Project Report for Partial Completion of

Corporate Finance Subject

Impact of size on Capital Structure: A Study of Indian Firms

Submitted to:
Professor Shaphali Gupta
Marketing
MDI, Gurgaon
Presented by:
Group-3 Section-A NMP-29
Abhijeet Sharma
Anupam Kumar
Ashish Sharma
Bhupesh Chawla
Debraj Sinha Roy
Neerja Malik

Abstract

29NMP01
29NMP13
29NMP17
29NMP21
29NMP23
29NMP47

One of the key determinants of leverage is firm size. Larger firms are usually more
established in their markets, diversified and less likely to fail. Therefore, it has been
argued that size can be seen as an inverse measure of bankruptcy risk. The aim of
this project is to investigate the relationship between firm size and the capital
structure of Indian small and medium-sized enterprises. Most of previous studies
have shown a positive relationship between firm size and leverage. But, several
empirical studies found negative relationship between firm size and leverage.
Research indicates negative relationship between firm size and leverage. But, firm
size differently affect short-term and long-term leverage. The relationship between
firm size and short-term leverage is negative but not statistically significant in all
observed years. The relationship between firm size and long-term leverage is
positive in all observed years but is not statistically significant, except one year.
Trade-off theory predicts that larger firms tend to be more diversified, and hence
less risky and less prone to bankruptcy. Further, if maintaining control is important,
then it is likely that firms achieve larger size through debt rather than equity
financing. Thus, control considerations also support positive correlation between
size and debt. However, it can also be argued that size serves as proxy for
availability of information that outsiders have about the firm. From pecking order
point of view, less information asymmetry makes equity issuance more appealing to
the firm. Thus, a negative link between size and leverage is expected.

Introduction

Capital structure can be define as the proportional relationship

between equity and debt. Decisions concerning capital structure
and it is way of financing is the most important issue for
managers and owners of the enterprises. However, it is not an
easy job because it involves the wise proportional selection of
debt and equity which includes different costs and benefits in
balancing between debt and equity. A wrong decision in the
selection between the funds may lead the firm to financial
distress and eventually to bankruptcy (Andrei, 2013)1 . The
process of financing takes a very important place in firm
management because it must ensure financial continuity
necessary for growth and maintaining competitiveness in their
environment. This is especially evident in transition economies,
where due to underdeveloped capital markets debt remains the
main source of financing. Capital structure theories offer a
number of determinants that are responsible for various impacts
on capital structure, while the empirical literature tend to find
evidence that firms behave in accordance with the theoretical
predictions (Shamshur, 2010)2 . Mostly they focus on those
determinants which are more likely to have a major role on
leverage decisions. Although there have been various studies
analysing capital structure, it is still debated what the
determinants of capital structure are and how they impact capital
structure decisions. Since Modigliani and Miller published their
seminal paper in 1958, the issue of capital structure has
generated great interest among researchers. From the theoretical
point of view, existing empirical studies widely used two models
of capital structure: the trade-off theory and the pecking order
theory. Trade-off theory implies that a company's capital structure
decisions involve a trade-off between the tax benefits of debt
financing and the costs of financial distress. The pecking order
theory points out that there is a certain order in financing, starting
from retained earnings as a primary source of internal financing,
then moving to debt and using equity only as the last resort. Each

of these theories suggests how certain determinants affect capital

structure. According to theories, researchers found various
impacts of determinants on capital structure depending on the
country they are analysing.

Background

Classical Modigliani-Miller theorem (1958) asserts irrelevance of debt-to-equity ratio for firm
value. However, complete markets, no taxes, absence of transaction and bankruptcy costs, the
theory about the debt irrelevance is hardly realistic. Later, Modigliani and Miller (1963) relaxed
a no-tax assumption and developed a theory about tax benefits of debt. That paper gave rise to a
serious academic discussion on the theory of capital structure.
There are two main benefits of debt for a company. The first one is the tax shield: interest payments
usually are not taxable, hence the debt can increase the value of the firm. Another benefit is that debt
disciplines. Managers use free cash flows of the company to invest in projects, to pay dividends, or to
hold on cash balance. But if the firm is not committed to some fixed payments such as interest
expenses, managers could have incentives to waste excess free cash flows. That is why, in order to
discipline managers, shareholders attract debt. Besides, it is a popular practice in debt agreements
between banks and borrowers to introduce some financial covenants for firms (minimal level of the
free cash flow, debt-to-EBITDA ratio, EBITDA-to-interest expenses ratio etc.). Companies cannot
break these covenants, and hence are bound to be more effective. In addition, the law usually

guarantees a right of partial information disclosure to the companys debt holders, which serves
as additional managers supervision tool. As a result, actions of managers become more
transparent, and they have more incentives to create higher value for the owners. This is the
essence of Free Cash Flow Theory of capital structure.

Extravagant investments is one of the ways in which managers may not behave in the owners
best interests. This is called hazard problem. A standard example is huge exploration spending
by oil industry managers in the late 1970s, when it was cheaper to buy oil on the Wall Street than

to drill for it or to pump it. Besides, managers of the oil industry companies invested a large part
of their excess cash into non-core activities (Jensen, 1988). Blanchard et al. (1994) showed that
managers of firms who received cash windfalls often spent them on acquisitions of unrelated
firms and other activities which did not create any value for shareholders. These and other facts
prove that conflict of interest between managers and owners exists.
The cost hypothesis predicts that higher level of debt is associated with better firm performance.
Agency costs are costs which arise in agency conflict. There are several mechanisms through
which high leverage may reduce agency costs and as a result increase firm value:
1. Monitoring activities of debt holders
2. Managers fear of firm bankruptcy and liquidation, following misuse of funds, which may

lead to losses of reputation and salaries

3. Reduction of overinvestments.

Undoubtedly, there are other ways for shareholders to discipline managers. For example, owners
may commit managers to pay dividends, leaving less free cash flow at managers disposal. As a
result, firms with clear separation of managers and owners should pay higher dividends
.However, in this study we concentrate only on debt as a disciplining mechanism.
Since the value of the firm is directly related to its performance (the better a firm performs, the
higher its value is), economists study the relationship between leverage and firm performance in
order to check theory . Empirical studies have not reached an agreement about the relationship
between leverage and firm performance yet. Coricelli et al (2011) in their EBRD study of Central and
Eastern European companies showed hump-shaped relationship between the level of debt and
productivity growth. At the same time, Majumdar and Chhibber (1999) found significantly negative
effect of level of debt on firm performance. results even in basic facts about capital structure.
Therefore, an empirical evidence of the relationship between leverage and firm performance is still
not conclusive.

Firms with lower expected cash flows find it more costly to attract new debt. So, when the firm
attracts new debt, it commits itself to future interest payments and signals about its stable
financial position and ability to make these payments in the future.
There could also be inverse causality between firm performance and leverage. According
to efficiency-risk hypothesis, higher efficiency of the firm reduces expected costs of bankruptcy, and

such firms may attract more debt. On the other hand, according to franchise value hypothesis,
more efficient firms would like to protect economic rent derived from their efficiency, and might
choose lower leverage.
Moreover, we may expect, that relations between leverage and firm performance will not be
instantaneous and time lags could be present. Pecking order theory confirms this expectation and
explicitly states that past rather than current firm performance could have an effect on capital
structure.
In particular, we will explore the following questions: Does higher leverage results in better firm
performance? Is debt a disciplinary mechanism of the decrease of agency costs and thus in the
improvement of firm performance.
Understanding the relationship between the company debt and value could provide useful insights for
investors for two reasons. Firstly, shareholders would be able to target optimal debt-to-equity ratios,
which may improve discipline of the managers, but does not overburden a firm with extraneous
interest payments. Secondly, debt holders would have a tool in hand to identify overleveraged and
underleveraged firms. This may help them allocate their funds more effectively.

Capital Structure Theories

1. Meaning of Capital structure:

a. It means finding the relative composition of debt-equity of the
company.
b. It is also known as financial structure of the company.
c. Since debt is used along with the equity, it is known as trading on
equity and the term trading on equity is driven from the fact that it is
the equity which is used to raise the debt.
2. Meaning of optimum capital structure:
a. Theoretically, optimum capital structure is one where EPS and market
value of share is maximum but marginal cost of each source of fund is
minimum.
b. Practically, there is no optimum capital structure. And the word
Optimum is not realistic also. Better to say appropriate capital
structure.
3. Factors determining the capital structure:
a. Basically risk, control and cost are the three factors affecting the
capital structure but there are other factors also.
b. Minimization of Risk :
i. Capital structure must be consistent with business risk.
ii. It should result in a certain level of financial risk.
c. Control: It should reflect the managements philosophy of control over
the firm.
d. Flexibility: It refers to the ability of the firm to meet the requirements of
the changing situations.
e. Profitability: It should be profitable from the equity shareholders point
of view.
f. Solvency: The use of excessive debt may threaten the solvency of the
company.
g. Cost: it refers to the overall cost capital. If it is less, the capital
structure is appropriate.
4. Capital structure theories:
a. Net income approach (NI)
b. Net operating income approach (NOI)
c. Traditional approach
d. Modigilani and Miller Approach (MM)
Net income Approach
5. Net income approach:
a. According to this approach, the weighted average cost of capital is
depended on the capital structure.
b. So by changing the debt equity ratio, firms cost and value can be
changed.

c. Assumptions of this approach:

i. Kd < Ke
ii. No change in risk
iii. There are no corporate taxes.
d. Since net income means after tax earnings and while net operating
income means pretax earnings. But sine this method assumes no
taxes. So NI = NOI. But whenever debt is there in the question then
Net income = NOI - interest
Effect
on
K0

Increase in leverage

Decrease in leverage

Decrease (by using less expensive debt)

Increase ( since we using more

expensive equity)
Decrease (since K0 is increased)

Value of
Increase (since K0 is decreased)
firm
Leverage means using borrowed funds. In above table since you are
borrowing funds so that must be cheaper. This is assumed.
6. Steps involved in calculating the weighted average cost of capital under Net
income approach:
a. MV of equity share =
b. MV of debt =

Net income
Ke

Net operating incomeinterest

Ke

Interest
rate of interest

c. Total value of firm = MV of equity + MV of debt

d. Weighted average cost of capital K0 =

Net operating income

Total value of the firm

Net Operating income approach

7. Net operating income approach:
a. According to this approach, K0 is independent of its capital structure.
That means by changing the debt equity ratio, a firm cannot change its
value and cost of capital.
b. Assumptions of NOI approach:
i. Kd and K0 are constant.
ii. Split of market capitalization into debt and equity is insignificant
since K0 doesnt affect the value and cost of capital.
iii. There are no taxes.
iv. Neutralization :Using the less expensive debt, implicit cost
(interest) and explicit cost (increase hopes of ESH due to
increase in risk since debt is raised) are neutralized
Effect of increase in leverage
Effect on
Effect
Reason
Ke
increase High debt increases risk for ESH, so to compensate K e get
increased due to ESH hopes
K0
Constan Due to assumption of neutralization

t
Total Value of
constan Since K0 is content
firm
t
Decrease in leverage, would have same consequences expect that K e will
decrease.
8. Steps for calculating the Ke:
a. Total value of firm =

NOI
K0

b. Total value of debt =

interest
interest rate

c. Value of equity = firms value debt value

d. Ke =

Net income
Value of equity

Net incomeinterest
Value of equity

Traditional Approach
9. Traditional approach:
a. Traditional approach is intermediate of NI and NOI approach. Since it
considers both the approaches.
b. The calculation and steps involved in this approach are same as NI
approach.
Modigilani and Millar approach
10.MM approach:
a. According to this approach, K0 is independent of its capital structure.
That means by changing the debt equity ratio, a firm cannot change its
value and cost of capital.
b. If two firms are identical in all aspects except for the degree of
leverage, firms will have different MV so the arbitrage will start.
c. Assumptions:
i. There is perfect capital market.
ii. Homogenous risk class.
iii. No taxes
iv. All investors have same expectations.
v. Company has 100% payout ratio.
d. Criticism:
i. There is no perfect market.
ii. Arbitrage may fail.
iii. Existence of corporate tax

Summary of all capital structure theories is shown in Table 1:

Table 1.
Summary of capital structure theories.

Theory
Modigliani and Miller
(1963)

Relationship Causality
Positive

Performance affects debt

Trade-off

Positive

Performance affects debt

Pecking-Order

Negative

Performance affects debt

Free-cash-flow

Positive

Debt affects performance

Company Background:
TCS:
Type

Public

Industry

IT services, IT consulting

Founded

1968

Founder

J. T. Tata, F. C.bdjgkc

Headquarters

Mumbai, Maharashtra, India

Area served

Worldwide

Key people

N. Chandrasekaran (CEO & MD

IT, business consulting and

Services

outsourcing services

Revenue
Operating
income

US$16.54 billion (2016)[2]

Profit

US$3.70 billion (2016)

Total assets

US$13.76 billion (2016)

Total equity
Number of
employees

US$11.10 billion (2016)

Parent
CTS:

US$4.38 billion (2016)

362,079 (Aug 2016)

Tata Group

Type

Public

Industry

IT services, IT consulting

Predecessor

Dun & Bradstreet

Founded

January 26, 1994

Founder

Kumar Mahadeva, Francisco D'Souza

Headquarters

Teaneck, New Jersey,United States

Area served

Worldwide

Key people

Francisco D'Souza (CEO)

Services

IT, business
consulting andoutsourcing services

Revenue

US$12.416 billion (2015)

Operating income

US$2.142 billion (2015)

Profit

US$1.623 billion (2015)

Total assets

US$13.065 billion (2015)

Total equity

US$9.278 billion (2015)

Number of
employees

244,300 (2016 Q2)

WIPRO:
Type
Industry

Public

Founded

IT services, IT consulting
29-12-1945,(Mumbai, Maharas
htra)

Founder

Mohamed Hasham Premji[1]

Headquarters

Bangalore, Karnataka, India

Area served

Worldwide

Key people

Azim
Premji (Chairman),Abidali
Neemuchwala (CEO)

Services

Digital Strategy, Business

Consulting and IT Services

Revenue

US$7.735 billion (2016)

Operating income

US$1.463 billion (2016)

Profit

US$1.348 billion (2016)

Total assets

US$10.94 billion (2016)

Total equity

US$7.070 billion (2016)

Owner

Azim Premji (73%)

Number of employees
3i Infotech

173,863 (June 2016)

Type

Public company

Industry

Technology services, IT
services,Outsourcing

Founded

1993

Area served

World wide

Key people

Padmanabhan Iyer,
Executive Director & Chief
Executive Officer

Revenue

1,344.00
crore(US$200 million)

Net income

-936.52 crore (US$

140 million)

Number of employees

over 200

ROLTA:
Type

Public company

Industry

Technology services,Outsourcing

Founded

1989

Headquarters

Mumbai, India

Area served

Worldwide

Key people
Revenue

Kamal K Singh (Chairman & Managing Director)

Number of employees

~1700

36,794.57
million (US$550 million) (2015)

GEO:
Type

Public

Industry

Outsourced correctional services

Predecessor

The Wackenhut Corporation

Founded

1984 (as Wackenhut Corrections

Corporation (WCC))

Founder

George Zoley

Headquarters

621 NW 53rd St.Boca Raton, Florida, US

Area served

USA,Australia,South Africa, UK

Key people

George Zoley(Chairman) & (CEO)

Revenue

$ 1.61 billion (2011)

Operating income

$ 192.2 million (2011)

Net income

$ 77.5 million (2011)

Total assets

$ 3.049 billion (2011)

Total equity
Number of
employees

$ 1.039 billion (2011)

20,000- 2011

Company Data for Analysis:

Company
Name

Financial
Year

Cognizant
Technology
Solutions(CTS
)

2015
2014
2013
2012
2011
2010
2009
2008
2007
2006

865367.2
725759.8
503173.0
357316.9
292498.8
204886.3
155320.0
115581.7
72456.8
58687.9

-39.47
-27.61
-61.08
-98.99
-61.53
-62.11
-52.74
-38.80
-45.66
-60.38

GEO Is.

2015
2014
2013
2012
2011
2010
2009
2008
2007
2006

7944.0
7525.0
6595.5
5662.5
4924.5
3481.3
3148.1
3447.7
4009.4
3912.8

-31.01
-22.34
-33.53
-24.40
-23.63
-7.18
-7.34
31.95
9.66
26.62

2015
2014
2013
2012
2011
2010
2009
2008
2007

13425.3
26553.0
38032.2
37749.8
40645.4
42517.2
38860.0
38576.5
23585.6

208.46

3i Infotech

Total
Assets

Net Debt To
Equity

431.34
228.90
162.80
142.58
200.17
186.24
133.89

2006

13491.6

115.89

Rolta

2015
2014
2013
2012
2011
2010
2009
2008
2007
2006

31595.0
22556.9
9797.6
8353.2
10134.1
9372.2
9090.3
11907.4
12227.2
5470.0

209.23
227.80
208.75
131.92
70.28
71.94
57.46
13.31
-10.81
-11.43

Tata
Consultancy
Services(TCS)

2015
2014
2013
2012
2011
2010
2009
2008
2007
2006

893843.8
736608.8
671307.8
521678.7
413304.9
332607.5
273942.2
226373.4
175653.1
131861.5

-41.34
-37.41
-30.55
-18.89
-21.34
-17.45
-37.57
-23.28
-26.85
-22.86

WIPRO

2015
2014
2013
2012
2011
2010
2009
2008
2007
2006

724921.0
600033.0
502304.0
439730.0
436001.0
371443.0
329928.0
278511.0
216340.0
141550.0

-22.80
-32.70
-35.71
-31.52
-21.20
-23.97
-1.20
-6.08
4.73
-50.24

Results:
A. Correlation Results of Capital Structure & Assets for Wipro:

Correlations

Wipro Total Assets

Wipro Total

Wipro Net Debt

Assets

To Equity

Pearson Correlation

-.189

Sig. (2-tailed)

.601

N
Wipro Net Debt To Equity

Pearson Correlation

10

10

-.189

Sig. (2-tailed)

.601

10

10

Result: Weak Negative Correlation.

B. Correlation Results of Capital Structure & Assets for TCS:

Correlations

TCS Total Assets

TCS Total

TCS Net Debt

Assets

To Equity

Pearson Correlation

Sig. (2-tailed)
N
TCS Net Debt To Equity

Pearson Correlation
Sig. (2-tailed)
N

Result: Medium Negative Correlation.

-.569
.086

10

10

-.569

.086
10

10

C. Correlation Results of Capital Structure & Assets for CTS:

Correlations

CTS Total Assets

CTS Total

CTS Net Debt

Assets

To Equity

Pearson Correlation

Sig. (2-tailed)

.454

N
CTS Net Debt To Equity

.268

10

10

Pearson Correlation

.268

Sig. (2-tailed)

.454

10

10

Result: Weak Positive Correlation.

D. Correlation Results of Capital Structure & Assets for GEO:

Correlations

GEO Total Assets

Pearson Correlation

GEO Total

GEO Net Debt

Assets

To Equity
1

Sig. (2-tailed)
N
GEO Net Debt To Equity

Pearson Correlation
Sig. (2-tailed)
N

-.728*
.017

10

10

-.728

.017
10

10

*. Correlation is significant at the 0.05 level (2-tailed).

Result: Medium Negative Correlation

E. Correlation Results of Capital Structure & Assets for 3i Infotech:

Correlations
3i Net Debt To
Equity
3i Net Debt To Equity

3i Total Assets

Pearson Correlation

.283

Sig. (2-tailed)

.460

N
3i Total Assets

Pearson Correlation

.283

Sig. (2-tailed)

.460

10

Result: Weak Positive Correlation.

F. Correlation Results of Capital Structure & Assets for Rolta:

Correlations

Rolta Total Assets

Pearson Correlation

Rolta Total

Rolta Net Debt

Assets

To Equity
1

Sig. (2-tailed)
N
Rolta Net Debt To Equity

.628
.052

10

10

Pearson Correlation

.628

Sig. (2-tailed)

.052

Result: Medium Positive Correlation.

10

10