CAPITAL STRUCTURE MANAGEMENT OF MANUFACTURING INDUSTRIES OF NEPAL

A Thesis Proposal Submitted to Faculty of Management for the Fulfillment of the Master of Business Studies Tribhuvan University New ori!on "ollege# $upandehi# Nepal

By %ila &hanal Master of Business Studies T'U' $eg'No' ()*)+,)-*.),/ Symbol No' ++011*+

Feb# .1*+

1. General Background
The capital structure concept has an importance place in the theory of financial management' Financial structure refers to the way for firm2s assets are financed' 3t is entire right hand side of the balance sheet' "apital structure is the financing of the firm represent primarily by long term debt# preference share and common stoc4# but e5cluding all short term credit' Thus# a firm6s capital structure is only a part of its financial structure' "apital structure policy involves a choice between ris4 and e5pected return' "apital structure of company consists of debt and e7uity securities# which provide fund for a firm on the same way capital structure made of debt and e7uity securities# which comprise a firm2s finance of its assets# it is a permanent finance of a firm represented by long term debt plus preferred stoc4 plus net worth' The term capital structure refers to the proportion of debt and e7uity capital' Thus# the financing decision of a firm relates to choice of proportion of debt and e7uity to finance the investment re7uirement' A proper balance between debt and e7uity is necessary to ensure of trade off between ris4 and return of these financing' A capital structure with reasonable proportion of debt and e7uity# capital is called optimal capital structure' 8ecision ma4ing is a process of choosing among alternatives' Alternative having minimum cost with reasonable return to other is acceptable' The cost of capital refers to the discount rate that would be used in determine the present value of the estimated future cash proceeds and eventually deciding whether the pro9ects worth under ta4ing or not' The term of capital structure means the financial planning according to which the assets of the company are furnished' The term capital structure means the proportion of different types of securities issued by a firm where the firm must should have to ma4e pertinent capital structure decision in identifying e5actly how much capital is needed to run their operations smoothly' :enerally# fund is ac7uired by the firm two ways# e7uity and debt' ;7uity provides the ownership fund of the shareholders and the debt or borrowed fund high a fi5ed charge irrespective to the earning of the firm' <hich# has to pay the fi5ed charge periodically to the debt provider= owever# it does not matter whatever the source of fund used by company# ultimately it is supply of fund in return there is need of some benefits in term of dividend or fi5ed interest charge to fund provider'

The capital# which can be collected from the owners of the organi!ation# is called e7uity capital' 3t provides ownership of the firm to its shareholder# who will get a return as per the profitability capacity of the company when they made capital investment' Actually# it is not compulsory to pay return in fi5ed rate of e7uity shareholders' The second and the ma9or source of borrowing the fund of capital is debt' 3n which we pay certain amount as the investment for it' <hatever gets firms profit or not' Sometimes higher debt increases the ban4ruptcy cost also due to the fact# if the operating earnings of the company is insufficient to pay interest on debt# the company must pay it even by selling the fi5ed assets' Thus# both debt and e7uity capital has their own value in the financial mi5' By good proportion combination of the firm arise the optimal capital structure' Through two sources of funds debt and e7uity together represent a capital structure of the firm' But while changes occur in the proportion of debt and e7uity is considering whole value as it is# it certainly affected to the total value of the firm' Thus every firm must determine the point at which the value of firm would be highest and the cost of the capital is lowest such point is called optimal capital structure which is the standard necessary re7uired of the firm' $a9an and >ingales ?*,,(@ conceptuali!ed the most important departures from the Modigliani and Miller assumptions that ma4e capital structure relevant to a firm2s value' Thus# there e5ist theories of capital structure# but very little is 4nown about their empirical relevance' Although much research in the area of capital structure has been completed# the pu!!le of how firms ma4e capital structure decisions is considered one of most significant unresolved problems in finance ?Brealey and Myers# *,00@' 8espite the theoretical appeal of capital structure# researchers in financial management have not found the optimal capital structure' Further the lac4 of a consensus about what would 7ualify as optimal capital structure has necessitated the need for this study' The capital structure is one of the most comple5 areas of financial decision ma4ing due to its interrelationship with other financial decision variables ?:itman# .11*@ and is crucial for any organi!ation because of the need to ma5imi!e returns to various organi!ational claimants and also because of the impact such a decision has on a firm2s ability to deal with its competitive environment' 3t also appears from theories of capital structure that the optimal use of debt and e7uity result into reduction in overall cost of capital that ma5imi!es the value of firm because of gain and cost of leverage' 3f the cost of capital can be minimi!es via some 9udicious mi5ture of debt and e7uity financing than the financing decision can ma5imi!e the value of the firm ?"opeland and <eston# *,,.@' A

Thus# the firm should strive to use optimal level of capital structure as part of its value ma5imi!ation ob9ective' 3n this bac4ground# a study devoted to e5pose more facts about determining factors of capital structure may be rewarding one and this study is one additional attempt in this direction'

. S!a!e"en! o# !$e Pro%le"

Previous studies on determinants of capital structures attempted to define the optimal capital structure for firms from various perspectives# such as ban4ruptcy costs ?Berger et' al'*,,(@# agency theory ?Bensen and Mec4ling# *,/-C Smith and <arner*,/,@# and asymmetric information ?Mayers and Ma9luf# *,0+@' ;ven if there e5ists the factors affecting capital structures# one cannot truly affirm an optimal capital structure in practice' A broad range of issues have also been discussed in empirical studies that focus on determinants of capital structures# such as firm characteristics# company strategy# or managing decision' A review of previous studies reveals that the following factors from firm characteristic affect capital structure areD firm si!e ?Myers and Ma9luf# *,0+@# profitability ?Myers and Ma9luf# *,0+@# non)debt ta5 shields ?Modigliani and Miller# *,(0C 8eAngelo and Masulis# *,0+@# "ollateral value of assets ?Mayers# *,//@# operating ris4s ?Mayers *,//@# dividend policy ?smith and <arner# *,/,@' Among these factors# firm si!e# collateral value of assets is positively correlated to capital structure# whereas profitability is negatively correlated to leverage' The non) debt ta5 shields# operating ris4 and dividend policy may have either positive or negative correlation' The capital structure has been the sub9ect of controversy since the publication of Modigliani and Millers ?*,(0@' Analysis of capital structure in selected public enterprises ?Shrestha# *,0(@' They hold the view that cost of capital to firm remains invariant to the capital structure changes on the other hand the traditional belief is that the cost of capital is the function of capital structure' Many empirical studies e5ist supporting the M'M' and traditional view' The capital structure concept has become very important since the publication Modigliani and Millers classical proper *,(0 ?:himire *,,,# pA@' They hold the view# that the cost of a firm remains invariant to capital structure changes' En the other hands# the traditional proposition is that the cost of capital is the function of capital structure ?Solomon *,-A@' There are many empirical studies e5ist supporting and refuting the M'M' and traditional view' Similarly by using British data of three

unregulated industries such as davenport ?*,/*# *A/)*-.@# <ipperh ?*,--# -*()-AA@ and Sharma and $ao ?*,-,#-/A)-//@ study are presented by first one tries to test M)M cost of capital proposition and regression e7uation were estimated and his result supported the traditional view# second one also conducted a test of the relationship between leverage and cost of capital and concluded that shareholders wealth can be enhanced by a 9udicious use of debt financing and lastly in respect of M'M' hypothesis and conclude that the cost of capital is affected by debt apart from its ta5 advantages' $espectively# ?Panday# *,0*@ compute the multiple regression e7uation to test the validity of M'M' Proposition and his results concluded that cost of capital is the function of capital structure investment' owever# when one or more of the assumptions are rela5ed# many authors demonstrate how firm2s value may vary with the changes in the debt)e7uity mi5' Most fre7uenty# the optimal capital structure ma5imi!es firm2s value by simultaneously minimi!ing e5ternal claims to the cash flow streams flowing from the firm2s assets' Such claims include ta5es paid to the government by the firm and its security holdersC ban4ruptcy costs paid to accountants# lawyers and the firm2s vendorsC and For agency costs incurred to align managerial interests with the interest of capital suppliers' *' <hat is the structure of debt ratios in Manufacturing 3ndustries= .' <hat is the trend in depreciation ta5 shield line= A' +' ow has growth opportunities changed over time in Manufacturing 3ndustries= ow does the ta5 ad9ustment stoc4 yield is effected by leverage# si!e of capital employed# growth in total assets# dividend payout ratio# earning variability and li7uidity ratio of Manufacturing 3ndustries= (' <hat are the relationships among leverage# cost of capital# si!e of capital employed# growth in total assets# dividend payout ratio# earning variability and li7uidity ratio of Manufacturing 3ndustries= -' 3s there proper relationship between capital structure and cost of capital in the conte5t of manufacturing companies= /' 0' ow much debt capital is preferred to use in capital structure= ow do the chief e5ecutive managers ma4e decision in funding new pro9ects= decisions of manufacturing industries=

,' <hich financial principles are given relatively importance in ma4ing financing

&. Re'earc$ O%(ec!)*e'+

The ma9or ob9ective of the study is to analy!e the capital structure in Manufacturing 3ndustries of Nepal' The following are the specific ob9ectivesD *' To e5amine the si!e and structure of capital structure ratios over time' .' To analy!e the structure of 4ey financial ratios in relation to capital structure' A' To e5amine the relationship of debt ratios with non)debt ta5)shield# growth opportunities# profitability and li7uidity' +' To analy!e the factors affecting capital structure' (' To e5amine the capital structure management practices in Manufacturing 3ndustries'

-' To identify the preference ran4ing of %ong)term sources of funds among

manufacturing industries that follows a financing hierarchy'

4. Theoretical Framework:
:enerally the term capital structure is referred to represent the proportionate relationship between the different forms of financingC it refers to the composition of firm2s capital structure with different sources of funds' Some time the distinction is made between the term Gfinancial structure and capital structure2' The term financial structure is used to represent the way a firm2s finances its total assets that cover entire capital and liability side' <hereas the term capital structure is used to indicate the composition of long term sources of funds# such as debenture# long term loan# preference capital# and e7uity capital including the reserves and surpluses# and e5cluding the short term debts' Studies embar4ing on analy!ing the factors in relation to the amount of debt in the capital structure of the companies do not seem to have reached conclusive results' Their findings are either contradictory# or statistically insignificant' For e5ample# while the correlation of factor can be positive in one study it can be negative in another' Furthermore# what could be applied to developed countries might not be applicable to less developed nations' $elative to the sub9ect matter of this study# the empirical literature suggests a

number of factors that may influence the financial structure of companies' As argued by Titman and <essels ?*,00@ and arris and $aviv ?*,,*@# the choice of the underlying owever# most of the e5planatory variables is fraught with difficulty' This is why different researchers have considered different 4ey variables in their respective studies' published studies have considered company si!e# profitability# li7uidity# growth opportunities# non)debt ta5 shields# and business ris4 are possible determinants of the capital structure choice' 3n this study following variables will be used as dependent H independent variablesC Model I 8ependent Iariable 3ndependent Iariables J%i7uidity J:rowth Epportunities Total %everage JNon)8ebt Ta5)Shields JProfitability Model II 8ependent Iariable Short Term %everage 3ndependent Iariables J%i7uidity J:rowth Epportunities JNon)8ebt Ta5)Shields JProfitability Model III 8ependent Iariable 3ndependent Iariables J%i7uidity J:rowth Epportunities Short Term %everage JNon)8ebt Ta5)Shields JProfitability De,enden! -ar)a%le'+ Total %everage K Total 8ebtFTotal Assets %ong Term %everage K %ong Term 8ebtFTotal Assets Short Term %everage K Short Term 8ebtFTotal Assets

Inde,enden! -ar)a%le' %i7uidity K "urrent AssetsF"urrent %iabilities :rowth Epportunity K Percentage "hange 3n Total Assets Non)8ebt Ta5)Shield K 8epreciationFTotal Assets Profitability K ;arnings Before 3nterest H Ta5FBoo4 Ialue of Total Assets

..1 T$eor)e' o# Ca,)!al S!ruc!ure/ The capital structure concept has an important place in theory of financial management' The term# capital structure# also 4nown as financial structure or financial plan or leverage' The financial decision of the firm is of the tool for achieving firm2s ob9ective of shareholders wealth ma5imi!ation' The term capital structure refers to the proportion of debt and e7uity capital' Thus# the financial decision of a firm related to choice of proportion of debt and e7uity to finance the investment re7uirement a proper balance between ris4 and return to the shareholders' owever# it can be e5pected that if the capital structure decision affects the total value of firm# a firm should selected such a financing mi5# which ma5imi!ed the shareholders wealth' The optimal capital structure and its implication are more noticeable' Argument between those who believe that is an optimal structure for each firm and among those who believe in the absence of such optimal capital structure for each firm and among those who believe in the absence of such optimal capital structure began late *,(1s and there is yet no resolution of the conflict ?Necon air# .11.@' 3n theory# capital structure can affect the value of the company by affecting either its e5pected earnings or the cost of capital or both# which it is true that financing mi5 can affect the total earning of firms as they are determined by the investment decision# it can affect the share of earnings belonging to the shareholders' But the leverage cans large influence the value of firm through the cost of capital' +'*'* Modigliani)Miller ?MM@ Approach The modern theory of capital structure began with the celebrated paper of Modigliani and miller published in *,(0 ? arris and $aviv# *,,1@' 3t is an alternative approach to the cost of capital which argues that# in the absence of corporate income ta5# the cost of capital and the mar4et value of a concern is independent of the capital structure' This approach is identical with the net operating income theory' The NE3 approach does not 0

provide operational 9ustification for the irrelevance of the corporate capital structure# while MM approach provide operational 9ustification for the constraint overall cost of capital and# therefore# the total value of the company' The hypothesis gets support from the presence of arbitrage in the capital mar4ets' Arbitrage Process Arbitrage is an act of buying assetsFsecurities in one mar4et ?at lower price@ and selling it in another ?at a higher price@' "onse7uently# e7uilibrium is restored in the price of securities in different mar4ets' ;ssentially# the arbitrage process is the purchase of securities whose price are lower and sale of securities whose prices are higher #in related mar4ets which are temporarily out of e7uilibrium' 3t is a balancing operation and implies that securities cannot sell at different prices' +'*'. Towards and Eptimal Financing Policy Modigliani and Miller ?*,-A@ argued that since the corporate ta5 allows the deduction of interest payment in calculation ta5 able income# the more debt in the capital structure# the lower the corporate ta5 liability# the higher after ta5 cash flows# and the greater the mar4et value of the firm' Miller ?*,//@ argues that ta5 advantage of debt is e5aggerated by considering the corporate profit in solution from personal income ta5es' e argues that the corporate ta5 advantage of debt is offset by personal ta5 rules on investor debt income that are higher than ta5 rate on investor e7uity income' 3n additional# Brennan and Schwat9?*,/0@ also argue that the corporate ta5 advantage of debt is lower because the interest ta5 shield is lost if the firm goes through ban4ruptcy and li7uidation' Furthermore# 8eAngelo and Massulis?*,01@ argue that substitute ta5 shield# such as investment ta5 credit# also reduce the corporate ta5 advantage of debt' MMs original wor4# published in *,(0# assumed a !ero corporate ta5 rate' 3n *,-A# they published a second article that included corporate ta5 effects' <ith corporate income ta5# they concluded that leverage will increase a firm2s value# because interest on debt is a ta5 deductible e5pense# and hence more of a leveraged firms operating income flow through to investors' The MM propositions when corporation are sub9ect to income ta5 follow'

Proposition 3 The value of levered firms is e7ual to the value of an unlevered firm in the same ris4 class plus the gain from leverage' <hich is the value of the ta5 saving and which e7uals the corporate ta5 rate times the amount of debt the firms uses' Therefore# I%KIULT8 The important point here is that when corporate ta5es are introduced# the value of the levered firm e5ceeds that of the unlevered firm by the amount T8' Proposition 33 The cost of e7uity to a levered firm is e7ual to the cost of e7uity to unlevered firm in the same ris4 class plus a ris4 premium whose si!e depends on the differential between the cost of e7uity and debt to an unlevered firm# the amount of financial leverage# and the corporate ta5 rate' Therefore# &S%K &SU L ?&SU M &d@ ?*)T@ ?8FS@ +'*'A Trade)Eff Theory of "apital Structure The preceding arguments of corporate ta5 effect of MM# which contend that capital structure matters and the presence of financial or ban4ruptcy costs led to the development of NTrade)off MtheoryO of capital structure' Modigliani and Miller ?*,(0@ tried to bring the theory closer to reality by incorporating the e5istence of the corporate income ta5# however# they were at fault and they had to correct the findings ?Modigliani and Miller# *,-A@' They agreed with a positive value of the ta5 shield in the case when the paid interests are the ta5 deductible e5penses# whereas dividends are not' 3n this case the value of the firm is e7ual to the value of the unleveled firm plus the present value of the ta5 shield' owever# if the benefit of the ta5 shield is admitted# the optimal capital structure is achieved when the firm if financed entirely by debt' 3t is not a result supported by empirical evidence' Therefore# there should be also some disadvantages of using debt financing' "osts associated with debt financing in case of the trade)off theory are the costs of financial distress' Therefore# the value of the firm is e7ual to the value of the unleveled firm plus the present value of ta5 shields minus the present value of the costs of financial distress' <hen leverage is low# the benefits of the ta5 shield on additional debt outweigh the increasing costs of financial distress' 3n general# trade off theory predicts that firm maintains a target debt e7uity ratio that ma5imi!ed the firm value by minimi!ing the cost of prevailing mar4et imperfection' Brigham and ;hrhardt

*1

?.11+@ states# in trade)off model# optimal capital structure can be visuali!ed as a trade)off between the benefit of the debt ?the interest ta5 shelter@ and the cost of debt ?the cost of financial distress or ban4ruptcy H agency costs@' The theory claims that the trade)off between the losses and gains of borrowings# holding the firm assets and investment constant# determines the optimal debt ratio' The firm substitute debt for e7uity or e7uity for debt until the value of the firm is ma5imi!ed' According to the trade off model is firm should set a target capital structure that balance the costs and benefits of leverage# because such a structure will ma5imi!e the value of the firm' Financial manager often thin4 of the firms debt e7uity decision as a trade)off between interest ta5 shields and the cost of financial distress and agency costs' Ef course there is controversy about how valuable interest ta5 shield are what 4inds of financial troubles are most threatening' This trade off theory of capital structure recogni!es that target debt ratio may vary from firm to firm' "ompanies with safe tangible assets and plenty of ta5able income to ta5 shield ought to have high target debt ratio' Unprofitable companies with ris4y# intangible assets ought to rely primarily on e7uity financing' +'*'+ Pec4ing Erder Theory The pec4ing order theory would indicate that the profitability of a firm affects its financing decision' 3f it issues debt# this means that the firm has an investment opportunity that e5ceeds its internally generated funds' So# changes in the capital structure often serves as a signal to outsiders about the current situation of the firm as well as the managerial e5pectations concerning future earnings' This is called the signaling theory' The debt offering is believed to reveal information the management of a firm is e5pecting about future cash flows if it will cover the debt costs' owever# the ban4ruptcy fears still impact the signal and intensify the cost of this signal' Such conclusions are supported by results of most empirical wor4s for e5ample# As7uith and Mullins ?*,0-@ and ;c4bos ?*,0-@Mthat documented a positive effect on stoc4 prices when leverage increases while leverage decreasing announcement have a negative effect' 3n their pioneering wor4# Myers and Ma9luf ?*,0+@ showed that' 3f investors are less well informed than current firm insider about the value of the firm2s assets# then e7uity may be mispriced by the mar4et# if firms are re7uired to finance new pro9ects by issuing e7uity' Under pricing may be so serve that new investors capture more than the NPI of the new pro9ect# resulting in a net loss to e5isting shareholders' 3n this case the pro9ects will be re9ected even if its NPI is positive 'this under investment can be avoided if the **

firm can finance the new pro9ect using a security that is not so severely undervalued by the mar4et' For e5ample# internal fund and For ris4less debt involve no undervaluation# and therefore# will be preferred to e7uity by firms in this situation' ;ven ?not too@ ris4y debt will be preferred to e7uity' Brennan and &ran ?*,0/@# Noe ?*,00@# and "onstantinides and :rundy ?*,0,@ cast doubt on the pec4ing order theory' These papers enrich the set of financing choices that a firm may ma4e when faced with the situation modeled by Myers and Ma9luf?*,0+@' They concluded that firms do not necessarily have a preference for issuing straight debt over e7uity and that the underinvestment problem can be resolved through signaling with the rich set of financing options' 8onaldson ?*,-A@ reaches a similar conclusion of resorting to e5ternal financing only if financing cannot be generated internally which supports the pec4ing order theory of capital structure' According to him capital structure choice depends on the firm2s investments opportunities and its profitability' ighly profitable firms might be able to amaifar et al' finance their growth by using retained earnings and by maintaining a constant debt ratio' 3n contrast less profitable firms will be forced to resort to debt financing' ?*,,+@ and Titman and <essels ?*,00@ report results that are consistent with the notion that larger firms have higher debt ratios' There is also strong empirical evidence for the profitability and debt ration that supports of &ester ?*,0-@ and $a9an and >ingales ?*,,(@ lend strong support for the negative relationship of profitability and debt' The pec4ing order theory e5plains the inverse relationship between profitability and debt ratio' +'*'( Agency "ost Theory Beusen and Mec4ling ?*,/-@ developed the capital structure theory based on the different agency cost and argued that an optimal capital structure can be obtained by trading off the agency related costs and benefits' 3n modern business# separation of owners and business may create the conflicts between agents and principal' 3f the parties in agency relationship are utility ma5imi!es# there is good reason to believe that agency may not always act in the best interest of principal H conflict arise' Thus# such conflicting interest between principal and agency# and e7uity holders and debt holders create agency costs' The cost arising from the conflict of interest of the agency principals and e7uity holders) debt holders are of two typesD the agency costs of e7uity and agency costs of debt' According to the agency cost theory of capital structure# optimal capital structure e5ists when total agency cost A%?;@ in the firm in minimal' Total agency cost is defined by *.

A%?;@ KASE?;@ L AB?;@'<hereas# ASE?;@ is the outside e7uity agency costs incur due to conflict between management and e7uity holders# AB?;@ is defined the debt agency costs due to the conflict between debt holders and e7uity holders# ; K s E F ?sELB@# so# is the outside e7uity held by anyone outside the firm# B is debt held by anyone outside the firm' The optimal capital structure is attainable where the agency cost At?;@ becomes minimum' Thus# this theory advocates that there is optimal capital structure' The agency costs arise from two agency relationships) ?*@ between shareholders ?owners@ and debt holders# and ?.@ between shareholders ?owners@ and managers ?non) owners@# both being based on information asymmetry' "onflict between shareholders and debt holders is described by Bensen and Mec4ling ?*,/-@' They come up with the arguments of why the probability distribution of a firm2s cash)flows is not independent of its capital structure' 3n reference to their study# when a company is highly levered# owners have incentives to engage in highly ris4y pro9ects that will increase their wealth if they are successful but that will pre9udice debt holders if they are not' 3n other words# higher ris4 increases the upside for stoc4holders while the downside must be absorbed by the firm2s creditors' As a conse7uence# it becomes necessary to establish control devices in debt contracts' "onflict between debt and e7uity investors in the case when there is a ris4 of default is well documented by Myers ?*,//@' e points out that when a firm is li4ely to go ban4rupt# shareholders may have no incentives to provide new capital# and even it is invested in the pro9ects with a positive net present value' The reason is that the shareholders pay all costs# whereas some part of returns may be captured by debt holders' En the other hand# some models show that the incentives of levered shareholders to engage in ris4y pro9ects are reduced' For e5ample 8iamond ?*,0,@ introduces a model which is based on reputation' shareholders and debt holders@ problems' A different reputation)based model is built by irshleifer and Tha4or ?*,,.@' They have e analy!es the 9oint influence of adverse selection ?different types of firms@ and moral ha!ard ?conflict between

analy!ed the situation in which a manager may manipulate investment policy of the firm in order to develop a personal reputation for high ability' The conflict between shareholders ?owners@ and managers ?non)owners@ is a classical principal)agent relationship' 3t is assumed that managers have some scope for pursuing their own interests at shareholders2 e5pense because of asymmetric information and that it is the costly mechanisms imposed by principals upon agents in order to prevent these *A

self)interest)performances of theirs that create the costs' Managers have incentives to act in their own interest which may result in actions against the owners2 interests' The concept of agency costs into the area of capital structure management' The contribution revolves around of concept that Bensen labels Nfree cash flowO' Free cash flow is cash flow in e5cess of that re7uired to fund all pro9ects that have positive net present values when discounted at the relevant cost of capital ?Benson# *,0-@' Bensen then puts forth that substantial free cash flow can lead to misbehavior by manager and poor decisions that are not in the best interest of the firm2s common stoc4 holders' 3n the other words managers have an incentive to hold on to the free cash flow and have fun with it# rather than using the cash in the form of higher cash dividend payments' This leads to what Bensen calls his Ncontrol hypothesisO for debt creation' By levering up# the firm2s shareholders will en9oy increase control over their management team' For e5ample# if the firm issues new debt and uses the proceeds to retire the outstanding common stoc4# then management is obligated to pay out cash to service the debt)this simultaneously reduces the amount of free cash flow available to management with which to have fun' 8ebt Financing and Agency Problems 3n agency cost models# financing decisions affect value of the firms because they produce behavior of manager of the firms that affects profitability' Thus# Bensen and Mec4ing ?*,/-@ argue that higher leverage allows a firms manager to hold a larger fraction of its common stoc4' This reduces agency problems by aligning the manager2s interests more closely with the interests of other stoc4)holders' Bensen ?*,0-@ argues that leverage also enhances value by forcing the firms to payout resources that managers might otherwise waste on bad investment' En the other hand# Fama and Miller ?*,/.@ and Bensen and Mec4ling ?*,/-@ suggest that leverage increases the incentives of stoc4holders to ma4e ris4 investment that shift wealth from bondholders but do not ma5imi!e the combined wealth of security holders' Myers ?*,//@ suggests that leverage can cause firms to under invest because the gains from investment are shared with the firms e5isting ris4y bonds' Agency theorists have long recogni!ed that the separation of ownership and control common in most corporations creates conflicts of interest between a firm2s managers and shareholders' These conflicts ?agency problems@ arise because managers have the opportunity to use the assets of the firms in ways that benefit themselves personally but

*+

decrease the wealth of the firm2s shareholders' ;5amples of this type of opportunistic behavior by managers include consuming an e5cessive amount of pec4s# shrin4ing of their responsibilities# and investing in negative net present value ?NPI@ pro9ects that offer personal diversification benefits that firms managers' Amihud and %ev ?*,0*@ Friend and asbrouc4 ?*,00@ believe that some of these opportunistic behaviors results because many managers have large proportions of their personal wealth invested in their firm2s common stoc4 and in firms)specific human capital' Because their personal wealth is heavily invested in their employers# these managers will lose a large part of the personal wealth if their employer goes ban4rupt' $is4)averse managers may see4 to mitigate this ris4 by acting to reduce the ban4ruptcy ris4 of the firm' Friend and asbrouc4 ?*,00@ suggest that one way to accomplish this is to use less than the optimal amount of debt in the firm2s capital structure' Further# the greater the proportion of personal wealth is that managers have tied up in the form of common stoc4 and firm) specific human capital and greater their incentive to minimi!e the use of debt in the firm2s capital structures' +'. $eview of Ma9or ;mpirical <or4s $eview of related empirical wor4s is a way to discover what other research in the area of problem under study has uncovered' 3t specifies the way to avoid investigating problem that has already been definitely answered' Thus# considering the importance of the related past studies# this chapter summari!es the empirical evidence concerning a firms capital structure' ;ver since publication of Modigliani and Miller ?*,(0@ seminal paper# scholars have carried out number of empirical studies on the capital structure issues must of these empirical studies have been carried out and published in the USA and other developing and least)developed mar4et conte5t' The review of all empirical wor4s# which are available in finance literature# is not possible within the scope of this study' Therefore# only the review of related empirical literature on capital structure has been carried out in this study' The review has been underta4en by classifying the literature under different periods in which the literature on MM hypothesis is presented first' Additionally# the review of literature in 3ndian and Nepalese conte5t has been carried out'

*(

Some of the studies concentrated on testing MM hypothesis are presented in Table .'*'

Table .'* Re*)e0 o# "a(or e",)r)cal 0ork'

Studies MM (1958) Dohaldson (19 1) Topic Major finding Test of MM independent Acceptance of MM hypothesis. hypothesis De!t capacity theory The financing hierarchy si"ilar to pec#ing orders (the i"plied rejection of MM $eston (19 %) MM (19 %) )eterson (19 9) Test of MM hypothesis hypothesis). &ejection of MM hypothesis.

Test of ta' ad(antage on Acceptance of ta' ad(antage on le(erage. le(erage. Test of relationship !et*een !usiness ris# and capital structure. Test of MM hypothesis Test of MM hypothesis Test of fir" si1e and capital structure +apital structure (aries *ith the !usiness ris#. Accepted of MM hypothesis. &ejection of MM hypothesis. )ositi(e relationship !et*een fir" si1e and capital structure. )ositi(e relationship !et*een fir" si1e and capital structure. 2egati(e relationship !et*een fir" si1e and capital structure. )ositi(e relationship !et*een profita!ility and le(erage.

,a"ada (19-.) /lath and 0noe!er (198%) Marsh (198%)

Auer!ach (1985)

Test of fir" si1e and capital structure

Tit"an and $essels Test of fir" si1e and (1988) 3o*e and Taylor (1998) capital structure Test of profita!ility and le(erage

owever# their studies have been critici!ed on many grounds' The unrealistic assumption was critici!ed much' Beside# the selection of firm2s i'e' oils companies and electric utilities display diverse characteristics which violate the assumption of same ris4 class re7uired by both assumptions' The business toward irrelevance proposition by use of same denominator in both dependent and independent variables has also been pointed out by Baryes ?*,-A@' Futher business may also occur from the e5clusion of other variables in their regression model in their study' The capital structure has been considerable number of empirical studies underta4en in recent years# which e5amined the traditional capital structure determinants' Among the traditional determinants of capital structure si!e# growth# profitability# ris4# assets structure are the ma9or variables e5amined in these literatures' The ma9or recent studies areD Bevan and 8onbold#.111C Pandey#.11*C "asser and *olmes#.11AC Both et al'.11*C

"asser and and

omes# .11AC Frydenberg#.11AC and leverage and si!e?BevanH

8onbold#.111C Pandey#.11*C Both et al'.11*C Antoniou et al'.11.C Fran4 H :oyal# .11+ aung HSong#.11.@' Some of the studies concentrated on capital structure studies Table .'. $eview of ma9or studies during .111s
Studies Sa"ple and Major finding )ositi(e and highly significant relationship !et*een long ter" de!t and the le(el of gro*th opportunities in !oth 1991 and 199-. Significant positi(e relationship !et*een co"pany si1e and long co"pany si1e and short ter" !an#. period 4e(an and 1556 non Don!old (.555) financial listed 70 fir"s o(er fro" 19918 +asser and ,ol"es (.55%)

are presented in table .'.'

the ti"e period ter" de!t *hile significant negati(e relationship !et*een 199-. /inal sa"ple of Assets structure9 profita!ility and gro*th are i"portant of capital 1555 Australian of capital structure and financing. )rofita!ility "easures !y &:A fir"s for 19958 are negati(e and significant.;ro*th is positi(e for all dependent 1998. (aria!les and significant for le(erage9 short8ter" le(erage and outside financing. +oefficients of ris# are positi(e for all capital structure "easured assets structure and le(erage relation found /ryden!er 1655 g (.55%) 2or*egian "anufacturing co"panies for /an et al. (.55%) 19958.555. S%66 firs of ele(en %9 countries o(er 19918 to !e negati(e. The lag de!t le(el has positi(e and significant influence on today<s de!t le(el the fi'ed assets appear to !e significant and positi(e. The &:A coefficient is found to !e negati(e and significant. 2on de!t ta' shield has negati(e coefficient *hile the si1e (aria!les has positi(e coefficient. The e(idence indicates that the institutions factor "ainly the legal and ta' syste"s clears affects capital structure choices across The present of infor"ation inter"ediaries is associated *ith lo*er le(erage.

industries fro" countries.

.555. /ran# and :!ser(ations of This study e'a"ines the relati(e i"portance of "any factors in ;oyal (.556) 7S pu!licly traded fir"s e'cluding financial fir"s for sa"ples years 19558 .555. the le(erage decisions of pu!licly trade 7.S. fir"s fro" 1955 to .555. The finding are the "ost relia!le factor are "edian industries le(erage (=effect on le(erage)9 "ar#et8to8!oo# ratio (8)9 collateral (=)9 profit (8)9 di(idend paying (8)9 lag of assets (=)9 and e'pected inflation (=). >ndustry su!su"es a nu"!ers of s"aller effects.

*/

,aas and )anel dataset peters (.55 ) for non8 go(ern"ent

)rofita!ility and age are found to !e the "ost ro!ust deter"inants of forget capital structure across countries. There is a significant negati(e relationship !et*een profita!ility for get le(erage in the out of 15 country

o*ned fir"s in total sa"ple regression9 as *ell as in ?astern ?uropean countries during 1995s

ten central and regression. The negati(e coefficient point to infor"ation asy""etries and su!stantial e'ternal financing pre(ious in the o(erall regression9 as *ell as in all indi(idual country regressions9 as enters positi(ely and significantly.

The related studies that have been made into Nepalese enterprises and related as well as relevant to this study have been reviewed under this sub)section of thesis' These ma9or studies that have been done in the past by Nepalese scholars during the different time periods from *,0( to.11/ are presented into table .'A and there are closely related to this research wor4 about capital structure managements'

Table .'A
Ma9or Nepalese studies on capital structure
2epalese Topic Major findings studies Shrestha Analysis of capital structure in @ery i"!alance and confusing capital structure. (1985) 0hanal (199.) Shrestha (199%) Sherpa (.55-) 4hattarai (.55-) selected pu!lic enterprises. +apital structure of industrial pu!lic enterprises. +apital in(est"ent and earning *ere not correlated9 de!t eAuity ratio and financial

perfor"ance also !ad thus "ost of )?s in loss. +apital structure selected and Most of the" ha(e no transparent capital structure listed pu!lic co"panies. +orporate capital structure 2epal. Deter"inants of capital structure in 2epalese e(idences and these co"panies are adhoc deter"ined the capital structure *ithout realistic para"eters. +apital structure is finding in relation to the "easure"ent of (aria!les. +apital structure is depends on sa"ple si1e9 liAuidity position9 profita!ility situation and attitudes of shareholders.

and its deter"inants a case of (ariation of sa"ple si1e9 study period and

Most of the studies appeared the finance literature has attempted to further e5plain the capital structure by loo4ing into several determinates of capital structure under different theoretical framewor4' Some of the recent studies have also focused on e5ploring the lin4 between capital structure theory and the corporate practice' The review of several relates studies indicate that there is no agreement in the results of these studies' For

*0

e5ample# the tangibility or the collateral assets# si!e# profitability# growth# ris4 of the firm# non)debt ta5 shields# li7uidity# industrial classification and many other firm related variables are found to be significant in determining the capital structure of the firm' owever# the finding regarding how these variables are related with and affects to capital structure has remained as unresolved issues' These variables have been found important in many conte5ts such as in the conte5t of USA# ;urope# Australia# Bapan and some other Asian countries' The similar findings appeared also in the 3ndian conte5t' But# the direction and significance of impact these variables on leverage were found varied across firm# industry and country' Few studies in the Nepalese conte5t also find more or less the similar contradictory results as in the studies of other countries' Beside# the review has also revealed many other variables as the li4ely influential variables in the determination of capital structure' The review of studies reveals additional 7ualitative factors such as financial fle5ibility# credit rating# earning and cash flow volatility# insufficient internal founds among others as factors influencing the capital structure decision' Therefore to conclude the capital structure issue has been remained highly contentions in the field of finance' The determinants of capital structure vary greatly across different firms' There are the several factors that determine the capital structure of the firms' These factors are collateral value of assets# growth opportunities# profitability# firm si!e# and volatility of income and non debt ta5 shield that includes depreciation# investment ta5 credit' The empirical studies have shown that the leverage is positively related with collateral value of assets and si!e of the firm whereasC it is negatively related with growth opportunities# volatility# profitability and non debt ta5 shield'

1. Re'earc$ Me!$odolog2+
The basic ob9ectives of this study as described in the introductory chapter are to e5amine the management of capital structure of Manufacturing 3ndustries of Nepal' To achieve the above )mentioned ob9ective# appropriate research methodology has to be followed' Therefore in this study# focuses will be made on research design# nature and sources of data# selection of enterprises and method of analysis' 1.1 Re'earc$ De')gn

*,

The analysis of this study will be based on certain research design' $esearch design means definite procedure and techni7ue which guides in studying profound ways for research viability' So selection of appropriate research design is necessary to meet the study ob9ectives of any research' 3t emphasi!es on descriptive and analytical study of the collected data on profit and loss account and balance sheet over a period of time and it gives suggestion on the improvement of the capital structure' So this study will be based on description and analytical research design' A research design is the arrangement of conditions for collection and analysis of data in a manner that aims to combine relevance to the research purpose with economy in procedure' Using 7uantities and 7ualitative analysis method will be carried out in this study' Mostly# the secondary data will be used for analysis' The discussion and personal interview with concerned employees of the industry will not be used for 7ualitative analysis' $esearch may be defined as the ob9ectives and systematic methods of finding solution to a problem i'e' systematic collection# recording# analysis# interpretation and reporting of information about various facts of a phenomenon under study' 3n other word# research refers to the systematic method consisting of enunciating the problem# collecting factors of data# analy!ing the facts critically and reaching conclusion based on them' ence# the research design adopted in this study is descriptive type on it is based on fact finding operation surveys' 1. Na!ure and Source' o# Da!a This study will be made mainly from the secondary data analysis as well as primary tools of data collection and analysis as per the research need to fulfillment of the main ob9ective of research' The necessary data and information will be collected from different sources covering a period of si5 year .11/ to .1*.' 3t will e5clude ban4# finance company and other financial institutions from the sample' This study will not cover each of the Nepalese manufacturing industries because of the data problem' All data in this study will be compiled from the financial statements and annual reports of the industries' Effice of the Accountant brings out the official annual reports# which contain the profit and loss account# balance sheets of the manufacturing company of Nepal' Similarly# some of the manufacturing organi!ations listed in stoc4 e5change submit their annual .1

financial report to the Securities Board of Nepal ?S;BEN@' These organi!ations compile these data in their own format' The necessary data on capital structure and other related variables used in this study will be collected mostly from these reports' The balance sheet will give information of debt and e7uity' Similarly# the profit and loss account will give data on trading sales and e5penses' The annual report will also give the brea4down of these items' Secondary data which will be obtained through annual reports of sample firms contain the annual report of the auditor general office ?A:E@ .11/ to .1*.' Annual report of concerned industries and security e5change board of Nepal will be the ma9or sources for secondary data' 1.& Po,ula!)on 3 Sa",le Enly ( manufacturing companies will be selected as sample' Much li4e in other capital structure research# ban4s and financial companies will be e5cluded in the sample' The manufacturing companies will thus constitute the population' The random sampling techni7ue will be adopted in selecting the companies as sample' The period covered for the study will be .11/ to .1*. but may vary depending on the availability of data' 1.. Da!a Pre'en!a!)on 3 Me!$od o# Anal2')' Presentation and analysis of data is one of the important part of the research wor4' The collected raw data will be first presented in systematic manner in tabular form and then will be analy!ed by applying different financial and statistical tools to achieve the research ob9ectives' The tools that will be applied will be) 1. F)nanc)al Anal2')'+ The ma9or tool employed for the analysis of this study will be the ratio analysis that established the 7uantitative or numerical relationship between two variables for the financial statements' Some of the financial ratios that will be calculated areC Profitability# %i7uidity# :rowth Epportunity# Non)8ebt Ta5)Shield# Total %everage# %ong Term %everage# Short Term %everage etc' . S!a!)'!)cal Anal2')'+ Beside financial analysis# the statistical tools will also be used in this study' Statistical tools are the important tools to analy!e the data' There are various tools for the analysis of data such as mean# standard deviation# regression analysis# correlation analysis# various types of tests etc' The convenient statistical tools will be used in this thesis study'

.*

Re#erence'
$ishi $a9 :autam H &iran Thapa# ?.110@ "apital Structure Management# Asmita Publication# Pn'.,()A* A!aya B' Sthapit# ?.1*1@ Statistical Methods# Buddha Publication' Shyam)Sunder# %' and S'"' Myers# *,,,# NTesting Static Tradeoff against Pec4ing Erder Models of "apital Structure#O Journal of Financial Economics (*# .*,) .++' F' Modigliani and M' ' Miller# NThe "ost of "apital# "orporation Finance and the Theory of 3nvestmentO American ;conimic $eview ?Bune *,(0@ Pn .-*).,/' Michael Pinegar and %isa <ilbricht# ?*,0,@' <hat Manager Thin4 of "apital Stucture Theory# A survey Barges# A' ?*,-A@' The effect of capital structure on the cost of capitalD A test and evaluation of the Modigliani and Miller proposition' ;nglewood "liffs# New Bersey' Prentice all' Miller# M' ' H Modigliani F' ?*,--@' Some estimates of the cost of capital to the electric utility industry' American ;conomic $eview# (-?.@# AAA)A,*' Nepal Stoc4 ;5change %td' ?.11,P*1@ Trading $eport# &athmandu' Norton# ;' ?*,,*@' Factors affecting capital structure decisions' The Financial $eview# .-?A@#+A*)++-' Pandey# 3'M' ?*,/-@' "apital structure and the cost of capital' New 8elhiD Ii4as Publishing ouse Pvt' %td' Pandey# 3'M' "hotigeat# T' H $an9it# M'&' ?.111@' "apital structure choices in an emerging capital mar4etD case of Thailand# Management and change# +?*@A()-,' $a9opadhyay# pradip ?.11/@# Nan investigation into capital structure issues# A case of Nepal'O M'phil thesis# Tribhuvan University' Security Board ?.11,P*1@' Annual $eport' &athmandu' Sherpa# %a4pa :elu# ?.11/@' N"orporate capital structure and its determinantsO' M'phil# Tribhuvan University' Shrestha# M'&' ?*,0A@' Financing of public enterprises in NepalD a study with special references to financial planning in public utilities# Ph'8' ThesisD Faculty of Management# 8elhi University'

..

 Shrestha# M'&' ?*,0(@' Analysis of capital structure in selected public enterprises' The Nepalese Bournal of public Administration# *-?.@# +.)(A' APPENDI4D) 3 5UESTIONNAIRES Name of $espondentD '''''''''''''QQQQQQQQQQQQQQQQQQ AgeD QQ

*' 8o you have debt capital in your firm= a' Res

b' No

.' 3s there any relationship between used debt capital and overall cost of capital of a firm= a' Res b' No

A' <hat do you thin4 the optimal debt capital ratio in a firm= a' %ess than .1 percent of the total asset' b' .1 to +1 percent of the total asset' c' +1 to -1 percent of the total asset' d' Above -1 percent of the total asset'

+' 8o you have practice of determining the optimal capital structure in your firm= a' Res b' No

(' Please indicate whether your firm has target ?optimal@ debt to total asset ration= a' Target b' Actual c' Not yet 8etermined

-' $an4 the following sources of long)term funds in order of preference for financing new investments' ?*K first choice# -K last choice@ a' 3nternal ;7uity ?$etained ;arningFAccumulated Profit@ SSSSSSS b' ;5ternal "ommon ;7uity ?"ommon Share 3ssue@ SSSSSSS

.A

c' Straight 8ebt d' "onvertible 8ebt e' Straight Preferred Stoc4 f' "onvertible Preferred Stoc4

SSSSSSS SSSSSSS SSSSSSS SSSSSSS

/' Appro5imately what percent of the time would you estimate that your form2s outstanding securities are priced fairly by the mar4et= a' More than 01 percent of the time b' Between (1 to 01 percent of the time c' %ess than (1 percent of the time

0' :iven an attractive new growth opportunity that could not be ta4en without departing from your target capital structure or financing hierarchy# what action do you suggest to your firm most li4ely to ta4e= a' To far go the growth opportunity b' To deviate from the target capital structure or financing hierarchy c' To cut the dividend d' To sell off the other assets

,' <hich of the following purpose is most important of using debt capital= ?3ndicateD %ess 3mportant# 3mportant# More 3mportant or Most 3mportant@ a' To reduce ta5 liability' b' To magnify return to shareholders' c' To reduce the agency cost' d' To maintain ownership control unchanged'

Than4s for your 4ind co)operation'

.+

.(