CHAPTER – 5 Review of Literature

179

CHAPTER – 5

Business theory draws heavily from Economics and Social

sciences. Profitability and productivity are the two yardsticks against

+which the performance of any business organization is being measured.

Before the industrial revolution, business system was simple and the

organizations were relatively small. The advent of mechanization,

increase in the volume of business and invention of Company form of

organization required that the financial transactions of the business need

be more scientific and organized. The science of book keeping, which

was invented in 1494, was the obvious remedy to record, monitor and

control the commercial transactions of various businesses.

Book keeping and Accounting are the fore runners of Finance. In fact, the

science of financial management is based on Accounting and Economics.

Accounting is defined as the art of recording and summarizing business

transactions and of interpreting their effect on the affairs and activities of

an economic unit. l This definition given long back in 1955, is referring to

management's use of accounting data for quantifying and appraising of

the business activities. Another definition by a well known author is :

Accounting deals almost exclusively with data that can be measured and

reported in monetory terms.2 Business is concerned with money, and the

measure and reporting is thro accounting mechanism. Accounting has

often been called the language of business because people in the business

world - owners, managers, bankers, brokers, lawyers, engineers, and

investors use accounting terms and concepts to describe the events that

make up the existence of business of every kind.3

180

John Myer, a renowned authority on Financial Statements

Analysis, has referred that in the initial years of 20th century, the bankers

and securities exchange authorities were extensively relying on the

financial statements of the companies for analysis, monitoring and control

of the activities and performance of businesses. The history, principles

and financial statement analysis has been referred by another authority

also : Kennedy and McMullen.4

Literature on Economics also has a reference to accounting and

financial management. The aim of financial management has been linked

with (1) the field of basic economics, and especially micro economics

(use of scarce resource). (2) by examining the many and diverse activities

and decisions which occupy financial managers.

Long back (1957), EF Donaldson referred to the importance of

business and financial reporting. He highlighted that the economy

depends on the business organizations for goods and services. United

States believes in corporate world. The financial activities of business

enterprises of production and sale is of utmost importance. In his well

known publication (Corporate Finance, 1957) he has referred to all

important aspects of business finance like organization structure,

securities, production, capitalization, working capital, administration of

income, expansion and combinations (mergers), reorganization and

readjustments.

Another authority has aptly said that: Accounting is a systematic

means of writing the economic history of an organization.5 Here there is a

reference that the economic activity of any business enterprise is

involving money and accounting is concerned with record keeping of

181

such monetary transactions of the business. The authority has referred

that invention and growth of corporations (company form of

organization) and need for keeping monetary records of growing and very

large businesses were the basic reasons for the phenomenal development

of accounting science and importance of financial statements as well as

its analysis. This data was useful to the owners, government, customers,

investors and the society. The important principles of verifiability,

objectivity, consistency and comparability were developed, so that the

statements become more reliable and useful. The authors have also

mentioned that in the initial period of twentieth century, the following

principles of management accounting were evolved and developed. (1)

Relevance. (2) Flexibility. And (3) Timeliness.

Another definition by a well known author can also be referred :

Accounting is score keeping, attention directing and problem solving.6

This authority states that accounting system provides information for

three broad objectives. (1) Internal reporting to managers for use in

planning and control of current operations. (2) Internal reporting to

managers for use in strategic planning, and (3) external reporting to

owners, government and other outsiders. As a score keeping activity, all

relevant data are generated by the system which becomes a guide for

attention directing and problem solving in different areas like inventory,

production, sales etc. The authors have referred to important aspects

accounting principles, importance of Annual Reports, measurement of

income, marginal costing and efficiency.

Robert Anthony, Professor of Accounting and Financial Control at

Harvard University has written many authoritative books on accounting

182

and financial management. He defines Accounting as a means of

collecting, summarizing, analyzing and reporting in monetary terms,

information about the business. This simple definition highlights the

importance of accounting and financial information in the business

enterprise. There is a reference to the following accounting principles and

scope of the field of accounting and finance.

Principles :

(1) Objectivity. (2) Going concern. (3) Realisation. (4) Matching

and constant rupee measurement. (5) Consistency. (6) Verifiability.

(7) Conservatism.(S) Disclosure. And Economic feasibility.

Scope :

(1) Accounting Concepts. (2) Records, measurement. (3) Financial

Statement Analysis. (4) Performance appraisal and control. (5) Behaviour

of costs in the organization. (6) Choices of decision making.

Another well-known publication on Financial Management,

Financial Decision Making By John Hampton (1983) covers authoritative

and lucid exposition on the subject covering : Financial accounting,

Financial Statements, Financial analysis, Leverage, Working capital,

capital Budgeting, valuation of the Firm, Mergers, acquisitions and

reorganization And Financial decisions.7

The fundamental behaviour of finance is based on two basic

variables of (a) risk and (b) uncertainty. Both refer to situations in which

future outcomes are imperfectly known. The term risk commonly denotes

only those future events in which the probabilities of alternative possible

outcomes are known. Objective probability is a measure of the relative

frequency of alternative events, and is strictly applicable only to those

183

events which are repetitive in nature, and so possess a frequency

distribution from which observations can be drawn and statistical

inferences can be made. Subjective probability may be interpreted as a

measure of the degree of ignorance or belief held with regard to the

outcomes of particular future events.The less perfectly the conditions of

the law of large numbers are satisfied, the more uncertain are subjective

probability estimates concerning future possible states of the world. The

term uncertainty is commonly used to denote the degree of ignorance

about the frequency distribution of a future event. Even with uncertainties

of investments and funds deployment for business, the firms have no

choice but to commit themselves to some decision. This is the reality of

basic financial behaviour.8

The basic objectives of Financial Management of (a) Liquidity and

(b) Profitability are discussed at length by this authority in the above

publication. It covers the discussion about functions leading to liquidity :

(1) forecasting cash flows. (2) rationing funds. (3) managing flow of

internal funds. The functions leading to profitability are : (1) cost control.

(2) pricing. (3) forecasting profits. (4) managing required return. The

financial tools have been discussed with the focus on (1) Use of tools for

measuring the effectiveness of actions (like ROI). (2) Use of tools for

measuring validity of decisions (like capital budgeting).

SC Kuchhal, noted Indian authority on Financial Management and

Professor of Finance, IIM, Ahmedabad wrote an authoritative publication

on Financial Management way back in 1969 which served as a valid

guide to corporates, banks, financial institutions, Professors, management

students and researchers. He defines Finance as a science of money. The

184

finance functions are (1) Providing funds required by business. (2)

Finance is money, hence every business transaction involves money

(Finance) directly or indirectly. (3) Procurement of funds and their

effective use. Important finance functions referred by this authority are :

1) Establishing asset managing policies.

2) Determining the allocation of net profits.

3) Estimating and controlling cash flows and requirements.

4) Deciding the needs and sources of outside financing.

5) Negotiations for outside financing.

6) Checking upon the financial performance.

The scope of finance as discussed by Prof. Kuchhal covers :

1) Basics of Financial Management.

2) Corporate planning and financial Management.

3) Ratio analysis.

4) Cost Volume Profit analysis.

5) Analysis of operating and financial leverages.

6) Financial forecasting.

7) Short term and long term finance.

8) Capital budgeting.

9) Cost of capital.

10) Planning of capital structure.

11) Valuation.

12) Amalgamations and reorganization.9

The remarkable contributions by other well known authorities on

Financial Management include :

185

1) Brigham E F and Houston JF (Fundamentals of Corporate Finance,

1930 ).

2) HG Guthman (Analysis of Financial Statements, 1925).

3) Solomon E. (Theory of Financial Management, 1969).

4) Van Home JC (Financial Management and Policy, 1989 ).

5) Weston J. Fred et. Al. (Managerial Finance, 1981).

6) R A Foulke (Practical Financial Statements Analysis, 1976 ).

7) John Myer ( Financial statement Analysis, 1961 ).

8) H. Black & J. Champion (Accounting in Business Decisions,

1961).

9) HG Guthman & H. Dougall (Corporate Financial Policy, 1955).

10) Carl Moore & Robert Jadicke (Managerial Accounting, 1974).

11) Robert Anthony & Glen Welsch (Fundamentals of Management

Accounting, 1981).

11) Charles Horngren (Accounting for Management Control, 1974).

12) McMennamin Jim (Financial Management, 2000).

13) RM Srivastav ( Financial Decision Making, 1972 ).

14) Bhattacharya & Dearden (Accounting for Management, 1976 ).

15) PV Kulkarni (Financial Management, 1972 ).

16) Prasanna Chandra (Financial Management, 1980 ).

17) MY Khan & PK Jain (Financial Management, 1981 ).

18) IM Pandey ( Financial Management, 1978 ).

In the financial literature a lot of importance has been attached to

financial ratios for assessing the financial health of a firm. Financial

health will decide the repayment capacity of the debt sought by any

business enterprise. William Beaver10 studied important ratios of 79

186

Companies. These ratios were important ratios which decided the success

and failure of the concerned Companies. The important ratios identified

by this researcher were :

(1) Cash flow to total debt.

(2) Net income to total assets.

(3) Total debt to total assets.

(4) Working capital to total assets.

(5) Current ratio.

The failed firms had more debt and lower return on assets. They

had less cash but more receivables as well as low current ratio. The also

had less inventory.

In the Indian context, LC Gupta11 attempted a refinement of

Beaver’s method with the objective of building a forewarning system of

corporate sickness. A simple non-parametric test of measuring the

relative differentiating power of the various financial ratios was used. The

study covered cross section of companies falling under various industries.

Fifty six (56) ratios were tested for the period of 1962 to 1974, i.e. for

twelve (12) years. As per this study, it was found that the following five

(5) ratios have high degree of predictive power. These are :

(1) Earnings before depreciation, interest and taxes (EBDIT) to Sales.

(2) Operating cash flow (OCF) to Sales.

(3) EBDIT/Total assets including accumulated depreciation.

(4) OCF/Total assets including accumulated depreciation.

(5) EBDIT/(Interest + 0.25 Debt).

Among the balance sheet ratios, only two ratios were found to have

some power of predicting possible sickness. They were :

187

(1) Net worth/Debt, including both short term and long term debt.

(2) All outside liabilities/Tangible assets.

An important outcome of the research was that weak equity base

can lead to sickness.

Another important research was carried out by E.I. Altman 12

which is referred to as Multiple Discriminant Analysis (MDA). After

studying 66 Companies, Altman concluded that a set of ratios can be

developed which has failure predictive power. Altman developed a

discriminant function, covering following ratios.

(1) Net working capital/total assets (percentage).

(2) Retained earnings/total assets (percentage).

(3) EBIT/total assets (percentage).

(4) Market value of total equity/book value of debt (Percentage).

(5) Sales/total assets (times).

The mixed result of these five ratios was Z score, on the basis of

which the firms can be classified either financially sound or otherwise.

Eltman found that a score above 2.675 was believed to be healthy. The

score below this, warranted overall financial weakness. In Eltman’s

study, half of the firms became bankrupt.

Eltman’s study was refined later on in 1977 which is more broad

and 70 % accurate13.

Many studies have taken place on the issue of methods, tools,

techniques and practices of business performance appraisal of companies.

This is critical, since this system plays a key role in developing strategic

plans and evaluating the achievements of the firm. Research has been

undertaken by premier business schools, consultant firms and others.

188

Individual researchers from various fields of accounting, finance and

control, economics, strategy, operations management and others , are

exploring the subject and also trying to understand the drivers of

corporate performance, the linkages between them, and how to measure

their impacts on profitability.

David Otely has mentioned that the financial performance

measures serve three important ends : (1) They act as tools of financial

management. (2) They form a major objective of business organization.

(3) They act as a mechanism for motivation and control within the

organization.14

As referred by Bititci, Carrie and Turner, the business performance

measurement has variety of uses, like : (1) To monitor and control. (2) To

drive improvement. (3) To maximize the effectiveness of the

improvement effort. To achieve alignment with organizational goals and

objectives. (5) To reward and to discipline.

Also, as referred by Simmons,15 performance measurement is the

tool of balancing five major tensions within the firm : (1) Balancing

profit, growth and control. (2) Balancing short term results against long

term capabilities and growth opportunities. (3) Balancing performance

expectation of different constituencies. (4) Balancing opportunities and

attention. (5) Balancing the motive of human behaviour.

The shifts in performance (value) measurement can be summarized

as follows :

189

Sr. No.

Period Performance Measurement Paradigm

1 1920s Dupont Model, ROI 2 1970s Price/Equity Multiples, Earnings per Share 3 1980s Market to book value Ratios, Return on Equity, Return on

Net Assets, Cash flow, Quality management 4 1990s Economic value added, Market value added, EBIDTA,

CFROI, Total Shareholders Return, Balanced Scorecard, Performance prism, Customer satisfaction

5 2000s EVA, Balanced Scorecard, Sustainability Group Index, Global Reporting Initiatives, Environmental Performance Metrics, Intellectual Asset Monitor.

Dr. Bob Frost and Ken Forbes16 had deep studies on the subject of

performance measurement and addressed the crucial questions like :

1) What is performance management ?

2) What is the science behind performance management ?

3) Where does performance improvement come from ?

4) What are the common challenges in performance management ?

Enterprise Performance Management System has now become an

important discipline in big enterprises to measure and monitor the

achievement of business goals.

Subhash Chander and Anjana Bedi conducted an empirical study of

significance of financial objectives (2004)17 where they studied the

performance of Top 500 Indian companies covering 8 industries as per

1998 CMIE data. The performance was analysed with reference to

following variables.

1) Book value of networth.

2) Market value per share.

3) Cash flow per share.

190

4) Operating profit before interest and taxes.

5) Price earnings ratio.

6) Market rate of return.

7) Return on investment.

8) Net profit to Net worth.

9) Net profit margin.

10) Market share.

11) Earnings per share.

12) Total Assets.

13) Sales.

They observed:

(1) Maximising Sales, Return on Investment and operating profit

before interest and taxes have emerged as the most significant

financial goals. Surprisingly, goals having market related variables,

such as maximization of market rate of return, price-earnings ratio

and market value per share are the least preferred. Factor Analysis

has also shown that the Return on Investment is the most

significant factor to Companies in India.

(2) The assumption of pursuing the single financial objective has been

refuted by this study.

(3) The Companies are found to be postulating multiple financial

objectives.

(4) The nature of the industry to which a company belongs

significantly affects its perceived significance of different financial

goals.

A gist of their study is present in the following table.

191

Table : 5.1

Performance of Industries Covering Specific parameters

Industries Financial objectives

1 2 3 4 5 6 7 8

A. Book value of Networth

3.25 3.33 4.00 4.00 2.67 4.70 4.20 3.88

B. Market value per share

3.50 2.33 3.67 3.64 4.00 2.80 2.50 3.58

C. Cash flow per share

3.75 3.33 5.00 4.19 4.17 4.50 4.00 4.41

D. Operating profit before interest and tax

4.25 5.00 5.00 4.36 4.50 3.70 4.40 4.79

E. Price earnings ratio

3.00 2.67 2.67 3.58 3.00 3.20 3.11 3.50

F. Market rate of return

3.25 2.33 3.67 3.50 3.33 3.30 2.88 3.36

G. Return on investment 4.67 5.00 5.00 4.75 4.33 4.30 4.40 4.88

H. Net profit margin

4.24 4.67 5.00 4.75 4.33 4.30 4.40 4.88

I. Net profit to Net worth

4.24 4.67 5.00 4.08 4.33 4.30 4.40 4.88

J. Market share 4.50 4.00 3.67 3.55 4.50 4.00 4.22 .35

K. Earnings per share

4.25 3.00 5.00 3.83 4.67 3.90 4.00 4.50

L. Total Assets 4.25 3.67 4.67 3.64 3.67 4.20 3.50 4.04

M. Sales 4.25 5.00 4.67 4.58 4.33 4.50 4.70 4.83

Note : Classification of Industries : (1) Investment and Finance. (2)

Cotton spinning. (3) Synthetic fibre, silk and woolen. (4) Electronics,

electric equipment and cables. (5) Metal alloys and metal products. (6)

192

General Engineering. (7) Chemical dyes, pharmaceuticals, refineries and

plastics. (8) Miscellaneous.

Basil Moore (1968), referred to the basic reality about the growth

of business. He argued that shareholders benefit not from a high level of

profits per se, but rather from increases in the level of profits. They will

particularly be concerned that earnings and dividends for a firm grow

over time, so as to produce a higher yield on the historical value of their

own investment. In addition, in an expanding economy growth is

essential merely to maintain a firm's competitive market position vis-à-vis

its competitors. For both of these reasons shareholders are concerned

fundamentally about the growth prospects of their corporations, rather

than with the static profit maximization.18

The different theories of capital structure suggest that the firms' debt

equity choice is dependant on asset structure, new debt tax shields, growth,

bankruptcy risk, industry classification, company size, earnings volatility and

profitability. (Titman and Wessels, 1988).19Firms are heavily influenced by

market conditions and past history of security prices in choosing the debt and

equity mix (March, 1982). Apart from the use of traditional non-convertible

debentures, firms switched over to innovative instruments such as convertible

debentures in the early 1980s. However, with the liberalization and the new

Securities and Exchange Board of India (SEBI) guidelines, firms have

attempted to use innovative debt instruments such as triple option convertible

debentures, multiple option convertible debentures, zero interest bonds,

auction rated debentures, inflation Bonds, split coupon debentures, secured

premium notes, floating rate notes, foreign currency convertible bonds, and

securitized instruments. However, the pace of innovation has been very slow.

193

(Barua, Raghunathan, Varma and Venkatiswaran, 1994).20 The choice of

financial products is also dependant on firm specific characteristics. The most

important determinants of financial structure have been asset composition,

business risk, growth rate, earnings rate, industry class, debt service capacity

and corporate size. Financial leverage has been a significant factor considered

in financial structure decision (Johnson, 1997)21, and previous research shows

that financial leverage is influenced by factors such as operating leverage.

(Ferri and Jones, 1979),22 volatility of earnings (Cartannios, 198323, Bradley,

Jannel and Kim, 198424, Bradley and Smith, 1996, Titman and Wessels,

1988, Johnson, 1997 Pandey et al. 2000) Value of collateral assets (Johnson,

1997) non-debt tax shields (Saa Requejo, 1996)25, Profitability (Titman &

Wessels, 1988, Johnson, 1997), market to book ratio (Myers, 1974.,

Castannias, 1983, Bradley, Jannel and Kim, 1984, Bradley and Smith, 1996.,

Johnson, 1997) and firm size (Titman and Wessels, 1988., Mcconaughy and

Misra, 1996).26

Indian Industry prefers a lower level of debt equity in their capital

structure. This implies that there is a strong belief by corporates that

lower levels of debt will maximize the economic welfare of the owners

and consequently the value of the firm.

A study by MS Narsimhan, IIM, Bangalore of 208 companies

covering 8 years showed that there is a negative correlation between

growth rate of EBIT and debt levels. There is increasing dependence of

companies on the internal resources for their funding requirements. 27

It is generally accepted and believed that financial leverage is

beneficial and useful for maximizing return to the owners of the firm only

when favourable economic factors exist and the economy is booming.

194

Since financial leverage is also known as a double edged sword, it can

produce the opposite result in adverse economic conditions. These facts

may justify the performance for switchings to lower debt-equity levels

1995 onwards.28

Singh and Hamid (1992)29 and Singh (1995)30 have analysed the

financing pattern of nine developing countries likes India, Korea, Jordan,

Pakistan, Thailand, Mexico, Malaysia, Turkey and Zimbabwe and found

that in all these developing countries' corporations rely in general, very

heavily on external funds and new issues of shares to finance their growth

of net assets. They have also concluded that there were important

differences between the two groups of corporations. Specifically, they

suggested that less developed Corporations used both external finance

and particularly equity finance to a much greater extent than their

counterparts in advanced economies. Their findings were almost reverse

of the Pecking Order pattern of finance observed for advanced country

corporations. Corbett and Jenkinson (1994,1997) have found that there is

no market based Anglo-US pattern of financing of industry. The

corporations in Germany, the United Kingdom and the United States are

internally financed with small or negative contributions from market

sources, while Japanese corporations are more externally financed with

both banks and markets contributing larger shares than in the former

group. They have also found that there is little evidence to support the

view that Germany is a bank financed system and that the UK or US are

market financed. Over the period of 1980s, all countries, except Japan,

have become more internally and less market financed.

195

Love et. Al., (2005)31 have analysed the financing pattern of the Indian Companies and found that while debt to asset ratios have been relatively stable, nominal debt growth has slowed down in recent years. Throughout the period of study (1994-2003), bank financing as a share of total debt has increased, while borrowing from non-bank financial institutions fell sharply. In terms of differences across firms, the finding is of that debt levels increase with firm size. Smaller firms have especially less debt relative to larger firms if they are young. Furthermore, while the ratio of debt to assets has been relatively stable for large firms, we observe a significant decline for smaller firms.

Pagano and Panetta (1998)32 have also found that the likelihood of an IPO is positively related to the company's size, and the industry's market-to-book ratio, Companies appear to go public not to finance future investments, and growth, but rather to rebalance their accounts after a period of high investment and growth. IPOs are also followed by a reduction in the cost of credit, and an increased turnover in control. These findings highlight some important differences between the role played by the equity market in Italy (and likely in other continental European countries), and in the United States. Hesuk and Smith (2000)33 found that current industry market-to-book increases IPO probability, while lagged market-to-book ratio decreases it. Sabine (2002)34 argued that the going public decision is influenced by financing needs, the market mood per industry, profitability, and size of the company. Financing needs, profitability, and size indicate the necessity of going public. The market mood indicates the opportunism by the company in the going public decision. They found that size is negatively related to the likelihood of going public, partly due to the size bias in the reference sample. Capital expenditure is negatively related to the likelihood of going public.

196

Growth increases the possibility of listing. Return on assets is positively related. They also found that the industry market-to-book ratio appeared to be the most important of the probability of listing.

Time series analysis of the behaviour of private sector companies, public sector companies and foreign companies covering the period 1966-2000, for tapping the equity capital from the market is presented below :

Table : 5.2 Public Issues Behaviour of Companies (1966-2000)

Variables Public Private Foreign 1966-

2000 1966-1983

1984- 2000

1966-2000

1966-1983

1984 2000

1966 2000

1966-1983

1984 2000

Cons- tant

-0.214 (0.203 )

-0.322 (0.089)

0.11 (0.06)

0.082 (0.136)

0.48 (0.11)

0.221 (0.11 6)

0.26 (0.05 8)

0.35 (0.059)

-0.17 (0.095)

TLB -0.133 (0.058 )

-0.73 (0.13)

-0.02 (0.01)

-0.25 (0.08)

-0.27 (0.14)

-0.59 (0.19 )

0.259 (0.17 8)

-0.44 (0.16)

0.093 (0.216)

SZ 0.021 (0.009)

-0.43 (0.04)

0.003 (0.004)

0.012 (0.005 )

-0.02 (0.006 )

0.007 0.003 )

-0.09 (0.02 )

-1.15 (0.541)

0.004 (0.025)

PR -0.026 (0.018)

0.007 (0.017 )

-0.06 (0.024)

-0.11 (0.049)

0.022 (0.027 )

0.067 (0.05 4)

-0.11 (0.04 )

0.05 (0.052)

-0.13 (0.059)

GR -0.04 (0.017 )

0.041 (0.024 )

0.05 (0.018)

0.013 (0.011)

-0.018 (0.024 )

0.002 (0.00 9)

0.47 (0.01 9)

0.058 (0.053)

0.002 (0.018)

LQ 0.05 (0.023 )

0.021 (0.031)

-0.008 (0.015)

0.116 (0.108)

-0.138 (0.117 )

0.042 (0.02 )

0.028 (0.03 4)

0.016 (0.009)

0.19 (0.076)

CE -0.002 (0.021 )

0.018 (0.026 )

-0.044 (0.042)

-0.06 (0.024)

-0.12 (0.047 )

0.021 (0.20 3)

0.101 (0.07 1)

-0.137 0.086)

0.036 (0.076)

CB -0.17 (0.047 )

0.16 (0.05)

0.171 (0.0223

-1.1 (0.204)

0.31 (0.14)

0.426 (0.53 3)

2.04 (0.22 3)

1.12 (0.32)

1.06 (3.33 )

NOB 35.00 18.00 17.00 35.00 18.00 17.00 35.00 18.00 17.00 R2 0.93 0.95 0.74 0.86 0.98 0.94 0.94 0.91 0.86 F Value

86.32 49.72 7.54 32.04 58.21 37.11 80.34 39.73 5.49

P Value

0.156 0.127 -0.075 0.185 0.025 0.068 0.138 0.041 0.036

Notes : TLB : Total long term borrowings. SZ : Size of the company. PR

GR: Growth rate. LQ : Liquidity. CE : Cost of Equity. CB : Cost

NOB : Number of observations. (1) The values in the parenthesis

are Probability values.

197

It was observed that total long term borrowings, size of the firm,

profitability, growth rate of the firm, and liquidity are the major

determinants of the equity capital financing in India. It has been found

that the variables like profitability, liquidity, and growth rate are

positively, and the variables like long term borrowings ratio, size of the

firm etc. are negatively related with the equity capital finance in India.

The time series model results show that the variables like total long term

borrowings, size of the firm and liquidity are statistically significant for

the determination of equity capital financing of the different types of

companies in India in the aggregate level. The period analysis shows that

the variables like total long term borrowings, size of the firm, growth rate

of the firm, and liquidity are statistically significant in panel data models

and also in the time series model in the aggregate level which means that

these are the major factors which affect demand for the equity capital of

the private corporate sector in India.35

A study by Opler, Saron and Titman (1997) highlight the

importance of corporate liability management for creating value for

shareholders. Their study covered analysis of optimal capital structure

(debt equity mix) in such a way that the sum of taxes paid by the firm and

the costs of financial distress are minimized.

Another study (1997) related to developing optimal asset allocation

strategy revealed that the objective of maximizing the utility of wealth.

There are relevant factors governing the development of an optimal

strategy as diffusion processes and assets as correlated Brownian notions.

A study of six industries for the period 1980-1996 by A.

Vijaykumar (Management Accountant. May, 1998) revealed that growth

198

is found to be significantly associated with profitability. There is the

influence of size, return on net worth, retention of profits and long term

borrowings and net assets. There can be industry variations on account of

varying degree of competition, demand conditions and government

controls. However, profitability explains considerable part of the growth

of the firms.36

The composite profitability of a firm can be measured by the

method of multivariate analysis. Gross earnings ratio, gross profit ratio,

operating profit ratio and net profit ratio can help to study the profitability

in relation to sales. Gross surplus ratio and return on total tangible assets

can help to study the profitability in relation to total assets. Return on

capital employed (EBIT To CE) and cash flow plough back ratio can help

to study the effectiveness of capital employed. Return on shareholders'

equity studies the profitability in relation to shareholders' funds. Times

interest earned ratio can study the profitability of a firm from the point of

view of long term creditors. The high correlation existing between the

profitability ratio under each main head (margin on sales, return on total

assets and return on capital employed) are partly due to the common

elements found in both the ratios. Another reason for the high correlation

is that both ratios are influenced by the common economy-wide and

industry-wide factors. 37

A study was conducted by Economic Times of 348 companies

(which include Engineering companies also) for a period of 8 years. It

was found that the net profit growth rate is not substantially different

from growth rate of nominal GDP. The expectations during 2003 of

nominal GDP growth over the next 3 to 4 years are about 10 to 12 %,

199

with the real growth of about 6 to 7 %. And inflation of 4 to 5 %. The

dividend yield of sample companies is about 3.5 % having increased from

a less than 2 %, 5-6 years ego. Adding this to the expected earnings

growth, the expected stock market return then should be between 13.5 to

15.5 %. Hence, there is a need for a shift in the investor mental

programming of high return on equity investments.38

Aggregate tax provisions have declined by 25 % in 1997 compared

to 1996 even when 4 % rise in profits, because of tax planning avenues

helping private sector companies. (Economic Times study of 50

companies. November, 1997).

The growth in sales has been considerably lower at 9.90 % during

first half of 1997-98 against 17.60 % of the corresponding period of

1996-97. However, the net earnings increased to 9 % against 0.50 % on

account of sharp drop in interest rates, fall in corporate tax rates and fall

in manufacturing expenses. (ICICI study of 1619 companies. January,

1998). 39

The huge funds raised and invested in the corporate sector during

the initial years of liberalization were not utilized properly in average

terms. A study of 373 companies by CII in this reference may be referred.

Only 98 companies (like Bajaj Auto, BHEL, Hindustan Lever, Asian

Paints etc.) posted positive EVA considering the cost of capital and

RONW. Other companies have failed on both the counts. It is also

evident that share prices are not always influenced by financial

performance, but many a times by market whims.

Higher Dividend payout is not a solution. A dividend can cushion

stock price., but will not necessarily keep it from collapsing. Stocks are

200

risky investments, with dividend or with no dividend. As investor

attitudes gradually swing back into balance, stocks should resume their

traditional dual role of providing investor with a source of long term

capital growth and a steady stream of income from rising and suddenly

fashionable dividends. (Keith Black, 2003).

Miller and Modigliani (1961) have found dividend as irrelevant in

a world without taxes, transaction cost or other market imperfections and

added that the investment decision of the firm is not affected by the

dividends because investors can homebrew their own dividends by selling

a part from or borrowing against their portfolio. The firms that issue

dividends would incur flotation costs on new securities they have to issue

to keep their investment policy intact.40

Lintner analysed as to how companies decide payment of dividend

and concluded that firms have four important concerns. Firstly, the firms

have long run target dividend payout ratios. The payment ratio is high in

case of mature companies with stable earnings and low in case of growth

companies. Secondly, the dividends change follows shift in long form

sustainable earnings. Thirdly, the managers are more concerned with

dividend changes than on absolute level. Finally, managers do not intend

to reverse the change in dividends. (Lintner J. 1956).41

A study of 110 companies (Standard & Poors list) revealed that 90 %

of companies use dividends as a signal of their future earnings. They are very

reluctant to cut dividends, regardless of the purpose for such a cut. Even when

the companies initiate the stock buy back programme, they do not reduce the

dividends to support the repurchase. 75 % of the firms have actually increased

their dividend payments. (Lazo Shirley. 1999).42

201

Baker et al. (2001) survey of 118 CFOs of NASDAQ listed firms

on 22 variables of the dividend policy found that Lintner's (1956) survey

results and model is valid.43

Managements of the firms believe that they do not have target

dividend payout ratio and dividend change follows the sustainable

increase in the level of earnings.44

A study of dividend payout ratio of 2535 Indian Companies by P.

Mohanty (1999) indicates that firms maintain a constant dividends per

share and have fluctuating payment ratio depending on their profits.

Raghunathan and Dass (1999) found that the top 100 and high

networth companies have maintained a stable dividend payout policy of

around 30 % during the period 1990 to 1999 in India.45

As per a study by Manoj Anand (2002), the management of

corporate India believes that dividend decisions are important as they

provide a signaling mechanism for the future prospects of the firm and

thus affect its market value. They do consider the investors' preference for

dividends and shareholder profile while designing the dividend policy.

They also have a target dividend payout ratio but want to pay stable

dividends with growth. Therefore, dividend policy does matter to the

CFOs and the investors.46

Kaplan (1934), Worthy (1987) and Brimson and Berliner (1987)have

suggested following for better cost management for improved performance.

1) Adopting cost based pricing.

2) Judging the cost of significant activities.

3) Charging technology costs.

4) Analysing value added and non value added costs.

202

Harris and Pingle (1985) and Rubak (1995) studied the equations

of valuation which were based on the assumption that the leverage driven

value creation or value of the tax shields is the present value of the tax

shields discounted at the required return to the unleveled equity.

Myers (1974) assumed that the value of the tax shields is the

present value of the shields discounted at the required return to debt.

Modigliani and Miller (1963) calculated the value of tax shields by

discounting the present value of the tax savings due to interest payments

of a risk free debt at the risk free rate.

An empirical study was conducted by L. Sarda, A. Seetharaman

and MI Ahmad (2002) to study correlation of tax adjusted earnings, size,

growth and debt on firms value. The findings were : Debt advantage in

terms of market value turned out to be significant. The data covered by

study supported the theory advanced by Miller and Modigliani. Absence

of taxes on interest and dividend have significant implications for the

finance controller of companies for maximization of shareholder wealth.47

A study of capital structure decision was conducted by MS

Narsimhan and S. Vijaylakshmi (2003) covering 478 companies for the

period of 1989 to 2002. The findings were : (1) After 1991, the Indian

firms have been exposed to increased competition following the

economic liberalization. The business risk has consequently gone up and

has affected the profitability of Indian firms. (2) There was sharp decline

in ROCE. (3) The firms were found to be more liberal in dividend

payments. (4) The firms were inclined to increase debt after taking due

care of size, industry and payment impact on capital structure. 48

203

A study of RPL-RIL merger was conducted for focusing on wealth

maximization for shareholders of RIL (Reliance Industries Ltd.) and also

the post merger corporate performance. It revealed (1) The results do not

support the capitalization hypothesis that bidders' gains are captured at

the beginning of merger programme. (2) The merger which could be

explained in terms of operational synergy, has not led to financial synergy

in the short run. The operating performance analysis reveals that

percentage changes in the post merger period with respect to EPS and PE

ratio showing negative changes. (Rajesh Kumar).49

A mail survey of 196 companies and in depth interviews of 16

company's executives (1996-2004) by Eric Laursen revealed that in the

area of working capital management, day's working capital and days sales

outstanding were important variables of working capital matrices.

Fuller and Farell (1987) have attempted to decide the strong form

of market efficiency into two distinct parts : he super strong form and

non-strong form. The three forms of market efficiency have been a

subject of intense research in the field of finance. (Efficient market

hypotheses (EMH) has been examined in three different forms : the weak,

semi strong and strong ).

Ball and Brown (1968)50, Beaver (1968)51 and Beaver et al.

(1980)52 examined the magnitude of price changes surrounding the

assessment of a firms' annual earnings. Their results showed that the

relation occurred quickly and, therefore, the EMH in the semi-strong

form holds ground. Dixit (1986)53 found that dividend was most

important determinant of share prices.

204

Narayan Rao (1994)54, who examined the share prices responses to

some of the corporate financial policy announcements, reported that the

stock market is efficient in the semi strong form.

Barua and Raghunathan (1990)55, Sundaram (1991)56 and

Obaidullah (1991)57 cast doubt in the consistency of the observed price -

earnings ratio with fundamental factors like dividend growth and pay out

ratios.

The co-integration of macro economic variables and stock market

has been an extensive area of research in financial econometrics. In India,

the studies have been carried out by Lee (1992), Mukerjee and Naka

(1995), Poon and Tyler (1991) and Leigh (1997). The stock market, being

an important part of the financial system should have a systematic linkage

with fundamentals of the economy. The economic reason behind the logic

is the price of a stock necessarily reflects all the future cash flows depend

on many economic factors like GDP growth, price index (WPI), interest

rate, exchange rate fluctuations, global and domestic prices etc. 58

The macro-economic variables were considered for analyzing stock

prices in Indian market for 88 months from April, 1998 to July, 2003. The

variables considered were : WPI, exchange rate, IIP, foreign exchange

reserves, stock index, M 3, oil price index, real effective exchange rate,

91 day Treasury Bills yield as well as 10 year yields. It was found that

only two variables, of oil prices and exchange rate have correlation with

stock prices. Other factors are not relevant.59

205

References :

(1) William Pyle & John White, Fundamentals of Accounting Principles, P.1 Richard D. Irwin, Chicago. 1955.

(2) William Paton & Robert Dixon, Essentials of Accounting, Macmillan, 1958.

(3) Walter Meigs, Charles Johnson, Financial Accounting, P.1, AN Mosich. (McGraw Hill Book Co., 1970.

(4) Ralph Kennedy & Stewart McMullen, Financial Statements, Form, Analysis and Interpretation, Richard D. Irwin, 1946.

(5) M. Gordon & G. Shilinglaw, Accounting : A Management Approach, Richard D. Irwin, Homewood, Illinois, USA, 1951.

(6) Charles Horngren, Accounting for Management, Prentice Hall, NJ, USA 1965.

(7) John Hampton, Financial Decision Making, Prentice Hall of India, New Delhi) 1983.

(8) Basil Moore, Theory of Finance, P. 33,The Free Press (Macmillan), USA. 1968.

(9) SC Kuchhal, Financial Management.. (Chaitanya Publishing House, Allahabad). 1969.

(10) Beaver WH. “Financial Ratios as predictors of Failure.”

Empirical Research in Accounting : Selected Studies. Supplement

to Journal of Accounting Research, 1966. P.77-111.

(11) Gupta LC. Financial Ratios as Forwarding Indicators of

Corporate Sickness. Bombay : ICICI,1979.

206

(12) Altman E. I. “Financial Ratios, Discriminate Analysis, and the

prediction of Corporate Bankruptcy.” Journal of Finance (Sept.,

1968) P. 589-609.

(13) Altman E. I., RG Heldeman and P. Narayanan. “Zeta Analysis : A new Model to identify Bankruptcy Risk of Companies” Journal of Banking and Finance. (June, 1977) P. 29-54.

(14) Dr. Bob Frost & Ken Forbes. Measurement International, CTO, Blue Pumpkin Software.

(15) Robert Simmons, Levers of Control: How Managers Use Innovative Control Systems to Drive Strategic Renewal, Harvard Business School Press, Boston, 1995

(16) Dr. Bob Frost & Ken Forbes. Measurement International. CTO, Blue Pumpkin Software.

(17) ICFAI Journal of Applied Finance, Pp 10-15, Dec., 2004.

(18) Basil Moore, Theory of Finance, P-74, The Free Press. (Macmillan), USA.

(19) The Determinants of Capital Structure Choice, P.1-19, S. Titman & R. Wessels. Journal of Finance,1988.

(20) Barua S K, Raghunathan V., JR Verma & N. Venkiteshwaran, Analysis of the Indian Securities Industry : Market for Debt, P3-21, Vikalpa.

(21) Johnson SA. An Empirical Analysis of the Determinants of Corporate Debt ownership Structure, Journal of Financial and Quantitative Analysis. March, 1997. P. 47-70.

(22) Ferri MG & WH Jones, Determinants of Financial Structure : A New Methodological Approach. Journal of Finance. 34(1979). P. 631-644.

207

(23) Cantainnios R., Bankruptcy Risk and Optimal Capital Structure, Pp.1617-1635 The Journal of Finance. 38, 1983.

(24) Bradley M., GA Jarrel and EH Kim, On the Existance of optimal Capital Structure Theory and Evidence, Journal of Finance. 39 (1984) P. 857-878.

(25) Saa Requejo J., Financing Decisions : Lessons from the Spanish Experience. Financial Management.Pp. 44-56 Autumn/25 (1996).

(26) McConaughy D., & CS Mishra, Debt, Performance - Based Incentives and Firm Performance. Financial Management. P.37-51, Summer/25,1996.

(27) Chartered Financial Analyst. P. 38, Jan., 2003.

(28) RN Misra & Chinmay Sahu, Management Accountant, January, 2000. P. 48.

(29) A. Singh & J. Hamid, Corporate Financial Structures in Developing Countries, IFC Technical Paper, Washington DC.

(30) A. Singh, Corporate Financing Patterns in Industrial Economies : A Comparative International study, IFC Technical Paper No. 2, Washington, DC., 1995.

(31) M. Solebad & M. Peria, Firm Financing in India : Recent Trends and Patterns. I. Love, The World Bank Policy Research Working Paper (2005)34760.

(32) Fabio Panetta and Luigi Zingales, Why do Companies Go Public ? An Empirical Analysis, Vol. 39, Pp. 234-278, Pagano, Marco,. Journal of Finance 1998.

(33) Hesuk Chun and Stephen Smith, New Issues in Emerging Markets : Determinants, Effects and Stockmarket Performance of IPOs in Korea. 2000.

(34) Sabine P., Going Public : Opportunities or Necessity ? Empirical Evidence from Belgium IPOs.. Eunip Conference Paper, 2002

208

(35) Jitendra Mahakud & Prabhash Kumar Rath, Determinants of External Equity Finance : Evidence from the Indian Corporate Sector, PP. 56-69, The ICFAI Journal of Applied Finance. May-June, 2005.

(36) Management Accountant. May, 1998.

(37) RK Sahu, A study about Profitability of 100 listed Companies (1985-1994), Management Accountant, P. 571, August, 2000.

(38) Chartered Financial Analyst, January, 2003.

(39) ICICI study of 1619 Companies, January, 1998.

(40) Mestan Miller & Franco Modigliani, Dividend Policy, Growth and Value of Shares, Vol. 34, Pp. 411-413, Journal of Business, 1961.

(41) Lintner J., Distribution of Incomes of Corporations among Dividends, Retained earnings and taxes, Vol. 46, Pp. 97-113, American Economic Review.

(42) Lazo Shirley, How do Corporate Leaders see Payouts ? An Important signals, survey findings, P. 40,.Barrons. Jan., 1999

(43) Baker H., Theodore E. & Garry Powell, Factors influencing the Dividend Policy Decisions of NASDAQ Firms, Vol. 38. PP. 19-38, Financial Review., 2001

(44) IM Pandey & Ramesh Bhat, Dividend Decisions : A study of Managers' perception., Vol. 21 (1&2), 1994.

(45) Raghunathan & Dass, Corporate Performance : Post Liberalisation, ICFAI Journal of Applied Finance. Vol. 5(2). PP. 6-31, 1999

(46) Manoj Anand, A Study of 525 Companies. ICFAI Journal of Applied Finance. PP. 5-16. Feb., 2004.

(47) ICFAI Journal of Applied Finance. August, 2004. PP. 43-53.

209

(48) ICFAI Journal of Applied Finance. Sept., 2004. PP. 5-12.

(49) ICFAI Journal of Applied Finance. Sept., 2004. PP. 13-35.

(50) Ball R. & Brown, An Empirical Evaluation of Accounting Income Numbers. Vol. 6. PP. 159-178, Journal of Accounting Research, 1968.

(51) Beawer W., The Information Content of Annual Earnings Assessment. Empirical Research in Accounting : Selected studies, Vol. 6. PP. 67-92, Supplement to Journal of Accounting Research.. 1968

(52) Beaver W., Lambart R. & Morse D., The Information content of Security Prices, , Vol. 2. PP. 3-28, Journal of Accounting & Economics. 1980

(53) Dixit R K, Behaviour of Share Prices and Investment in India, Deep & Deep, New Delhi. 1986.

(54) Narayan Rao, The Adjustment of Stock Prices to Corporate financial Policy Announcements. Vol. 8. PP. 941-953, Finance India..

(55) Barua SK & V. Raghunathan, Soaring Stock Prices, Defying Fundamentals, Vol. 25. PP. 2559-2561, Economic and Political Weekly.. 1990

(56) Sundaram SM, Soaring Stock Prices Economic and Political Weekly. Vol. 26. P. 1184, 1991.

(57) Obaidullah M, The Price-Earnings Ratio Anomaly in Indian Stock Markets, Vol. 18., Pp. 183-190, Decision. 1991

(58) GC Nath & Dr. YV Reddy, Macro Economic indicators and Stock Prices - Indian Evidence, Pp. 29-45, ICFAI Journal of Applied Finance. April, 2004.

(59) B S Lee, Causal Relation among Stock returns, interest rates, real activity and inflation, Vol. 47. PP. 1591-1603, Journal of Finance,1992

210