Managerial Finance

Agency theory, capital structure and firm performance: some Indian evidence
Varun Dawar

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Managerial Finance, Vol. 40 Iss 12 pp. 1190 - 1206
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MF
40,12

Agency theory, capital structure

and firm performance:
some Indian evidence

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1190
Received 6 October 2013
Revised 30 January 2014
Accepted 6 February 2014

Varun Dawar
IMT (Institute of Management Technology) Ghaziabad, Ghaziabad, India
Abstract
Purpose Based on the agency theory, the purpose of this paper is to empirically investigate the
impact of capital structure choice on firm performance in India as one of the emerging economies.
Design/methodology/approach Fixed effect panel regression model is used to analyse ten years
of data (2003-2012) on the sample units, to find the relation between leverage and firm performance
after controlling for factors such as size, age, tangibility, growth, liquidity and advertising.
Findings Empirical results suggest that leverage has a negative influence on financial performance
of Indian firms, which is in contrast with the assumptions of agency theory as commonly received and
accepted in other developed as well as emerging economies. Consequently, postulates of agency theory
have to be seen with different perspective in India given the underdeveloped nature of bond markets
and dominance of state-owned banks in lending to corporate sector.
Practical implications The findings of the paper will enable the practitioners and analysts to
understand as to why, in the bank-dominated debt financing system in India, leverage is negatively
associated with firm performance.
Originality/value The results of the study enrich the literature on capital structure and agency
costs issues in several ways.
Keywords India, Capital structure, Agency theory, Firm performance, Emerging economy
Paper type Research paper

Managerial Finance
Vol. 40 No. 12, 2014
pp. 1190-1206
r Emerald Group Publishing Limited
0307-4358
DOI 10.1108/MF-10-2013-0275

1. Introduction
The theory of capital structure and its association with firm performance and value has
been an important issue in corporate finance literature ever since the publication of the
seminal paper of Modigliani and Miller (1958). Modigliani-Miller (MM) propagated that in
a perfect capital market free of taxes, transaction costs and other frictions, capital structure
is irrelevant in determining firm value. They showed that the choice between debt and
equity financing has no material effect on the firm value and consequently management
should not be concerned about the proportion of debt and equity that constitute the capital
structure of the firm. This led to a plethora of research on the topic (both theoretical
and empirical) with researchers examining the robustness of the MM model in the light
of realistic assumptions relating to market frictions and the information asymmetries.
Although various alternative capital structure theories have been developed during the
last 50 years so as to determine the optimal capital structure and its impact on firm value,
they differ in their relative emphasis. For instance, while trade-off theory suggests an
optimum debt level or target level in terms of balance between tax savings and bankruptcy
cost, pecking order theory (Myers and Majluf, 1984; Myers, 1984) assumes hierarchy of
financial decisions under which firm resort to external financing only in absence of internal
financing. Similarly agency theory of debt (Jensen and Meckling, 1976) talks about agency
costs which arise on account of conflict between managers and shareholders.
Agency costs theory, identified by Jensen and Meckling (1976), has its genesis in the
idea that the interests of the companys managers and its shareholders are not perfectly

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aligned. The conflict between managers and shareholders, on account of separation of

ownership and control, arise as managers tend to maximize their own utility rather
than the value of the firm. Consequently, issuing debt may lower agency costs and
affect firm performance by disciplining or encouraging managers to act in the best
interests of the shareholders rather than indulge in discretionary behaviour (Grossman
and Hart, 1982; Jensen, 1986; Harris and Raviv, 1991 for overviews).
While there is a vast amount of literature examining the choice and impact of
capital structure decisions on firm performance over the past few decades (Taub, 1975;
Miller, 1977; Stulz, 1990; Roden and Lewellen, 1995; Champion, 1999; Ghosh et al., 2000;
Gleason et al., 2000; Simerly and Li, 2000; Hadlock and James, 2002; Berger and
Bonaccorsi di Patti, 2006; Rao et al., 2007; Margaritis and Psillaki, 2007, 2010; Weill,
2008; Ebaid, 2009; Nunes et al., 2009; Sadeghian et al., 2012), empirical evidence has
been mixed and contradictory with regards to debt adding positive or negative value to
the firm. Also most of the studies examining the implications of capital structure on
firm performance exist in developed markets (USA, UK and Canada) with little
empirical evidence regarding the same in emerging markets, particularly India.
As against the capitalistic nature of political and economic environment and dominance
of privately owned financial institutions in the west, financial landscape of emerging
market like India is dominated by state-owned enterprises (wherein Indian Government
is the majority shareholder) who controls majority share of the corporate funding.
Consequently it becomes necessary to examine whether the behaviour and performance
implications of capital structure choices on firm performance (with the assumptions
of agency theory) as commonly received and accepted in case of developed markets is
valid in emerging market of India or needs to be reassessed in the light of what data
might reveal.
Tests of the agency cost theory typically have been based on regressions of various
measures of firm performance on various indicator of leverage plus some control
variables. Elaborating on the above argument of agency issue this study reason and
empirically investigate the relationship between debt level and financial performance
of set of listed Indian companies during the period 2003-2012. To measure firm
performance, we use two accounting-based measures of firm performance namely,
return on assets (ROA) and return on equity (ROE). The study further controls for
differences in firm-related or industry-related factors by including variables such as
firm size, firm age, tangibility, sales growth, liquidity and advertising.
The results of the study enrich the literature on capital structure and agency cost
issues in several ways. First, we find that there is negative influence of capital
structure on financial performance of Indian firms (measured by ROA and ROE).
The result is in contrast with the postulates of agency theory as evidenced in other
developed as well as emerging economies. We argue that tenets of agency theory as
applied in other markets have to be seen in different light in case of India where bond
markets are yet to flourish and major source of corporate funding rests with the
banking sector. The underlying assumption behind the agency theory is that suppliers
of debt capital incentivise or discipline the managerial discretionary behaviour so as to
mitigate the agency conflicts and ensure superior firm performance. However, in India
suppliers of debt capital being primarily state owned are subject to minimal
disciplining influence by their owner-principal (government). Consequently, they have
reduced incentives for subsequent monitoring and disciplining their debtor firms.
Debtor firm managers, aware of this inconsequential presence of the lenders, continue
to pursue discretionary behaviour instead of striving for superior corporate profitability

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thereby resulting in negative association between leverage and performance. Second,

we find that while firm size, tangibility, liquidity and advertising are positively related
to firm performance, firm age tends to have a negative influence on the same.
The rest of the paper is organized in the following way: Section 2 discusses
literature review; Section 3 discusses the measures of firm performance and exogenous
variables; Section 4 describes the data and empirical model; Section 5 details the
empirical result and Section 6 concludes with summary of findings.
2. Literature review
Ever since publication of the seminal paper of Jensen and Meckling (1976) as regards
the agency costs, there has been a great deal of empirical work with several studies in
almost all countries (wherein private capital plays a major role in the economy)
examining the relationship between financial leverage and firm performance. Under
the agency cost hypothesis, separation of ownership and control in firms creates
conflicts of interest between the firms shareholders and managers. This is because
managers often indulge in investing the firms resources in projects that enhances their
own personal benefits rather than maximize the firm value (Jensen, 1986). Similarly the
firm managers are averse to giving up control of the firm and often tend to resist
liquidation despite it being in the best interests of shareholders (Harris and Raviv,
1988). Consequently, use of leverage in capital structure can mitigate agency costs by
constraining or encouraging managers to act more in the interests of shareholders by
regulating the choice of investment (Myers, 1977), the amount of risk undertaken
(Jensen and Meckling, 1976) and the conditions under which firm can resort to
liquidation (Grossman and Hart, 1982; Williams, 1987; Harris and Raviv, 1990).
Thus increasing leverage can mitigate agency costs and have a positive effect on
profitability and consequently firm performance. A number of empirical studies provide
evidence suggesting this positive relationship between debt level and firms
performance. For example, Taub (1975) examines the factors influencing the firms
choice of a debt-equity ratio for a set of US companies and find significant positive
association between debt and profitability. Similarly Grossman and Hart (1982) and
Williams (1987) finds that high leverage reduces agency costs and increases firm value
by encouraging managers to act more in the interests of equity holders. Roden and
Lewellen (1995) find significant positive association between profitability and total
debt as a percentage of the total buyout-financing package in their study on leveraged
buyouts. Similar results are documented by Hadlock and James, (2002) for a set of
companies in USA and by Lara and Mesquita in case of Brazilian companies.
Margaritis and Psillaki (2010) investigates the relationship between efficiency, leverage
and ownership structure using a sample of French manufacturing firms and finds that
higher leverage is associated with improved efficiency over the entire range of
observed data.
While increased leverage in the capital structure reduces the agency conflicts
between shareholders and managers, it can bring with it the commitment for future
cash outflows resulting in higher expected costs of financial distress, bankruptcy
and/or liquidation. Jensen and Meckling (1976) suggest that effect of leverage on total
agency costs cannot be monotonic. At low levels of leverage, while increase in debt
reduces agency conflicts through positive incentives for managers, at higher levels
losses increase on account of negative net present value projects leading to likely
situation of bankruptcy and distress. Thus, when bankruptcy and distress become
more likely, further increases in leverage can result in higher total agency costs leading

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to a negative effect on profitability and firm performance. A number of studies provide

empirical evidence supporting this negative relationship between debt level and firms
performance or profitability. For example, while Kester (1986) reports negative relation
between leverage and profitability in case of USA and Japan, Rajan and Zingales (1995)
report such results in case of G-7 countries (USA, Japan, German, France, Italy, UK and
Canada). Gleason et al. (2000) report negative relationship between capital structure
and performance in case of set of European retail firms. Similar results are reported by
Booth et al. (2001) for a set of ten developing countries including Brazil, Mexico, South
Korea, Zimbabwe and Malaysia among others. The findings indicate that agency costs
of debt are significantly large in developing countries compared to that in developed
markets. Goddard et al. (2005) finds evidence of negative relation between firms
gearing ratio and its profitability for a set of manufacturing and service sector firms in
Belgium, France, Italy and UK. Rao et al. (2007) examines the relationship between capital
structure and financial performance of Omani firms and find a negative association
between the level of debt and financial performance. They argue that the negative
association can be attributed to the high cost of borrowing and the underdeveloped nature
of the debt market in Oman. Similarly Nunes et al. (2009) confirms the negative
relationship in case of set of firms in Portuguese service industries.
Similarly some studies report both positive as well as negative effects of leverage on
firm performance. For instance, Simerly and Li (2000) find that debt has a negative
impact on competitiveness as the imposition of covenants limits the firm ability to
make decisions. However, as debt increases, corporate governance can change from
internal to external control thereby having a positive impact on firms profitability.
Similarly Berger and Bonaccorsi di Patti (2006) finds that for a set of banking firms in
USA while higher leverage or a lower equity capital ratio is associated with higher
profit efficiency, at higher levels of debt there are offsetting effects from the agency
costs of debt. Margaritis and Psillaki (2007) investigates the relationship between firm
efficiency and leverage for a set of New Zealand firms and find that while relation is
positive at low to mid leverage levels, it becomes negative at high leverage ratios.
While the evidence in developed markets with regards to relationship between
financial leverage and firm performance has been mixed and contradictory, a few
studies investigated this relationship in emerging markets. For instance, Majumdar
and Chhibber (1999) examine the relationship between capital structure and performance
for a sample of Indian firms and find the relation to be negative. Similarly Chiang et al.
(2002) finds negative relation between capital structure and performance of Hong Kong
firms belonging to property and construction sector. Abor (2005) examines the
relationship between capital structure and profitability of firms listed on the Ghana
Stock Exchange during a five-year period and finds the relation to be positive and
negative in case of short-term and long-term debt, respectively. Abu and Abdussalam
(2006) examine the relationship between firm structure and profitability in case of Jordan
listed firms and finds significant positive relation between the two. Kyereboah-Coleman
(2007) investigates the relationship between capital structure and firm performance
using a set of microfinance institutions in sub-Saharan Africa and finds the relation to be
positive. Abor (2007) extends his previous studies to small and medium-sized enterprises
in Ghana and South Africa and reports negative relation between debt (both long-term
and short-term) and performance. Zeitun and Tian (2007) study the relationship between
capital structure and performance of a set of Jordan firms and shows that debt level is
negatively related with both accounting and market measures of performance. Ebaid
(2009) using three accounting-based measures of financial performance (i.e. ROE, ROA

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and gross profit margin (GM)), finds that capital structure choice decision, in general
terms, has a weak-to-no impact on firms performance. David and Olorunfemi (2010)
study the impact of capital structure on corporate performance in case of Nigerian
Petroleum Industry and find positive relation. Onaolapo and Kajola (2010) study of
the impact of capital structure on firms financial performance using sample of 30
non-financial firms listed on the Nigerian Stock Exchange and find that leverage has
a negative impact on firms profitability (measured by ROA and ROE). Sadeghian et al.
(2012) investigates the relationship between capital structure and firm performance in
Tehran using a combination of accounting (ROA, ROE) and market measures
(Tobins Q) and finds the relation to be negative. Shubita et al. extends Abor (2005)
findings by examining the effect of capital structure on profitability of the industrial
companies listed on Amman Stock Exchange and report significantly negative relation
between debt and profitability.
The Indian context
In India, corporate bond market, unlike developed and other Asian counties, is
relatively underdeveloped both in terms of depth and liquidity and is still to gain
traction compared to equity markets which have grown leaps and bounds since
liberalization in early 1990s. Although there have been efforts on the part of
government to open up debt segment for foreign financial institutions through
increased investment limits (currently investment limit for foreign investors in Indian
corporate debt is $51bn)[1], response of foreign investors has been lukewarm with
major portion of the same remaining unutilized. While world over, debt markets
(especially corporate bond segment) have become much larger in size compared to
traditional banking and equity sources of financing, in India corporate funding is
primarily met by banks, particularly state-owned banks (wherein Indian Government
is the majority shareholder) who control majority of the bank lending in terms of
market share. Like most banking systems in developing countries, the banking system
in India is characterized by the coexistence of different ownership groups, public (state
owned) and private and within private domestic and foreign. State-owned banks owe
their existence to the various phases of the nationalization carried on by the Government
of India (GOI) during the last 60 years. While private sector banks as well as the
foreign banks were allowed to coexist with public sector banks, their activities
continued to be highly restricted through entry regulation and strict branch licensing
policies. As a result state-owned banks have continued to dominate the banking
business in India accounting for almost 77 per cent [2],[3] of the deposits and 73 per cent
(see footnote 2) of credit disbursed in terms of market share. Currently there are
26 state-owned banks, 20 private banks and 41 foreign banks operating in the Indian
banking industry. While all commercial banks in India (state owned, private and
foreign) are regulated by the countrys Central Bank, the Reserve Bank of India (RBI),
management of state-owned banks falls under the purview of the Department of
Banking in the Finance Ministry of GOI, which directly appoints the managing
directors of these banks and determines the constitution of the Board of Directors.
Given its proprietary interests, the GOI has its representatives on the Board of Directors
and there is a considerable degree of government intervention in the day-to-day
operational decisions of these banks that has seriously limited their operational
autonomy. Resultantly studying the relationship between capital structure and firm
performance in case of an emerging market like India assumes significant importance
as it can shed further light on role of state-owned suppliers of debt capital in

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disciplining or incentivizing the managerial discretionary behaviour as against the

prior evidence emanating from privately owned institutions in developed economies.
3. Measures of firm performance and exogenous variables
Measures of firm performance
The empirical literature employs a number of different measures of firm performance
to test its relationship with capital structure. These measures include accounting based
ratios from balance sheet and income statements such as ROA, ROE, asset turnover,
etc. (Demsetz and Lehn, 1985; Gorton and Rosen, 1995; Mehran, 1995; Majumdar and
Chhibber, 1999; Ang et al., 2000; Singh and Davidson, 2003; Fleming et al., 2005; Abor,
2005; Ebaid, 2009; Sadeghian et al., 2012), stock market returns and their volatility
(Cole and Mehran, 1998; Welch, 2004), measures such as Tobins Q, which mixes market
values with accounting values (Mehran, 1995; Himmelberg et al., 1999; Zhou, 2001; Abor,
2007; Sadeghian et al., 2012) and finally measures of profit efficiency i.e., managerial
efficiency computed using a profit function (Berger and Bonaccorsi di Patti, 2006).
In the present study, we use a similar approach and use commonly used accounting
based ratios such as ROA and ROE to measure firm profitability or performance.
Financial leverage
To assess the impact that leverage has on corporate profitability (or performance),
we use following two ratios as the principal explanatory variables:
(1)

short-term debt (STD) to total assets; and

(2)

long-term debt (LTD) to total assets.

Exogenous or control variables

In explanations of profitability or performance, we include a vector of control variables
to account for firm-related or industry-related factors and also to minimize specification
bias in the model. These are firm size, firm age, tangibility or asset structure, sales
growth, liquidity and ratio of advertising, distribution and marketing expenses to total
operating expenses. To control for the differences associated with firm size, we include
the size variable in the model measured by the log of total assets of the firm. This is in
line with prior research which suggests that size of the firm may have an influence on
its performance owing to differences in operating environment, access to the markets,
diversification of business and information asymmetry (Ferri and Jones, 1979; Myers
and Majluf, 1984; Rajan and Zingales, 1995; Ramaswamy, 2001; Frank and Goyal, 2003;
Ebaid, 2009; Sadeghian et al., 2012). Similarly firm age, measured as the number of
years since inception to the date of observation, is included as a control variable. Given
that older firms are able to achieve experience-based economies and can avoid the
liabilities of newness (Stinchcombe, 1965), positive relation is posited between age and
firm performance. We further introduce tangibility (asset structure) as a control
variable, calculated as ratio of net fixed assets to total assets. Prior research predicts
that tangibility can have conflicting effects on profitability. Given that tangible assets
are easily monitored and provide good collateral, they tend to mitigate agency conflicts
(Himmelberg et al., 1999; Booth et al., 2001). Conversely, firms with high levels of
intangible assets tend to have more investment opportunities in the long term and
consequently negative association between tangibility and profitability (Rao et al.,
2007; Zeitun and Tian, 2007; Weill, 2008, Nunes et al., 2009). Sales growth, measured as
rate of change in sales between the observation year and the preceding years, can have

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a positive effect on performance as companies are able to generate higher profits from
their investment (Margaritis and Psillaki, 2010; Zeitun and Tian, 2007; Nunes et al., 2009).
We further include liquidity, measured in terms of quick assets ratio or ratio of cash to
current liabilities, as another control variable since it helps control for industry-related,
firm-specific and business cycle factors. Lastly, ratios of advertising, distribution
and marketing expenses to total operating expenses is included to control for both
industry-related and firm-specific factors. In some cases, firms resort to heavy spend
on advertising, distribution and marketing expenses to garner higher market share
and consequent higher impact on profitability. The variables therefore tend to
capture firm level predilections. In other cases industry characteristics or settings may
warrant higher spend on advertising, distribution and marketing activities; thereby
industry-related effects are controlled to some degree.
4. Data and empirical model
Sample and data
The study uses the list of S&P BSE 100 index companies as its sample. The list consists
of 100 companies representing diverse sectors of the economy. The index is calculated by
the Bombay Stock Exchange (BSE) using free float capitalization weighted method
and represents about 80 per cent of the free float market capitalization of the stocks
listed on BSE. To construct the data sample, historical data have been taken from
prowess database of the Centre for Monitoring Indian Economy (CMIE) for ten
financial years from 2003 to 2012 for analysis. Out of 100 companies we exclude
banks and non-banking finance companies as per usual practice as their financial
characteristics are quite different from others. Resultantly, the sample size gets
reduced to 78 companies representing almost all the major sectors of Indian economy
except banking and finance sector. Table I provides the distribution of the sample
by industry.
Empirical model
To capture the relationship between leverage and firms performance, we formulate the
following regression model (Table II):
ROAit b0 b1 LTDi;t b2 STDi;t b3 SIZEi;t
b4 AGEi;t b5 TANGi;t b6 GROWi;t

b7 LIQi;t b8 ADVi;t ui;t

ROEit b0 b1 LTDi;t b2 STDi;t b3 SIZEi;t
b4 AGEi;t b5 TANGi;t b6 GROWi;t

b7 LIQi;t b8 ADVi;t ui;t

where ROAi,t is the return on assets of firm i at time t; ROEi,t the return on equity of
firm i at time t; LTDi,t the total long-term debt to total assets for firm i at time t; STDi,t
the total short-term debt to total assets for firm i at time t; SIZEi,t the size of firm i at
time t; AGEi,t the age of firm i at time t; TANGi,t the tangibility of firm i at time
t; GROWi,t the growth in sales of firm i at time t; LIQi,t the quick ratio of firm i at
time t; ADVi,t the advertising, distribution and marketing expenses to total operating

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Industry name
Agriculture
Capital goods
Chemical and petrochemical
Consumer durables
Diversified
FMCG
Healthcare
Housing related
Information technology
Media and publishing
Metal, metal products and mining
Oil and Gas
Power
Telecom
Textile
Transport equipments
Transport services

ROA
ROE
LTD
STD
SIZE
AGE
TANG
GROW
LIQ
ADV

% of firms
1
8
3
1
1
12
9
9
6
1
12
9
10
4
1
12
1

Return on assets has been computed as ratio of net profit to average total assets at the end
of each financial year from 2003 to 2012
Return on equity has been computed as ratio of net profit to average total equity at the end
of each financial year from 2003 to 2012
Long-term debt to total assets has been measured by dividing the book value of long-term
debt by the book value of total assets at the end of each financial year from 2003 to 2012
Short-term debt to total assets has been measured by dividing the book value of short-term
debt by the book value of total assets at the end of each financial year from 2003 to 2012
Natural log of the book value of total assets at the end of each financial year from 2003 to
2012 has been used as proxy for size
Firm AGE has been measured as the number of years since inception to the date of
observation
Tangibility has been calculated as ratio of net fixed assets to total assets at the end of each
financial year from 2003 to 2012
GROW denotes sales growth. It is defined as growth of sales and is measured for the ith firm
at time t as under:
Grow SalesiSalesi(t1)/Salesi(t1)
Liquidity has been measured by quick assets ratio or ratio of cash to current liabilities at the
end of each financial year from 2003 to 2012
Calculated as ratio of advertising, distribution and marketing expenses to total operating
expenses at the end of each financial year from 2003 to 2012

expenses of firm i at time t; b0 the common y-intercept; b1-b8 the coefficients of the
concerned explanatory variables; mi,t the stochastic error term of firm i at time t.
Research methodology
The study uses panel data regression methodology to conduct the analysis as it takes
into effect systematic differences between the firms as compared to OLS regression
methodology which assumes that model parameters remain constant across all firms.
Under panel data regression methodology, there are two types of data models: fixed
effect methodology (FEM) and random effect methodology (REM). FEM model takes

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Table I.
Industry distribution
of the sample

Table II.
Variables definition
and explanation

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into account the individuality of each firm or cross-sectional unit included in the
sample by allowing the intercept to vary for each firm but still assumes that the slope
coefficients are constant across firms. REM is theoretically the opposite of the FEM
and assumes that the variables are uncorrelated and appropriately can apply random
effects when performing the regression. Moreover, the REM disregards the need for
generating dummy variables and instead uses a disturbance term in correspondence
with the error term. To determine whether to use FEM or REM for the data set,
Hausman (1978) specification test is conducted. The Hausman test statistic is
asymptotically distributed as w2 and is based on the Wald criterion. The Hausman test
assumes the null hypothesis that there is no correlation between the individual effects
and the regressors and hence REM should be used. In case the null is rejected, implying
correlation between the individual effects and the regressors, FEM is preferred over
REM. Accordingly we formulate the following hypothesis:
H0. Null hypothesis there is no correlation between the individual effects and the
regressors.
H1. Alternate hypothesis there is correlation between the individual effects and
the regressors.
The results of the Hausman test in our study (Table III) reject the null hypothesis at 5
per cent significance level, thereby supporting the use of FEM over REM in all cases.
5. Empirical results
Descriptive statistics
This section presents the various estimation results and discusses the implications of
the empirical findings. The summary statistics of the dependent and explanatory
variables over the sample period are presented in Table IV, reflecting the average
values of the dependent and the independent variables. Table V shows the correlation
matrices among all the variables along with variance inflation factors (VIF). The VIF
values affirm the absence of multi-collinearity among the variables considered since
the values are well within the acceptable limits (VIF45 indicate multi-collinearity
as per Gujarati, 2003). Additionally we conduct Ramsey RESET test (Table VI) for
the model misspecification and the results suggest no apparent non-linearity in the
regression equations.
Regression results
Tables VII and VIII present the results of regression using FEM to test the relationship
between capital structure and firms profitability measured by ROA and ROE
(Models 1 and 2). As shown in these tables, the results indicate a significant negative

Table III.
Hausman test

Specification: Model 1 (ROA)

w2-statistic
Probability
Specification: Model 2 (ROE)
w2-statistic
Probability
Note: **Significant at 5 per cent level

20.17**
0.004
15.06**
0.035

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Variable

Min.

Max.

SD

ROA
ROE
LTD
STD
SIZE
AGE
TANG
GROW
LIQ
ADV

0.200
1.590
0.000
0.000
3.310
2.000
0.000
0.710
0.010
0.000

0.510
1.800
0.870
0.570
7.130
117.0
0.730
980.68
13.430
0.460

0.089
0.210
0.200
0.080
0.681
26.994
0.174
39.025
1.410
0.088

Notes: Sample of 9,780. Observations, 2003-2012

ROA
ROE
LTD
STD
SIZE
AGE
TANG
GROW
LIQ
ADV

ROA

ROE

1
0.77
0.43
0.23
0.48
0.01
0.26
0.03
0.13
0.42

1
0.24
0.17
0.37
0.08
0.14
0.01
0.14
0.37

LTD

1
0.13
0.12
0.28
0.03
0.00
0.25
0.18

Specification: model 1 (ROA)

F-statistic
Log likelihood ratio
Specification: model 2 (ROE)
F-statistic
Log likelihood ratio

STD

1
0.1
0.3
0.09
0.00
0.47
0.15

SIZE

1
0.2
0.22
0.01
0.27
0.53

AGE

1
0.09
0.07
0.16
0.02

TANG

1
0.05
0.31
0.35

GROW

1
0.02
0

LIQ

1
0.29

ADV

VIF

1.23
1.05
1.19
1.17
1.20
1.03
1.04
1.00
1.07
1.18

0.065
0.172

Probability
Probability

0.4924
0.4469

0.126
0.242

Probability
Probability

0.5881
0.5156

relationship between debt (both short term and long term) and firm profitability
(in case of both ROA and ROE); the coefficient of debt being negative and statistically
significant at 5 per cent level, which suggests that an increase in debt is associated
with decrease in profitability (or performance). This results thus implies that
an increase in short-term and long-term debt position is associated with a decrease
in profitability.
Firm size is positively and significantly related to profitability (or performance)
suggesting that large firms in India enjoy economies of scale and are able to exercise
considerable influence in product and factor markets. Firm age exhibits negative and
significant association with profitability (or performance) suggesting that newer firms
are able to score over older firms in adjusting/adapting to changing competitive
product and factor market place. Tangibility is found to be positively and significantly

Capital structure
and firm
performance
1199

Table IV.
Descriptive statistics

Table V.
Correlation matrices
and variation inflation
factors (VIF)

Table VI.
Ramsey regression
equation specification
error test (RESET)

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1200

Table VII.
Regression result of
capital structure
and performance
measured by ROA

ROAit b0 b1 LTDi;t b2 STDi;t b3 SIZEi;t b4 AGEi;t b5 TANGi;t b6 GROWi;t

b7 LIQi;t b8 ADVi;t mi;t
Dependent variable: ROAit
Explanatory variable

Coefficient

LTD
STD
SIZE
AGE
TANG
GROW
LIQ
ADV
R2
Adjusted-R2
SE of regression
Mean dependent variable
SD dependent variable
F-statistic
Prob(F-statistic)

0.29
0.26
0.04
0.07
0.05
0.00
0.05
0.11
0.44
0.41
0.92
2.56
0.97
84.90
0.00

t-statistics

Prob.

9.63**
8.87**
2.61**
2.43**
3.75**
0.93
2.56**
3.2**
Durbin-Watson
Akaike info. criterion
Schwarz criterion
Hannan-Quinn criterion

0.00
0.00
0.00
0.00
0.00
0.35
0.00
0.00
1.9
2.66
2.96
2.53

Note: **Significant at 5 per cent level

ROEit b0 b1 LTDi;t b2 STDi;t b3 SIZEi;t b4 AGEi;t b5 TANGi;t b6 GROWi;t

b7 LIQi;t b8 ADVi;t mi;t
Dependent variable: ROEit
Explanatory variable

Table VIII.
Regression result of
capital structure
and performance
measured by ROE

LTD
STD
SIZE
AGE
TANG
GROW
LIQ
ADV
R2
Adjusted R2
SE of regression
Mean dependent var.
SD dependent var.
F-statistic
Prob. (F-statistic)

Coefficient
0.22
0.20
0.07
0.01
0.03
0.00
0.04
0.44
0.34
0.30
0.56
1.85
0.51
73.38
0.00

t-statistics

Prob.

5.68**
4.46**
6.01**
2.56**
2.55**
0.37
2.49**
4.59**
Durbin-Watson
Akaike info criterion
Schwarz criterion
Hannan-Quinn criterion

0.00
0.00
0.00
0.00
0.00
0.17
0.00
0.00
2.0
2.55
2.51
2.53

Note: **Significant at 5 per cent level

related to firm profitability (or performance) suggesting that tangible assets are easily
monitored and provide good collateral and thus they tend to mitigate agency conflicts
between shareholders and creditors. Sales growth shows no significant relationship
with profitability (or performance). Liquidity has a positive and significant association

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with profitability (or performance) signifying the benefits of superior working capital
management and gains accruing on account of lower interest cost. Finally advertising
show a positive and significant effect on profitability (or performance) suggesting
that higher advertising spend can generate higher profits on account of product
differentiation (in line with industrial organization theory).
In summary, the results shown in Tables VII and VIII indicate that after controlling
for factors such as firm size, firm age, tangibility, sales growth, liquidity and
advertising, capital structure has a negative influence on financial performance of a set
of listed Indian firms. This evidence is in contrast with findings in developed (Taub,
1975; Grossman and Hart, 1982; Williams, 1987; Roden and Lewellen, 1995; Champion,
1999; Ghosh et al., 2000; Hadlock and James, 2002; Margaritis and Psillaki, 2007, 2010)
as well as emerging economies (Abor, 2005; Kyereboah-Coleman, 2007) which
document a positive impact of capital structure on firms performance.
The above evidence is not in accordance with the postulates of agency theory as
commonly accepted in other developed as well as emerging markets. In India, given the
underdeveloped nature of the corporate bond market, reliance on traditional sources of
financing has been excessive. Consequently, the suppliers of debt capital in India,
unlike developed economies, are primarily banks particularly state-owned banks who
control a major share of the lending. This dominance of state-owned suppliers of
debt capital plays an important role in determining whether presence of loan creditors
disciplines managers towards superior firm performance. State-owned banks in
India have not been able to incentivise or discipline the managerial discretionary
behaviour so as to mitigate the agency conflicts and bring it in congruence with the
best interests of shareholders. Unlike privately owned institutions, which are subject to
strict monitoring by their suppliers or owner principals, state-owned banks in India
do not face any such market discipline by their owners (government). Instead
they have often served as a vehicle for channelling government considerations to
favoured parties under the garb of industrial advancement or development.
Consequently, state-owned banks have reduced incentives for increasing monitoring
of their debtor firms as they are not likely to be penalized for making bad loans
decisions by their owners (government). This lack of monitoring incentivizes
debtor firm managers to pursue discretionary behaviour which have negative
performance consequences.
The above empirical evidence is further substantiated by the fact that the bad assets
(non-performing asset) of state-owned banks stands at a level of 4.1 per cent (as per cent
of gross advances) compared to just 2 per cent in case of private sector banks
(Table IX). Unlike private sector banks where presence of institutional investors had an
impact in influencing managerial behaviour and bringing in disciplinary pressures to
enforce hard budget constraints, in case of state-owned banks vesting of ownership

Capital structure
and firm
performance
1201

Trends in non-performing assets bank group-wise

State-owned banks
Private sector banks
Gross NPAs (in INR Billion)
Gross NPAs as per cent of gross advances (%)
2011-2012
2012-2013

1,650

210

3.30
4.10

2.10
2.00

Source: RBI Report on Trends and Progress of Banking in India 2012-2013

Table IX.
Trends in non-performing
assets bank group-wise

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1202

in the hands of government department (who holds all the shares on behalf of
government) has failed to keep a check on profligacy or lack of effort on discretionary
managerial behaviour in debtor firms. This further brings forth an important issue of
role of government nominee members on the board of debtor firms. Given their
unsatisfactory role in monitoring the performance of debtor firms consequently leading
to increasing NPAs, there is a need to revisit the monitoring capabilities of government
nominees to ensure any meaningful disciplining influence on Indian managers. Second,
project appraisal and credit analysis skills of state-owned banks needs to be overhauled
as promoters of economically unviable projects may have obtained large loans from these
institutions on account of political considerations and subsequently failed to honour the
commitments. These issues have been voiced by RBI in its report on Trends and Progress
of Banking in India (see footnote 2) wherein they had directed state-owned banks to take
adequate steps to strengthen their risk management systems, credit appraisal and
sanction process, post-sanction monitoring and follow-up and have a robust MIS
mechanism for early detection of incipient weaknesses/distress and for taking steps for
remedial measures and recovery of banks dues. Similarly apex banking lobby Indian
Banks association (IBA) have continuously raised concerns on instilling better
governance practices by state-owned banks while monitoring debtor firms.
6. Summary of findings and conclusion
A vast literature investigates the relationship between capital structure and performance
since the seminal work of Modigliani and Miller (1958). While most of these studies
explore the relationship in the developed countries, little is empirically known about such
implications in emerging economies such as India. The present study investigates the
impact of capital structure choice on performance of listed firms in India as one of
the emerging economies. Based on a sample of large cross-section of Indian firms and
using two accounting-based measures of financial performance (ROA, ROE), the results
indicate that capital structure negatively impact the firm performance. This is not in
accordance with the assumptions of agency theory as commonly received and accepted
in other developed as well as emerging markets. Consequently, postulates of agency
theory have to be seen with different perspective in India given the underdeveloped
nature of bond markets and dominance of state-owned banks in lending to corporate
sector. As against privately owned institutions in developed economies, state-owned
nature of lending in India has impacted the way in which presence of loan creditors
induces managers towards striving for superior corporate performance. State-owned
suppliers of debt capital (state-owned banks) have not been able to exercise considerable
disciplining influence on Indian corporate managers who have continued to indulge in
discretionary behaviour with negative performance consequences.
For future research sectoral analysis can be incorporated so as to explore whether
relationship is any different given the specific attributes particular to an industry.
Finally given that relationship between leverage and firm performance can assume
non-linearity, the same can be studied using quantile regression estimates.
Notes
1. Securities and Exchange Board of India (SEBI).
2. RBI Report on Trends and Progress of Banking in India 2012-13.
3. http://articles.economictimes.indiatimes.com/2013-12-16/news/45256402_1_bad-loans-staterun-banks-indian-bank

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About the author
Varun Dawar has worked extensively in Indian Equity and Debt Markets with companies like
the JP Morgan and the Max Life Insurance Limited. Before joining the IMT (Institute of
Management Technology) Ghaziabad as an Assistant Professor, the author was managing
funds in the capacity of Portfolio Manager covering both Equity and Debt markets. The author
is an MBA as well as adoctorate in finance. Varun Dawar can be contacted at:
varun.sep82@gmail.com

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