| Pub. Date | : April, 2021 |
|---|---|
| Product Name | : The IUP Journal of Accounting Research and Audit Practices |
| Product Type | : Article |
| Product Code | : IJARAP40421 |
| Author Name | : Vibha Tripathi |
| Availability | : YES |
| Subject/Domain | : Finance |
| Download Format | : PDF Format |
| No. of Pages | : 21 |
The financial performance and capital structure decisions cannot be independent of each other in the light of agency costs of risk shifting behavior in times of financial distress. Against this backdrop, the study investigates the relationship between capital structure and financial performance of the Automobile Industry in India from 2001 to 2014. Panel data approach has been applied to find out if financial performance represented by Return on Assets (ROA) and Return on Equity (ROE) has any relationship with the capital structure. Debt equity ratio (D/E ratio) represents the leverage or capital structure. Variables like growth, size, tangibility and CFCR are used as control variables. D/E ratio has a significant impact on the financial performance of the Automobile Industry. Out of the control variables, only growth had a positive and significant impact on the financial performance of the companies. Other variables like size, tangibility and CFCR were found to be insignificant in influencing the financial performance of the companies. The negative relationship between D/E ratio and financial performance signals agency problem between firm's equity investor and debt holders, where firms are likely to have high leverage, leading to low financial performance. Thus debt creates opportunities for shareholders to invest in a suboptimal manner. This can result in shifting risk from shareholders to lenders and of appropriating wealth in their favor. Due to risk shifting behavior, there is possibility of debt overhang. This leads to financial distress and higher agency costs to firms. Default risk leads to debt overhang and eventually bankruptcy and this becomes a cost.
In their seminal papers, Modigliani and Miller (1958) and Miller and Modigliani (1961) provide a new perspective on optimum capital structure. The perfect market assumptions underlying Modigliani and Miller (1958) differ from the real world in which firms operate. The absence of the assumptions of MM theorem actually gives reasons for capital structure relevance in the real world. Sixty years since the propositions by Modigliani and Miller (1958) and (1963), many researchers tried to extend the theories related to corporate leverage. The focus of these theories was impact of the capital structure choice on the firm value and cost of capital, i.e., WACC. Each theory raised new questions and some of them paved the way for new theories. A review of theories reveals that the companies either have target debt ratio or follow the pecking order model or a mix of both the theories in India. But what about Agency theory existence in Indian companies?