Capital Structure and Its Impact on Profitability: A Study of Listed Pharmaceutical Companies in

India

A

Synopsis

Submitted for the partial fulfillment of

Masters of Philosophy

In Accountancy & Law

(Commerce)

Under the supervision of

Prof. Pramod Kumar

Head

Deptt. Of Accountancy & Law

Submitted By

Sumit Samtani

M.Phil 1st Sem

Faculty of Commerce, DEI, Agra

April, 2012

Capital Structure and Its Impact on Profitability: A Study of Listed Pharmaceutical Companies in India

IntroductionIn Present scenario the environment of business is frequently changing. In changing

business environment, management of the business has to take various important

decisions. Capital Structure (CS) is one of the most important decision among all the

decisions. Many companies change their capital structuring according to changes takes

place in business environment. Capital structure (CS) consists of debt capital and equity

capital. In the capital structure debt and equity capital are mix in a certain ratio. It is

necessary for the companies to decide the optimum ratio of debt and equity in capital

structure because various things are depend upon CS such as profitability, solvency etc.

so, the main problem for the company is to decide the optimum capital structure. This

study will find the impact of capital structure on profitability and also suggests what

should be the optimum capital structure for the companies.

Capital Structure

Capital structure, otherwise referred to as, financial structure, is the means by which an

organization is financed. It is the mix of debt and equity capital maintained by a

Company. Companies can use either debt or equity capital to finance their assets. The

best choice is a mix of debt and equity.

Of all the aspects of capital investment decision, the capital structure decision is the vital

one since the profitability of an enterprise is directly affected by such decision. Hence,

proper care and attention need to be given while determining the capital structure

decision. In the statement of affairs of an enterprise, the overall position of the enterprise

regarding all kinds of assets, liabilities are shown. Capital is a vital part of that statement

(hereafter called Balance Sheet). So, virtually, capital structure is a part of financial

structure. The term ‘capital structure’ of an enterprise, is actually, a combination of

equity shares, preferences shares and long-term debts. This term may be defined in two

senses, viz. Narrow and wider. According to Bierman and Smidt and Guthman and

Donglalls capital structure is the relative proportion of the various kinds of securities a

company has used. The opinions of Taylor and Venhorne regarding capital structure is

that is the total sum of outstanding long-term securities, both equity and debt. Weston and

Bringham (1978) define it as the permanent financing of the firm represented by long-

term debt plus preferred stock and net worth. Though there are different views about the

total nature of ‘capital structure’ it is obviously true from the fact that everybody has

agreed about the common items, i.e. total of equity and long-term debt which represent

the permanent source of financing of a company. Therefore, capital structure may be

defined as the permanent source of capital in the form of long-term debt, preference

shares, ordinary shares, reserve and surplus.

Profitability Ratio

Profitability is the ability to earn a profit. The profitability ratios and other ratios

are keys to understanding financial statements. Our ratio calculation spreadsheets reduce

time and effort in calculating decision making ratios. They reduce risk for lenders and

investors and enable owners, managers and consultants to increase productivity and

business profits. These spreadsheets are bargain priced to provide a huge return on

investment.

Profitability is the measure that indicates how well a firm is performing in terms of its

ability to generate profit. Ratio is simply one number expressed in terms of another.

Profitability ratios are as follows:

Ratios Related to operations

Gross profit Ratio

Net Profit Ratio

Operating Ratio

Expenses Ratio

Ratios Related to Investment

Return on capital employed

Return on equity shareholder Fund

Return on Equity share Capital

Earning per share

Dividend payout Ratio

Dividend per share

Price Earnings Ratio

Dividend Yield Ratio

Ratios Related to Capital Structure

Debt-Equity Ratio

Debt to Assets Ratio

Capital Gearing ratio

Interest Coverage Ratio

Review of Literature

No. of Review of Literatures

National 3

International 8

Year Author Name Study2001 I.M.Pandey

Capital Structure and the Firm Characterstics: Evidence from an Emerging Market”

2004 Mr.Ushad Agathee Subadar, Mr Mathew Lamport,Mrs Wassila Bhujoo-Hosany

“Theories of capital structure: evidence from investment and non-investment firms listed on the stock exchange of Mauritius”

2005 Evaldo guimarães barbosa, Cristiana de castro moraes

“determinants of the firm’s capital structure the case of the very small enterprises”

2008 Ramachandran Azhagaiah, Candasamy Gavoury

“The Impact of Capital Structure on Profitability with Special Reference to IT Industry in India”

2009 Fatoki Olawale Olufunso, George Herbst and Mornay Roberts-Lombard,

“An investigation into the impact of the usage of debt on the profitability of small and medium enterprises in the Buffalo city municipality, South Africa”

2010 Onaolapo, Adekunle A,

Kajola, Sunday O “Capital Structure and Firm Performance: Evidence from Nigeria”

2010 Prashant Gupta, Aman Srivastava and Dinesh Sharma

“Capital Structure and Financial Performance: Evidence from India”

2010 Andreea Apostu “The Effects of Corporate Diversification Strategies on Capital Structure : An Empirical Study on European Companies”

2011 Mahira rafique “Effect of profitability & financial leverage on capital structure: a case of

Pakistan’s automobile industry” 2011 Qasim Saleem and Ramiz

Ur Rehman “Impacts of liquidity ratios on profitability (Case of oil and gas companies of Pakistan)”

2011 Puwanenthiren Pratheepkanth

“Capital structure and financial performance: evidence from selected business companies In Colombo stock exchange Sri lanka”

For the proposed study researcher refers some existing literature which are mentioned here of last 11 years (From 2001 to 2011).

I.M.Pandey(2001), “Capital Structure and the Firm Characterstics: Evidence from an Emerging Market”

We examine the determinants of capital structure of Malaysian companies utilizing data from 1984 to 1999. We classify data into four sub-periods that correspond to different stages of Malaysian capital market. Debt is decomposed into three categories: short-term, long-term and total debt. Both book value and market value debt ratios are calculated. The results of pooled OLS regressions show that profitability, size, growth, risk and tangibility variables have significant influence on all types of debt. These results are normally consistent with the results of fixed effect estimation with the exception that risk variable loses its significance. Unlike the evidence from the developed markets, investment opportunity (market-to-book value ratio) has no significant impact on debt policy in the emerging market of Malaysia. Our results are generally robust to time periods, but the significance of some variables changes over time. Profitability has a persistent and consistent negative relationship with all types of debt ratios in all periods and under all estimation methods. This confirms the capital structure prediction of the pecking order theory in an emerging capital market.

Mr Ushad Agathee Subadar, Mr Mathew Lamport and Mrs Wassila Bhujoo-Hosany (2004), “Theories of capital structure: evidence from investment and non-investment firms listed on the stock exchange of Mauritius”

This paper examines the issues affecting the capital structure of investment and non-investments. A sample of 7 investment firms and on 8 non-investment firms is used based on panel data methodology over the period 1998-2003. Overall, the results are consistent with the pecking order theory. For both investment and non-investment firms, profitability is negatively associated to leverage while the growth and age since incorporation are positively related to leverage. However, the variable firm size seems to be irrelevant for non-investment firms while for investment firms, the variables profitability, growth, asset structure and non-debt tax shield are found to be statistically

insignificant. Finally, stock price volatility in the Mauritian context seems to be inappropriate in accounting for firm risk.

Evaldo guimarães barbosa and cristiana de castro moraes , (2005), “determinants of the firm’s capital structure the case of the very small enterprises”

This paper seeks empirically to identify the determinants of the very small firms’ financial leverage. This is important because both these enterprises have been under-researched and research in the area has been troubled by samples biased towards very large enterprises. Results support hypotheses that size, growth, operational cycle and entrepreneur’s risk tolerance are positively and business risk, asset composition, profitability and inflation negatively associated with financial leverage. Additionally, there is support for a hypothesized relationship with industry but not with enterprise age. To achieve a wider understanding of these relationships, financial leverage is studied in combination with own working capital.

Ramachandran Azhagaiah, Candasamy Gavoury (2008), “The Impact of Capital Structure on Profitability with Special Reference to IT Industry in India”

Firms can use either debt or equity capital to finance their assets. The best choice is a mix of debt and equity. The present study mainly analyses how far the capital structure (cs) affects the Profitability (p) of corporate firms in India. The study tries to establish the hypothesized relationship as to how far the cs affects the business revenue of firms and what the interrelationship is between cs and Profitability. This study is carried out after categorizing the selected firms into three categories based on two attributes, viz. business revenue and asset size. First, firms are grouped into low, medium and high based on business revenue. Second, firms are classified into small, medium and large based on asset size to establish the hypothesized relationship that cs has significant impact on Profitability of Information Technology (it) firms in India. For the study, a sample of 102 it firms was chosen by the Multi- Stage Sampling Technique. The data for a period of 8 years ranging from 1999–2000 to 2006–2007 have been collected and considered for analysis. Regression Analysis (to analyze the unique impact of cs on Profitability), in addition to descriptive statistics such as Mean, Standard Deviation, and Ratios has been used. The study proves that there has been a strong one-to-one relationship between cs variables and Profitability variables, Return on Assets (roa) and Return on Capital Employed (roce) and the cs has significant influence on Profitability, and increase in use of debt fund in cs tends to minimize the net profit of the it firms listed in Bombay Stock Exchange in India.

Fatoki Olawale Olufunso, George Herbst and Mornay Roberts-Lombard, (2009), “An investigation into the impact of the usage of debt on the profitability of small and medium enterprises in the Buffalo city municipality, South Africa”

This study investigated the impact of the usage of debt on the profitability of small and medium enterprises (SMEs) in the manufacturing sector in the Buffalo City Municipality

of the Eastern Cape Province of South Africa. To achieve this objective, the research hypothesized that the usage of debt has a negative impact on the profitability of SMEs. The research further hypothesized that SMEs have a difficulty in accessing debt finance from commercial banks. The study is important because SMEs, despite their contributions to the South African economy, have not been given due attention as research on corporate finance has been biased towards large firms. The results indicated that the usage of debt has a significantly negative impact on the profitability of SMEs. The results also indicated that SMEs have difficulties accessing debt from commercial banks. Lastly, the study recommended some measures that are expected to improve the accessibility to debt and reduce the cost of debt to SMEs. These measures among others include reduction in interest rates, awareness programmes by the banks, more bank competition (specifically commercial banks that are focused on lending to SMEs) and training of the owners of SMEs in the areas of writing business plans.

Onaolapo, Adekunle A, Kajola, Sunday O, (2010), “Capital Structure and Firm Performance: Evidence from Nigeria”

This paper examines the impact of capital structure on firm’s financial performance using sample of thirty non- financial firms listed on the Nigerian Stock Exchange during the seven- year period, 2001- 2007. Panel data for the selected firms are generated and analyzed using Ordinary Least Squares (OLS) as a method of estimation. The result shows that a firm’s capital structure surrogated by Debt Ratio, DR has a significantly negative impact on the firm’s financial measures (Return on Asset, ROA and Return on Equity, ROE). The study by these findings, indicate consistency with prior empirical studies and provide evidence in support of Agency cost theory.

Prashant Gupta, Aman Srivastava and Dinesh Sharma (2010), “Capital Structure and Financial Performance: Evidence from India”

Financing decisions are one of the most critical areas for finance managers. It has direct impact on capital structure and financial performance of the companies. It has always been an area for interest for researchers to understand the relationship between capital structure and financial performance of the company. This paper is a moderate attempt to understand the relationship between capital structure and financial performance of the companies. For this purpose, the study used definition of capital structure in scope of book value to market value and measures were assumed for financial performance. In this paper, we applied the data of 100 companies listed on National Stock Exchange (NSE) of India in a 5-year time horizon (2006-2010). Results of our study demonstrated that capital structure influences financial performance. The significance of the influence of capital structure on performance is respectively belonged to measures of adjusted value, market value and book value.

Andreea Apostu , (2010), “The Effects of Corporate Diversification Strategies on Capital Structure : An Empirical Study on European Companies”

The role of diversification strategies in financial choices has received little attention in previous empirical financial studies. The aim of this paper is to study the effect of corporate diversification strategies on firm capital structure using a panel data analysis for a sample of 232 European firms during the period 2004-2007. Theoretical and empirical studies suggest that corporate leverage is positively related to diversification across product lines but negatively related to geographic diversification. Some studies show that these diversification strategies are complementary in generating debt usage. In the univariate analysis, we find product diversified firms to be significantly more leveraged, larger, less risky, less profitable and more diversified geographically. Multinational firms appear to be significantly larger, riskier and more diversified across product lines. After controlling for firm size, profitability, growth, assets tangibility and operating risk, we find that product and geographical diversification do not have a significant influence on leverage.

Mahira rafique (2011), “Effect of profitability & financial leverage on capital structure: a case of Pakistan’s automobile industry”

This paper focuses on investigating the effect of the profitability of the firm and its financial leverage on the capital structure of the automobile sector companies in Pakistan. To proceed with this, the capital structure of 11 listed firms has been analyzed by adopting an econometric framework over a period of five years. Estimating regression analysis and checking the relationship of the estimated model through Correlation Coefficient Test, we found that the profitability of the firm and its financial leverage have an insignificant impact on the capital structure of the studied firms during the examined period. Hence, the study is unable to establish any significant relation between profitability and financial leverage effect on the capital structure of a firm.

Qasim Saleem and Ramiz Ur Rehman (2011), “Impacts of liquidity ratios on profitability (Case of oil and gas companies of Pakistan)” The present study aims to reveal the relationship between liquidity and profitability so that every firm has to maintain this relationship while in conducting day to day operations. The results show that there is a significant impact of only liquid ratio on ROA while insignificant on ROE and ROI; the results also show that ROE is no significant effected by three ratios current ratio, quick ratio and liquid ratio while ROI is greatly affected by current ratios, quick ratios and liquid ratio. The main results of the study demonstrate that each ratio (variable) has a significant effect on the financial positions of enterprises with differing amounts and that along with the liquidity ratios in the first place. Profitability ratios also play an important role in the financial positions of enterprises. Every stakeholder has interest in the liquidity position of a company. Suppliers of goods will check the liquidity of the company before selling goods on credit. Employees should also be concerned about the company’s liquidity to know whether the company can meet its employee related obligations–salary, pension, provident fund, etc. Thus, a company needs to maintain adequate liquidity so that liquidity greatly affects

profits of which some portion that will be divided to shareholders. Liquidity and profitability are closely related because one increases the other decreases.

Puwanenthiren Pratheepkanth (2011), “Capital structure and financial performance: evidence from selected business companies In Colombo stock exchange Srilanka”

Capital structure is most significant discipline of company’s operations. This researcher constitutes an attempt to identify the impact between Capital Structure and Companies Performance, taking into consideration the level of Companies Financial Performance. The analyze has been made the capital structure and its impact on Financial Performance capacity during 2005 to 2009 (05 years) financial year of Business companies in Sri Lanka. The results shown the relationship between the capital structure and financial performance is negative association at -0.114. Co-efficient of determination is 0.013. F and t values are 0.366, -0.605 respectively. It is reflect the insignificant level of the Business Companies in Sri Lanka. Hence Business companies mostly depend on the debt capital. Therefore, they have to pay interest expenses much.

Need of the study

Capital is a vital part of the statement called Balance Sheet. So, virtually, capital structure

(CS) is a part of financial structure. CS is the mix of debt and equity capital maintained

by Companies. A company can use either debt or equity capital to finance their assets. In

a Company various Things are affected by CS with positive and negative impact. Such as

profitability, Liquidity and solvency of company is influenced by CS. So for knowing the

impact of CS on profitability in Pharmaceutical Companies, this study can be proposed.

Objectives of the study

The main objective of the study is to find out the capital structure and its impact on

profitability in selected pharmaceuticals companies of India and other objectives are:

1. To examine the capital structure of selected pharmaceuticals companies and its

impact on profitability.

2. To judge the relationship between capital structure and profitability of selected

companies.

3. To suggest the optimum capital structure.

Research Hypothesis

The following hypotheses are formulated for the study.

Ho=By and large there is no significant correlation between Capital structure and

profitability.

Ho=There is no impact of Capital structure on profitability.

Research Methodology

To accomplish the above objective of the study, the following research methodology is

proposed:

Sample Size

For attaining different objectives, five pharmaceuticals companies which are listed on

National Stock Exchange (NSE) in India, will be taken in to consideration on the basis of

capital size and net worth.

Type of Data

In order to analysis Profitability and Capital Structure of selected companies, secondary

data will be taken into consideration. Data will be collected from reports and researches

published in journals, web sites periodicals, magazines and annual reports of selected

companies.

Tools for analyzing data

Following are the statistical tools, which will be used for analyzing the data.

Tool Objective

Correlation For analyzing the relation between Capital Structure and profitability.

Multiple Regression Analysis For analyzing the impact of capital structure on

Profitability.

T-Test For the significance of hypothesis testing.

Duration of study

For the purpose of analysis of data, a period of five financial years (2007-08 to 2011-12) will be taken.

References

Onaolapo, Adekunle A, Kajola, Sunday O, (2010), “Capital Structure and

Firm Performance: Evidence from Nigeria” European Journal of Economics,

Finance and Administrative Sciences, Issue 25, pp-70-71

Andreea Apostu , (2010), “The Effects of Corporate Diversification Strategies

on Capital Structure : An Empirical Study on European Companies” Aarhus

School of Business, Aarhus University, August(2010),pp-4-7

Fatoki Olawale Olufunso, George Herbst and Mornay Roberts-Lombard,

(2009), “An investigation into the impact of the usage of debt on the

profitability of small and medium enterprises in the Buffalo city municipality,

South Africa” African Journal of Business Management Vol. 4(4), pp. 373-

381

Mahira rafique (2011), “Effect of profitability & financial leverage on capital

structure: a case of Pakistan’s automobile industry” Economics and Finance

Review Vol. 1(4) pp. 50 – 58

Qasim Saleem and Ramiz Ur Rehman (2011), “Impacts of liquidity ratios

on profitability (Case of oil and gas companies of Pakistan)” Interdisciplinary

Journal of Research in Business, Vol. 1, Issue. 7, pp.95-98

Johnson, A. S. 1977. “An empirical analysis of the determinants of corporate

debt ownership structure”, Journal of Financial and Quantitative Analysis,

32, 47-69.

Puwanenthiren Pratheepkanth (2011), “Capital structure and financial

performance: evidence from selected business companies In Colombo stock

exchange Srilanka” Journal of Arts, Science & Commerce, Vol.– II, Issue –

2,pp.171-183

Bibliography

Websites

www.wikipedia.org www.projectparadise.com

www.ssrn.com

www.businessjournalz.org

www.internationalresearchjournaloffinanceandeconomics.com

www.jimsjournal.org

Books

1. Management Accounting -Prof. Pramod kumar2. Management Accounting -S. P. Gupta

3. Auditing -Dr. L. N. Koli

4. Financial Management -Khan & Jain

5. Financial Management -Dr. R.S. Kulshreshtha

6. Book keeping and Accountancy -S.M.Shukla

7. Advance Statistical Method -S.P. Gupta

8. Management Accounting -I.M.Pandey

Proposed Chapter Plan

Chapter 1- IntroductionChapter 2-Review of Literature

Chapter 3-Capital Structure Theories- An Overview

Chapter 4-Analysis and Findings

Chapter 5- Conclusions and Recommendations

Bibliography