TheImpactofCapitalStructureonProfitability withSpecialReferencetoit Industry in India RamachandranAzhagaiah CandasamyGavoury Firms can use either debt or equity capital to finance their assets. The bestchoiceisamixofdebtandequity.Thepresentstudymainlyanaly- seshowfarthecapitalstructure(cs )affectstheProfitability(p )ofcor- porate firms in India. The study tries to establish the hypothesized re- lationshipastohowfarthecs affectsthebusinessrevenueoffirmsand what the interrelationship is betweencs and Profitability. This study is carried outafter categorizing the selected firms into three categories basedontwoattributes,viz.businessrevenueandassetsize.First,firms are grouped into low, medium and high based on business revenue. Second, firms are classified into small, medium and large based on as- set size to establish the hypothesized relationship thatcs has signifi- cant impact on Profitability of Information Technology (it )firmsin India. Forthe study, a sample of102it firms was chosen by the Multi- Stage Sampling Technique. The data for a period of8 years ranging from1999 –2000 to2006 –2007 have been collected and considered for analysis. Regression Analysis (to analyze the unique impact ofcs on Profitability), in addition to descriptive statistics such as Mean, Stan- dard Deviation, and Ratios has been used. The study proves that there has been a strong one-to-one relationship betweencs variables and Profitability variables, Return on Assets (roa ) and Return on Capital Employed (roce )andthecs has significant influence onProfitability, and increase in use ofdebt fund incs tendsto minimize the net profit oftheit firms listedin BombayStockExchangeinIndia. Key Words: capitalstructure,profitability,returnonassets, returnoncapitalemployed,debt,equity jel Classification:g30 ,g32 Introduction Ina wakeofliberalization andglobalization ofeconomicpolicies across the world, investment opportunities have expanded and financing op- DrRamachandran AzhagaiahisafacultymemberattheKanchi MamunivarCentreforPostGraduateStudies,Puducherry,India. DrCandasamy Gavouryisaresearch scholar attheKanchi MamunivarCentreforPostGraduateStudies,Puducherry,India Managing GlobalTransitions9 (4 ):371 –392 372 Ramachandran Azhagaiah andCandasamy Gavoury tionshavewidened,andabovealldependenceoncapitalmarketshasin- creased. A new business requires capital and still more capital is needed if thefirmistoexpand.Therequired fundscancomefrommanydiffer- ent sources and by different forms. Firms can use either debt or equity capital to finance their assets. The best choice is a mix of debt and eq- uity. One of the most perplexing issues facing financial managers is the relationshipbetweencapitalstructure(cs ),whichisthemixofdebtand equityfinancing,andstockprices. Thedebtisadvantageous(relativetoequity)ifDebtEquityRatio(der >1 ), otherwise it is harmful. The value of the firm is independent of its debtpolicyandisbasedonthecriticalassumptionthatcorporateincome taxesdonotexist.Inreality,corporateincometaxesdoexist,andinterest paid to debt-holders is treated as a deductible expense. Thus, interest payable by firms saves taxes. This makes for debt financing advantages. The value of the firm will increase with debt due to the deductibility of interest charges for tax computation, and the value of the levered firm will behigher thanthatoftheun-leveredfirm. The determinants ofcs considered by Modigliani and Miller (1958 ; 1963 ) in their seminal work on the subject, – whether interest was tax deductible or not – was pioneering. In the case where interest was not tax deductible, firms’ owners would be indifferent as to whether they used debt or equity, and where interest was tax deductible, they would maximizethevalueoftheirfirmsbyusing100 %debtfinancing.Inprac- tice, despite interest being tax deductible, the use of debt varies widely, hence giving rise to the ‘cs Puzzle’ (Myers1984 ). In recent years, there has been an increasing recognition that small enterprises are different from large ones and that these differences affect numerous aspects of small firms including theircs (Ang1991 ;1992 ). Hence, the higher the debt ratio, the greater the risk, and thus higher the interest rate will be. At the same time, rising interest rates overwhelm the tax advantages of debt. If the firm falls on hard times and if its operating income is insuf- ficient to cover interest charges, then stockholders will have to make up the short fall, and if they can’t, the firm may be forced into bankruptcy. Goodtimes may bejustaroundthecorner.But toomuch debtcankeep the company wipeout shareholders in the process. Several authors have pointedoutthatagencyproblemscanbereducedoreliminatedthrough theuseofmanagerialincentiveschemesand/ormorecomplicatedfinan- cialsecuritiessuchasconvertibledebt(Barnea,HaugenandSenbet1985 ; BranderandPoitevin1988 ;HaugenandSenbet1987 ). ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 373 A pecking order framework is intended to explain variations incs (Myers1984 ). The issue of external equity is seen as being the most ex- pensive and also dangerous in terms of potential loss of control of the enterprise by the original owner-managers. The information advantage ofthecorporatemanagerswillbeminimizedbyissuingdebt.Optimistic managers,whobelievethesharesoftheirfirmsareundervalued,willpre- ferimmediately toissue debtandto avoidequityissue. Onlypessimistic managers will want to issue equity, but who will buy it? Equity issues will occur only when debt is costly. If internally generated cash flow ex- ceeds capital investment, the surplus is used to pay down debt rather than repurchasing and retiring equity. As the requirement for external financingwillincrease,thefirmwillworkdownthepeckingorder,from safe to riskier debt, perhaps to convertible securities or preferred stock andfinallytoequityasalastresort(MyersandMajluf1984 ). The modern theory ofcs began with the paper of Modigliani and Miller (1958 ). They (mm ) pointed out the direction that such theories must take by showing under what conditions thecs is irrelevant. Since then,manyeconomistshavefollowedthepaththeymapped.Now,some 50 years later, it seems appropriate to take stock of where this research stands and where it is going. Some other recent surveys includeTaggart (1977 ), Masulis (1983 ), Miller (1988 ), Ravid (1988 ) and Allen (1991 ) and comments on Miller (1977 )byBhattacharya(1979 ), Modigliani (1982 ), Ross (1977 ), and Stiglitz (1974 ) and Masulis (1980 ), which are general surveys. Allen (1991 ) focuses on security design, and Ravid (1988 ) con- centratesoninteractionsbetweencs andproductmarket. Research in this area was initiated by Jensen and Meckling (1976 ) building on earlier work of Fama and Miller (1972 ). Empirically, prof- itability of firms in concentrated industries differs from that of firms in more competitive industries in terms of level and persistence. Firms in concentrated industries have relatively higher profits (Mackay and Philips2005 ). In addition to higher levels of profits, there is evidence that firms in concentrated industries behave differently in preserving profit margins when compared to competitive industries. Mark ups are countercyclical in concentrated durable goods industries. For the non- durable goods sector, mark-ups are relatively more pro cyclical in con- centratedindustries than those in competitive industries (Ian,Hubbard and Bruce 1988 ). The influence of persistence in profitability on the leverage-profitabilityrelationship has been addressed by Raymar (1991 ), SarkarandZapatero(2003 ),andLeland(1994 )withvaryingpredictions. Volume 9 · Number 4 · Winter 2011 374 Ramachandran Azhagaiah andCandasamy Gavoury InRaymar’s(1991 )model,firmsoptimallyrecapitalizeattheendofeach period,leadingtoapositiverelationshipbetweenleverageandprofitabil- ity. StatementoftheProblem, SignificanceandScope Thepresentstudymainlyanalyseshowfarthecs affectstheprofitability ofcorporatefirmsinIndia.Assetsizeandbusinessrevenuewouldappear to bethe importantfactorsin determining the profitabilityofcorporate firms.In India,few studies have analyzedthe relationship between asset sizeandbusinessrevenuesontheimpactofcs andProfitability. Thisstudyiscarriedoutaftercategorizingtheselectedfirmsintothree categories based on two attributes. First, firms are grouped into low, medium and high based on business revenue (total income). Second, firms are classified into small, medium and large based on asset size to establishthehypothesized relationship thatcs hassignificantimpacton Profitabilityofit firmsinIndia. Though many research studies have been undertaken in the field of cs ,onlyveryfewstudieshavebeenundertakentoanalyzetheassociation betweencs and Profitability. Therefore, this study is a maiden attempt toanalyzethe profitabilityofthefirms. significant relationship among different sized firms in terms ofcs andProfitability. The study constitutes an attempt to provide an empirical support to the hypothesized relationship betweencs and Profitability. Is there any significant difference in the impact ofcs on Profitability ofit firms in India?Howfardoesthecs affectthebusinessrevenueoffirms,andwhat istheinterrelationship betweencs andProfitability? ObjectivesandHypothesesoftheStudy Thepresentstudyisintended tostudythefactorsinfluencingcs ofselectfirmsbasedonassetsize andbusinessrevenue. to analyze the interrelationship betweencs and Profitability based onasset size andbusiness revenue. h 1 0 Thereisnosignificantrelationshipbetweenselectedcs variablesand Return on Asset(roa ) of Low Incomeit firms, Medium Incomeit firms,andHighIncomeit firms. ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 375 h 2 0 Thereisnosignificantrelationshipbetweenselectedcs variablesand roa of Small Sizeit firms,MediumSizeit firms,andLargeSizeit firms. h 3 0 There is no significant relationship between selected cs variables and Return on Capital Employed (roce ) of Low Incomeit firms, MediumIncomeit firms,andHighIncomeit firms. h 4 0 Thereisnosignificantrelationshipbetweenselectedcs variablesand roce of Small Sizeit firms, Medium Sizeit firms, and Large Size it firms. h 5 0 Thereisnosignificantrelationshipbetweenselectedcs variablesand roa ofOverallit firms. h 6 0 Thereisnosignificantrelationshipbetweenselectedcs variablesand roce ofOverallit firms. Review ofLiterature The value of corporate debt and capital structure (cs ) are interlinked variables. Debt values (and therefore yield spreads) cannot be deter- mined without knowing the firm’scs ,whichaffects the potential for default and bankruptcy, butcs cannot be optimized without knowing the effort of leverage on debt value. Both theoretical and empiricalcs studieshavegeneratedmanyresultsthatattempttoexplainthedetermi- nants ofcs . Modigliani and Miller (1958 ) state that interest tax shields createstrongincentivesforfirmstoincreaseleverage.Butalsothesizeof non-debtcorporatetax shields, like taxdeductions fordepreciation and investment tax credits, may affect leverage. Titman and Wessels (1988 ) extend the theories that have different empirical implications; measures of short-term, long term, and convertible debt rather than an aggregate measureoftotaldebt.BartonandGordon(1988 )suggestthatamanage- rial choice perspective may help to explaincs choice at the firm level of analysis. Sheel (1994 ) showed that all leverage determinants studied, excepting firm size, are significant in explaining leverage variations in debt be- haviour. Vogt (1994 ) analyzed a set of simultaneous equations for ex- ternal financing and investment spending that tests the pecking order hypothesis (Myers1984 )against a partial stock adjustmentmodel (Jalil- vandandHarris1984 andTaggart1977 ).Consistentwithapartialadjust- mentmodel, firms appear to adjust slowly to long-run financialtargets. However, additional financing needs follow a pecking order. And sup- Volume 9 · Number 4 · Winter 2011 376 Ramachandran Azhagaiah andCandasamy Gavoury port work by Fazzari, Hubbardand Petersen (1988 ).Rajan and Zingales (1995 ) found that factors identified by previous studies as correlated in the cross-section with firm leverage in theus are similarly correlated in other countries as well. Shyam Sunder and Myers (1999 )arguedthat mere reversionofleverageratioscanbeobservedevenifthe peckingor- der theory is true. Gleason, Mathur and Mathur (2000 ) accepted that variables other thancs also influence corporate performance. A nega- tive relationship betweencs and performance suggests that agency is- suesmaylead touse ofahigher thanappropriatelevelofdebt inthecs , thereby leadingtoalowerperformance. Graham (2000 ) estimated the tax advantage to debt. Stein (2001 ) found that a firm has the option to increase future debt levels; tax ad- vantagesto debt increasesignificantly.Booth etal. (2001 )statethatdebt ratios in developing countries seem to be affected in the same way and by the same type of variables that are significant in developed coun- tries. However, there are systematic differences in the way these ratios areaffectedbycountryfactors,suchasgdp growthrates,inflationrates, and development of capital markets. Um (2001 ) stated that the static trade-offtheoryofcs isobtained,wherethenettaxadvantageofdebtfi- nancingbalancesleveragerelatedcostssuchasbankruptcy,andsuggests that ahigh profitlevelgivesrise to ahigher debtcapacityandaccompa- nying tax shield. Hence it is expected that a positive relationship should exist between profitability and financial leverage. Antoniou, Guney and Paudyal (2002 ) found thatcs decisions of firms are not only affected by its own characteristics but also by its surrounding environments for different reasons, such as the deterioration or the improvement in the state of economy, the existence of a stock market and/or the size of the banksector. Berg er ,A.N.( 2002 ) findings are consistent with the agency cost hypothesis-higher leverage, or a lower equity capital ratio is associated with higher profit efficiency, all else being equal. The relationship be- tween performance and leverage may be reversed when leverage is very high due to the agencycost of outsidedebt. Profitefficiency isresponsi- bletoownershipstructureofthefirmconsistentwithagencytheoryand their argument that profit efficiency embeds agency costs. Hung (2002 ) foundthathighgearingreflectsmoreoflowequitybasethanhighlevelof debts, which indicatesthat capitalgearing ispositively related with asset but negatively with profit margins. Pandey’s (2002 ) findings vindicated the saucer-shaped relationship betweencs and Profitability because of ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 377 theinterplayofagencycosts,costsofexternalfinancingandinteresttax- shield, and proved that the size and tangibility have a positive influence andgrowth,riskandownershiphaveanegativeinfluenceoncs . Bhaduri (2002 )statedthattheoptimalcs choice canbe influencedby factorssuchasgrowth,cashflow,size andproductandindustry charac- teristics, and confirmed the existence of restructuring costs in attaining an optimalcs . Voulgaris, Asteriou and Mirigianakis (2002 ) found that the growth of asset utilization, gross as well as net profitability, and to- talassetshaveasignificanteffect onthecs .RonnyandClarirette(2003 ) supported the pecking order theory and rejected the trade-off theory of cs . Further, the small role played by the Mauritian capital market as a source of long-term financeis evidentfrom the results with respect to a number of explanatory variables including age, growth, risk and prof- itability. The strong and positive results for the size variable are con- sistent with the findings of other studies and with the trade-off theory. Sarkarand Zapatero (2003 ) suggested that the speed of reversion differs by competitive environment, and the time-series applications support thenotionthattheprofitabilityisdecreasingwiththespeed ofreversion inprofitability. Strebulaev(2003 )arguedthateventhoughapositiverelationbetween profitability and the optimal leverage ratio can be expected, there is a negative relation between profitabilityand the actual leverage ratio. Be- cause of transaction costs, firms do not rebalance their leverage ratios constantly; instead, they allow them to move within a range surround- ingthe optimalleverageratios. Mesquita andLara(2003 )stated thatthe choice between the ideal proportion of debt and equity can affect the valueof the company,as much as the return rates can.The results indi- cate that the return rates present a positive correlation with short-term debtandequity,andaninversecorrelationwithlong-termdebt.Azhaga- iahandPremgeetha(2004 )suggestedthattherapidabilitytoacquireand dispose of debt provides the desired financial flexibility of firms with a goalforgrowth.Thenon-debttaxshieldandgrowthratearestatistically significant,whichmeansthatthesevariablesarethemajordeterminants ofthecs ofPharmaceuticalCompaniesinIndia. Hennessy and Whited (2005 ) argued that the dynamic tax considera- tionscanalsocauseanegativerelationbetweenprofitabilityandleverage ratios. Therefore, these firms are more likely to face internal fund-debt financingdecisions.Ontheotherhand,lessprofitablefirms,duetolack of internal funds, are more likely to face the debt-equity financing de- Volume 9 · Number 4 · Winter 2011 378 Ramachandran Azhagaiah andCandasamy Gavoury cisions, and show that debt financing is relatively less attractive in the debt-equity financing decision because of different tax rates. Therefore, a negative relation between profitability and leverage ratio can be in- duced when firms facing internal fund-debt and debt-equity decisions are mixed together. Pandey (2004 ) predicted that there will be a non- linear relationship betweencs and profitability. Firms at a lower level ofprofitabilitywouldemploymore internalfunds,asexternalfundsare expensive and on debt tax shield (such as depreciation) may be more than enough to take advantage of tax benefits. Firms have more profit to shield from taxes as well, as they are able to generate more output by employingasseteffectively. Chen (2004 )suggested that some of the insights from the modern fi- nancetheoryofcs aretransferabletoChinainthatcertainfirm-specific factors that are relevant for explainingcs in a developed economy are also relevant in China. The significant institutional differences of finan- cialconstraintsinthebankingsectorinChinaarethefactorsinfluencing firms’ leverage decision. Chen and Zhao (2004 )suggested that dynamic taxconsiderationsareunlikelytobethemainreasonforthenegativere- lation between profitability and leverage either. Deesomsak (2004 )sug- gested that thecs decision of firms is influenced by the environment in which they operate, and finds a significant but diverse impact on firms’ cs decision. Loof (2004 ) found the ideas that the more unique a firm’s asset, is the thinner the market is for such assets. Henceone may expect thatuniquenessbenegativelyrelated toleverage. Voulgoaris, Asteriou and Mirigianakis (2004 ) found that the prof- itability is one of the major determinants ofcs for bothsme s andlse s size groups. However,efficientassetsmanagementandassetsgrowthare found essential for the debt structure oflse s as opposed to efficiency of current assets (ca s), size, sales growth and high fixed assets, which werefoundtoaffect substantially the credibility ofsme s. Joshua (2005 ) revealed a significantly positive relationship between the ratio of short termdebttototalassetsandroe .Song(2005 )indicatedthatmostofthe determinants ofcs suggested bycs theories appear to be relevant for Swedish firms. But one also finds significant differences in the determi- nantsoflongandshorttermformsofdebt. Harrington (2005 ) supported the theories ofcs , which indicates that profitabilityisanimportantdeterminantofleverage.Theresultssuggest that manufacturing firms in concentrated industries have a slower rate ofmeanreversioninprofitabilitywhencomparedtofirmsoperatingina ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 379 morecompetitiveenvironment.Aslowerrateofmeanreversioninprof- itabilityleadstoagreaterresponseofleveragetoprofitability.Huangand Song (2006 )foundthat,as in other countries, leveragein Chinese firms increases with firm size and fixed assets, and decreases with profitabil- ity, non-debt tax shield, growth opportunity, managerial shareholdings correlate with industries, and found that the ownership or institutional ownershiphasnosignificantimpactoncs .Tang(2007 )foundthatfixed assets, growth opportunities, and the joint effect of these two variables are the significant long-term debt determinants of the lodging indus- try, and suggests that fixed assets and growth opportunities affect each other’s relationship with long-term debt usage. Raheman, Zulfiqar and Mustafa (2007 ) indicated that thecs of the non-financial firms listed onIslamabadStock Exchangehas asignificanteffect onthe profitability of these firms. Dragota and Semenescu (2008 ) proved that the pecking order theory seemed to be more appropriate for the Romanian capital market,butthesignallingtheory wasnotentirelyrejected. Though many research studies have been undertaken in the field of cs and Profitability, very few studies have been undertaken to find the impact ofcs on Profitability. Therefore, to fill this gap in the literature andshedlight,thepresentstudyattemptstoanalyzetheimpactofcs on Profitabilitywithspecialreferencetotheselectedit firmsinIndia. Methodology sourcesofdata Secondarydatawereusedforthestudy.Therequireddatawerecollected fromcmie (Centre for Monitoring Indian Economy) Prowess Package. The public Ltd firms with Low Income, Medium Income and High In- comegroupsbasedonthelevelofincomefrombusiness,i.e.,firmswith Income < Rs.25 crore as Low, Income between Rs.25 crore and Rs.100 crore asMedium, andfirmswith business Income> Rs.100 crore is cat- egorized asHighincomegroup.FirmswithTotalAssets(ta s)worthbe- low Rs.25 crore are termed as ‘Small Size Firms,’ firms withta sworth Rs.25 croreandabove,butbelowRs.100 croreareconsideredas‘Medium Size Firms,’ andfirms withta s worth Rs.100 crore and aboveare classi- fiedas‘Large Size Firms.’ samplingdesign As on31 March2007 , the total number of firms listed in Bombay Stock Exchange (bse ) was 4916 , out of which 835 firms were listed under Volume 9 · Number 4 · Winter 2011 380 Ramachandran Azhagaiah andCandasamy Gavoury it Sector;736 were Software firms, and firms doing other than soft- ware business were99 .Outof736 software firms, only727 firms were listed continuously, which were considered for selection. Considering the availability of data and firms listed continuously for all the8 years (1999 –2000 to2006 –2007 ),116 firmswereselectedasasample(outof116 firmsremovingtheoutliersof14 firmsi.e.,thefirmswithextremevalues are removed). Finally a sample of102it firms (116 −14 ) was chosen by theMulti-StageSamplingTechnique. ToolsUsedforAnalysis The Statistical Techniques used for analysis are Pearson’s Coefficient of Correlation (to analyze the relationship betweencs and Profitability), Regression Analysis (ols Model to analyze the unique impact ofcs on Profitability)inadditiontodescriptivestatistics suchasMean,Standard Deviation,andRatio. Twodependentvariables,ReturnonAssets(roa )andReturnonCap- ital Employed (roce ) are considered as profitability variables (business revenue)forthe study. The independentvariablesofTotalDebt toTotal Assets (td _ta ) and Debt-Equity Ratio (der ) have been used as proxy forcs . The controlled variables, Expenses Ratios (exp _inc ) and Cur- rentRatios(ca )arealsoused. IndependentandDependentvariablesoftheselectedsamplefirmsfor the period ofstudy: 1 . DependentVariables(ProfitabilityVariable) ReturnonAssets(roa ) ReturnonCapitalEmployed(roce ) 2 . IndependentVariables(CapitalStructureVariables) TotalDebttoTotalAsset (td _ta ) ExpensetoIncomeRatio(exp _inc ) DebtEquityRatio(der ) CurrentRatio(cr ) 3 . ControlledVariable ExpenseIncomeRatio(exp _inc ) Correlationanalysisiscarriedouttofindouttheexistenceofmulti-co linearity amongindependentvariablesin orderto decide what variables can be used in regression model, or how the regression model with all independentvariablescanbeused. ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 381 MultipleRegression EquationModel Y e = a+b 1exp _inc +b 2td _da +b 3cr +b 4der +e, where Y e = Profitability variables (roa &roce ),exp _inc =Expenses –Income,td _ta = Total Debt – Total Asset,cr = Current Ratio, a = Intercept,b 1...b 4 =Estimated Coefficient,ande =ResidualError. PeriodoftheStudy Thedataforaperiodof8 years ranging from1999 –2000 to2006 –2007 havebeencollectedandconsideredforanalysis.Notalltheit firmswere continuouslylisted, andtheavailabilityofdataforthe yearstogether for theit firmsis8 years. LimitationsandScopeforFurtherStudy Analysis of the study is based on finance data collected from the cmie Prowess Package. The quality of the study depends purely upontheaccuracy,reliabilityandqualityofsecondarydata. Adetailedtrendcoveringalengthyperiodcouldnotbedonedueto lackofresources. For the availability of data and analysis, the size of sample is also restricted to102 ,outof116 software firms. The analysis is based on business revenue (low income below Rs.25 crore, medium in- comebetweenRs.25 toRs.100 croreandhighincome–aboveRs.100 crore); based on assets size (small size below Rs.25 crore, medium sizebetweenRs.25 toRs.100 croreandlargesizeaboveRs.100 crore) tomakethesampledistributionsomewhatnormal,removingfirms withunrealistic value(outliers);102 firmswereultimatelyselected. Today, no firm is involved exclusively in hardware or software.it hardware firms being switched overto software andalso outsourc- ing(mutualfundsandstockmarket)losetheiridentityashardware. So it isdifficulttoclassifythefirmsexclusivelyforsoftwareandex- clusivelyforhardware. Due to the influence of some extraneous variables the intercept is veryhighinafewregressionmodelanalyses.Hence,forfuturestud- ies, it is better to include those independent variables to find the trueimpactofthosevariablesonthefinancialdecisioninrespectof cs andProfitability. Volume 9 · Number 4 · Winter 2011 382 Ramachandran Azhagaiah andCandasamy Gavoury table1 ResultsofRegressionAnalysisforReturn onAssets(roa )oflowIncome, mediumincome,andhighincomeit Firms Variable CoefficientforLow Income Firms CoefficientforMedi- umIncomeFirms CoefficientforHigh Income Firms Intercept 16 .7369 *** 101 .2607 *** 126 .4997 *** exp _inc –0 .1037 *** –0 .8993 *** –1 .1508 *** td _ta –0 .0258 –0 .2309 *** 0 .0010 cr –0 .0241 –0 .2829 *** –0 .0610 der –0 .0536 –1 .5052 *** –11 .6766 *** R 2 0 .2270 0 .7728 0 .5792 Adjusted R 2 0 .2183 0 .7669 0 .5734 F Statistic 26 .07 *** 131 .78 *** 100 .15 *** P Value (F Statistic) 0 .000 0 .0000 0 .0000 notes *Significantat10 %level;**Significantat5 %level;***Significantat1%level The study is based onlyonit firms. Therefore, the inferences and re- sults will be of much use for further analysis by covering firms in other sectorsalso. Studies could be carried out covering other firms, and varying in- ferencescouldbeascertained. Studies could be carried out to find out whether there is any sig- nificantrelationshipbetween sizes ofcorporatefirmsotherthanit firmsinrespectofcs andProfitability. Studiescouldalsobecarried outinorderto findoutwhether there isanysignificant relationship between fixedassets, assets structure, investment, and volatility, advertising expenditure, the probability ofbankruptcy,anduniquenessoftheproduct,earningsvolatilityof corporatefirmsetc.,inrespectofcs andProfitability. IndustryAnalysisandMajorFindings From the analysis of data pertaining tocs and Profitability, the major findingsarepresentedintable1 . The use of debt fund incs androa of low incomeit firms (β = −0 .1037 , t =−10 .00 , p<0 .01 ); (R 2 =0 .227 , F =26 .07 , p<0 .01 ); (22 .7 per cent of the variation inroa ) is not significant (see table1 ). Hence, h 1 0 ‘Thereisnosignificantrelationshipbetweenselectedcs variablesand roa oflowincomeit firms’isaccepted.However,inrespectofmedium incomeit firms‘Thereisasignificantrelationshipbetweencs variables ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 383 androa .’ Profitability has a significant but inverse relationship withcs (R 2 = 0 .7728 , F = 131 .78 , p< 0 .01 ). Hence,h 1 0 in respect of medium incomeit firmsisrejected. The use of debt fund incs has a significant negative impact on prof- itability generated through use of assets in the case of High incomeit firms (R 2 = 0 .5792 , t = 100 .15 , p< 0 .01 ); coefficient of expenses ratio (exp _inc )β =−1 .1508 , t =−18 .71 , p<0 .01 ; andder (β =−11 .6766 , t =−3 .01 , p<0 .01 ) is statistically significant. So,h 1 0 in respect of High incomeit firmsisrejected. Inrespectoftherelationshipbetweencs andProfitabilityofthesmall sizeit firms, the correlation ofexp _inc withroa , and that oftd _ta withroa is negatively significant;andthat oftd _ta withroa .Among the individualβ coefficients, only the coefficient of expense ratio (β = −0 .2018 , t =−10 .44 , p<0 .01 ) and coefficient oftd _ta (β =−0 .1940 , t =−4 .05 , p< 0 .01 ); (R 2 = 0 .3426 , F = 30 .62 , p< 0 .01 ) is negatively significant (see table2 ). Hence,h 2 0 : ‘There is no significant relationship betweenselectedcs variablesandrao ofSmallSizeit firms’isrejected. Profitability of medium sizeit firms is inversely affected by the use of debt fund incs ,theβ coefficients with negative sign, (–0 .0978 )for exp _inc (t =−6 .37 , p< 0 .01 ), (β =−0 .0574 )fortd _ta (t =−2 .50 , p<0 .01 ),(β=−0 .2043 )forcr (t =−3 .03 ,p<0 .01 )and(β=−2 .2249 ) forder (t =−2 .31 , p< 0 .01 ) are significant. Hence,h 2 0 : in respect of Medium Sizeit firms is rejected. The increase in use of debt fund in cs tends to reduce the net profit scaled byta s for large sizeit firms. The roa is negatively significant, correlated withder ;td _ta ;der ; exp _inc (β = −0 .9763 , t = −16 .66 , p < 0 .01 );der (β = −8 .7959 , t =−2 .38 , p< 0 .01 ). Hence,h 2 0 in respect of Large Sizeit firms also isrejected. The relationship betweencs andProfitabilityfor all selectedit firms [roa withexp _inc ,td _ta ;cr is negatively significant. Profitability measured as a net profit relative tota s tends to decline with increase intd proportionate tota s when there has been an increase iner , and cr .Theβ coefficients, (–0 .1789 )forexp _inc (β =−0 .1789 , t =−13 .83 , p < 0 .01 ); (β = −0 .0954 )fortd _ta (t = −4 .68 , p < 0 .01 ), and β =−0 .1542 , t =−2 .80 , p< 0 .01 forcr are negatively significant (see table2 ).Hence,h 5 0 :‘Thereisnosignificantrelationshipbetweenselected cs variablesandrao ofOverallit firms’isrejected. There is no significant relationship between selectedcs variables and roce of low incomeit firms.exp _inc (β =−0 .0797 , t =−9 .56 , p< Volume 9 · Number 4 · Winter 2011 384 Ramachandran Azhagaiah andCandasamy Gavoury table2 ResultsofRegressionAnalysisforReturn onAsset(roa )ofsmallsize, mediumsize,largesizeandoverallit Firms Variable Coefficient forSmallSize Firms Coefficientfor Medium Size Firms Coefficient forLargeSize Firms Coefficientfor OverallFirms Intercept 28 .4528 *** 24 .4195 *** 110 .3241 *** 34 .7189 *** exp _inc –0 .2018 *** –0 .0978 *** –0 .9763 *** –0 .1789 *** td _ta –0 .1940 *** –0 .0571 ** –0 .0272 –0 .0954 *** cr 0 .0308 –0 .2043 *** 0 .2050 –0 .1542 *** der –0 .0417 –2 .2249 ** –8 .7959 ** –0 .2660 R 2 0 .3426 0 .1853 0 .5783 0 .2282 Adjusted R 2 0 .3315 0 .1744 0 .5720 0 .2244 F Statistic 30 .62 *** 17 .00 *** 91 .55 *** 59 .94 *** P Value (F Statistic) 0 .0000 0 .0000 0 .0000 0 .0000 notes *Significantat10 %level;**Significantat5 %level;***Significantat1%level 0 .01 );der (β=0 .1149 ,t =1 ,p<0 .01 ).Profitabilitybycapitalemployed isinverselyandsignificantlyinfluencedbyexpenditureandindependent of thecs of low incomeit firms (see table3 ). Hence,h 3 0 ‘There is no significant relationship between selectedcs variables androce of low incomeit firms’ is accepted. The fit of regression is good (F =24 .12 at 1 % level),howevertheR 2 valueisverylow(0 .2137 ),which givessupport foracceptingtheh 3 0 . However, there is a significant relationship betweencs variables and roce for medium incomeit firms (R 2 =0 .5650 , F =50 .34 , p<0 .01 ). Thenegativesignfortd _ta andder indicates that the proportion of debt incs plays a vital role in net earnings and increase in use of debt fund incs , which tends to significantly reduce the net earnings of this group of firms. Hence,h 3 0 in respect of medium incomeit firms is re- jected. There isasignificantrelationship between useofdebt fundincs androce of High incomeit firms (R 2 =0 .1588 , F =13 .74 , p<0 .01 ). Hence,h 3 0 inrespect ofHighincomeit firmsisalsorejected. The profitability of small sizeit firms is inversely affected by the use ofdebtfundincs .roce issignificantwithR 2 valueof0 .3641 andwithF valueof33 .63 (p<0 .01 );(exp _inc )(β=−0 .1747 ,t =−8 .92 ,p<0 .01 ); and there is an increase intd proportionate tota s(β =−0 .3761 , t = −7 .75 ,p<0 .01 ).Theprofitabilitymeasuredbyroce isnegativelysignif- ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 385 table3 Resultsofregressionanalysisforreturn oncapitalemployed(roce )oflow income,mediumincome,andhighincomeit Firms Variable CoefficientforLow Income Firms CoefficientforMedi- umIncomeFirms CoefficientforHigh Income Firms Intercept 12 .4991 *** 78 .9195 *** 53 .4934 *** exp _inc –0 .0797 *** –0 .5890 *** –0 .3290 *** td _ta –0 .0192 –0 .4669 *** –0 .1745 *** cr –0 .0133 –0 .4984 *** –0 .7391 *** der 0 .1149 –3 .2573 *** 5 .0630 R 2 0 .2137 0 .5650 0 .1588 Adjusted R 2 0 .2048 0 .5538 0 .1473 F Statistic 24 .12 *** 50 .34 *** 13 .74 *** P Value (F Statistic) 0 .0000 0 .0000 0 .0000 notes *Significantat10 %level;**Significantat5 %level;***Significantat1%level table4 Correlationmatrixanalysisresultsforallselectedit firms Variables roa roce exp _inc td _ta cr der roa 1 .0000 roce 0 .7282 *** 1 .0000 exp _inc –0 .4461 *** –0 .3763 *** 1 .0000 td _ta –0 .1646 *** –0 .1886 *** 0 .0536 1 .0000 cr –0 .1177 *** –0 .1349 *** 0 .1041 *** –0 .0906 *** 1 .0000 der –0 .0461 –0 .0259 –0 .0189 0 .0803 ** –0 .0248 1 .0000 notes **Significantat5 %level;***Significantat1%level icant, affected by the use of debt fund incs for small sizeit firms (see table5 ).Hence,h 4 0 :There isnosignificantrelationship betweenselected cs variablesandroce ofSmall Sizeit firmsisrejected. The increase in use of debt fund incs tends to reduce the net earn- ings significantly for medium sizeit firms. The results of regression on roce with expense, liquidity andcs ratios for medium sizeit firms (exp _inc )(β = −0 .0663 , t = −4 .69 , p < 0 .01 );cr (β = −0 .2103 , t =−3 .38 , p< 0 .01 ); andder (β =−2 .8458 , t =−3 .20 , p< 0 .01 )is negativelysignificantat1 percentlevel,andthatoftd _ta (β=−0 .0492 , t =−2 .33 , p< 0 .01 ). Hence,h 4 0 in respect of Medium Sizeit firms is rejected. The use of debt fund incs of large sizeit firms is less profitable. Volume 9 · Number 4 · Winter 2011 386 Ramachandran Azhagaiah andCandasamy Gavoury table5 Resultsofregressionanalysisforreturnoncapitalemployed(roce )ofsmall size,mediumsize,largesize,andoverallit Firms Variable Coefficient forSmallSize Firms Coefficientfor Medium Size Firms Coefficient forLargeSize Firms Coefficientfor OverallFirms Intercept 28 .2070 *** 21 .0961 *** 64 .1875 *** 26 .5529 *** exp _inc –0 .1747 *** –0 .0663 *** –0 .4916 *** –0 .1240 *** td _ta –0 .3761 *** –0 .0492 ** –0 .1636 *** –0 .0979 *** cr –0 .0243 –0 .2103 *** –0 .5859 *** –0 .1700 *** der 0 .1762 –2 .8458 *** 5 .8751*– 0 .1059 R 2 0 .3641 0 .1535 0 .3173 0 .1833 Adjusted R 2 0 .3532 0 .1422 0 .3070 0 .1792 F Statistic 33 .63 *** 13 .56 *** 31 .02 *** 45 .49 *** P Value (F Statistic) 0 .0000 0 .0000 0 .0000 0 .0000 notes *Significantat10 %level;**Significantat5 %level;***Significantat1%level The results of regression forroce with selected explanatory variables for large sizeit firms (R 2 =0 .3173 , F =31 .02 , p<0 .01 )arenegatively significant. The large sizeit firms with use of more debt fund incs are lessprofitableduringthestudyperiod. Therefore,h 4 0 inrespect ofLarge Sizeit firmsisrejected. The net profit against capital employed tends to decline with the in- crease inte ,td ,ca s, andcl s, andtheβ coefficients forall explanatory variables,exceptforder arenegativelysignificant.roce withexp _inc (r = −0 .3763 , p < 0 .01 ),td _ta ,cr , androa .Theβ coefficients, (– 0 .1240 )forexp _inc , t =−11 .11 , p< 0 .01 ); (β =−0 .0979 )fortd _ta (t =−5 .56 , p<0 .01 ), andβ =−0 .1700 , t =−3 .57 , p<0 .01 forcr are negatively significant(see table4 ). It is inferred thatcs has a significant impact on profitability ofit firms in India. Hence,h 6 0 : There is no sig- nificant relationship between selectedcs variables androce of Overall it firms,isrejected. ConcludingRemarks Two variables, viz., Return on Assets (roa ) and Return on Capital Em- ployed (roce ) are considered as profitability control variables for the study. The Total Debt to Total Assets (td _ta ) and Debt-Equity Ratio (der ) have been used as proxy forcs . For empirical evaluation of the ManagingGlobalTransitions TheImpact ofCapital Structure onProfitability 387 effect ofcs on Profitability, the statistical techniques, viz., Pearson’s co- efficient of correlation and regression analysis in addition to descrip- tivestatistics such asmean,standarddeviationhave been used. Analysis is carried out after categorizing the selected firms into three categories based on two attributes, viz., asset size; and business revenue. First, the selected firmsaresegmented intothreegroupsaslow,mediumandhigh based on business revenue (total income). Second, the firms are cate- gorized into small, medium and large based on asset size. Appropriate statistical tools are applied across all groups of firms. The selected firms are segmented into three groups based on the size of the assets used in thebusiness.Theprofitabilityandportionofdebtincs aswellasthere- lationshipbetweenprofitabilityandcs andimpactofcs onprofitability areanalyzedacrosssizeclasses. Based on the business revenue, the study proves that low incomeit firms with low expenses are highly profitable, but profitability of these groups of firms is independent of the level of debt fund in theircs . Therefore,profitabilitybycapitalemployedisinverselyandsignificantly influenced by expenditure and is independent of thecs of low income it firms.Themedium incomeit firmshaveperformed well bygenerat- ing substantial income with less debt. Thecs ofit firms with medium incomefrombusinesshasa significantimpacton profitability.The pro- portion of debt incs plays a vital role in net earnings, and the increase in use of debt fund incs tend to significantly reduce the net earnings of this group of firms.it firms belonging to the high business revenue group have shown better performance in managingcs but most of the revenue has been expended. Hence the use of debt fund incs has a sig- nificant negative impact on profitability generated through application ofassetsinthecaseofHighincomeit firms.Onthewhole,itisinferred that the increase intd proportionate tota tends to decrease the net earningsrelativeto capitalemployedwhen there hasbeen anincrease in total expenses and increase in use ofca sforit firms belonging to the highbusiness revenuegroup. Based onthe size of business, it isinferred that the small sizeit firms have not performed well in generating revenue. Profitability is inversely affectedbytheincreaseintotalexpensesandincreaseintd proportion- atetota s.cs hasasignificantuniqueimpactonprofitabilitywhenthere hasbeenaremarkablenegativeinfluenceoftotalexpensesonprofitabil- ity for small sizeit firms. On the whole, it is found from the regression resultsthat profitabilitymeasured byroce issignificantlynegativelyaf- Volume 9 · Number 4 · Winter 2011 388 Ramachandran Azhagaiah andCandasamy Gavoury fected by use of debt fund incs for small sizeit firms. In respect ofit firmsbelonging to the medium size group, the study provesthat the net earningshavestoodat10 percenttotheirta sandcapitalemployed,and debt incs is lesser for medium sizeit firms. Therefore, the profitabil- ity of medium sizeit firms is inversely affected by the use of debt fund incs , and the increase in the use of debt fund incs tends to decrease the net income significantly. The increase in the use of debt fund incs tends to reduce the net earnings significantly for medium sizeit firms. As far as the large sizeit firms are concerned, the study reveals that the large sizeit firms have neverrelied on debt fund in theircs .Theyhave yielded better net profitbyuseofless debtfund.Further, theincreasein theuseofdebtfundincs tendstoreducethenetprofitscaledbyta sfor largesizeit firmsinIndia,andthey,byuseofmoredebtfundincs ,are lessprofitableduringthestudy period. The relationship betweencs and Profitability, as well as the unique impact ofcs on Profitability across the classes by income and assets, reveals that the profitability of selectedit firms listed inbse decreases significantly with decrease in either spending out of business revenue (exp _inc ) or decrease in total debt proportionate tota sordecrease incr .cs has a significant impact on profitability ofit firms in India. 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