Academic journal article IUP Journal of Applied Finance

Corporate Financing Pattern in India: Changing Composition and Its Implications

Academic journal article IUP Journal of Applied Finance

Corporate Financing Pattern in India: Changing Composition and Its Implications

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.

- Keynes (1936, p. 159)


Several theoretical and empirical studies in the last three decades have emphasized the relationship between finance and investment, and argued that firms' financing decisions had implications for their investment activities.1 With the changes introduced in India's economic policies during the last two decades, the emphasis has been more on corporate investment- led growth, replacing the hitherto public sector investment-led growth (Rajakumar, 2011). Investment activity of corporate sector, thus, lies central to the economic performance of the country. Given the link between finance and investment, this paper seeks to examine the financing practices of corporate sector.

The Analytical Framework

The role of investment for economic growth is well emphasized in the economic literature. Studies of investment behavior in the neoclassical tradition had, however, ignored the role of financial factors.2 As Getler (1988) aptly remarks, the lack of emphasis on financial variables in the investment equation was due to the formal proposition of Modigliani and Miller (MM) which had two important implications, namely, investment decision was the only decision that mattered and firms need not care as to how to finance investment (MM, 1958). Thus, a firm's choice of a particular source of funds, whether it is retained earnings or issue of bonds/equity or borrowing, had no bearing on its investment decision.

The crucial assumption underlying the MM theorem is the 'existence of perfect capital market'. Implicit in this was the symmetric distribution of information between firms and investors, no transactions cost, no taxes, no bankruptcy, both firms and individuals had equal access to capital market, securities issued had perfect substitutes, investors maximize welfare (Fama and Miller, 1972), and that the existence of financial intermediaries would be of no consequence to real activity (Bernanke and Gertler, 1987). The MM theorem and its assumptions however came to be questioned in the course of time. Increasingly, there is a wider recognition that factors such as tax, asymmetric information and financial intermediaries could influence firms' financing behavior and thereby their investment decisions. In what follows, these factors have been discussed briefly.

Tax and Financing Practices

In corporate taxation, debt and equity finance are given different treatment. While interest payments (cost of debt) are generally allowed to be treated as an expense, dividend payments (cost of equity) are not. Because of this, the relative cost of debt decreases. Though this holds good only if firms show taxable income and depends upon the tax rate facing firms, to the extent of its deductibility, interest payments shield profit (known as interest tax shield), which in turn increases value of firms. In their own later version, MM (1963) recognized the gain associated with debt because of interest deductibility. They had shown that in the presence of taxes that allowed interest deductibility, value of leveraged firms was greater than that of unleveraged firms implying that a firm could increase its value by increasing leverage. Firms would therefore prefer debt financing.

It is also argued that such leverage gain need not arise under bankruptcy and when non- interest tax shields are available.3 Firstly, an increase in debt increases the probability of debt obligations exceeding the earnings of firms. This could lead to bankruptcy and so debt is considered risky. The risk aversive firms would, therefore, not be indifferent to debt. Thus, firms tend to follow an optimal capital structure policy, which is essentially a trade-off between tax advantage of debt and bankruptcy cost. …

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