economictimes.indiatimes.com/2013-12-16/news/45256402_1_bad-loans-staterun-banks-indian-bank
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[email protected]
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