Research of every firm. Hence, managers have to

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Topic: Impact of
Capital Structure on Profitability of Food Processing Firms in India.



Submitted by: Indu


BCom Honors









capital structure refers to the relationship between the various long-term
forms of financing such as debenture, preference share capital and equity share

capital structure of a firm is a mixture of diverse securities. In general,
firms can choose among many alternative capital structures. For instance, firms
can arrange lease financing, use warrants, issue convertible bonds, sign
forward contracts or trade bond swaps. Firms can also issue various distinct
securities in different combinations to maximize overall market value.



Forms of Capital Structure


capital structure of a company may consist of any of the following forms:


1.      Equity
Shares only

2.      Equity
and Preference Shares

3.      Equity
Shares and Debentures

4.      Equity
Shares, Preference Shares and Debentures



The present era is the era of extreme
competition and survival of the fittest is the slogan of the corporate world.
In such a situation decision making has appeared as one of the toughest tasks
as it decides the returns of every firm. Hence, managers have to take into
consideration the cause effect relationship while making a particular decision.
The managers of existing corporate world have to follow systems approach in
their decision making because a decision taken in isolation can bring a firm to
the edge of a disaster.


Of all the aspects of capital investment
decision, capital structure decision is the vital one, since the profitability
of an enterprise is directly affected by such decision. Hence, proper care and
attention need to be given while making the capital structure decision. There
could be hundreds of options but to decide which option is best in firm’s
interest in a particular scenario needs to have deep insight in the field of
finance as use of more proportion of Debt in capital structure can be effective
as it is less costly than equity but it also has some limitations because after
a certain limit it affects company’s leverage. Therefore, a balance needs to be






Determining the Capital Structure


The capital structure of a company is
determined by taking many factors into consideration. All these factors have
their own significance and therefore it is not possible to rank these factors.
The financial manager has to study the benefits and drawbacks of the various
sources of finance in order to select the optimal capital structure. The below
mentioned factors are the most significant factors in determination of capital


Trading on equity or financial leverage

Growth and stability of sales of the

Cost of the capital

Risk involved

Cash flow ability of the firm to service

Nature and size of the firm

Control over the firm

Flexibility of capital structure

Requirements of the investors of the

Capital market conditions

Asset structure of the firm

Purpose and period of financing

Costs of flotation

Corporate tax rate

Legal requirements



There are two main benefits of debt for
a company. The first one is the tax shield: interest payments usually are not
taxable; hence the debt can increase the value of the firm. Another benefit is
that debt disciplines managers. Managers use free cash flows of the company to
invest in projects, to pay dividends, or to hold on cash balance. But if the
firm is not dedicated to some permanent payments such as interest expenses,
managers could have incentives to “waste” extra free cash flows. That is the
main reason, in order to discipline managers, shareholders attract debt. Also,
it is a standard practice in debt agreements between banks and debtors to introduce
some financial covenants for firms (nominal level of the free cash flow,
debt-to-EBITDA ratio, EBITDA-to-interest expenses ratio etc.). Managers cannot
break these covenants, and hence are bound to be more effective. In addition,
the law usually guarantees a right of partial information disclosure to the
company’s debt holders, which serves as additional managers’ supervision tool.
As a result, actions of managers become more transparent, and they have more
incentives to create higher value for the owners.



In today’s competitive and dynamic
business world, financial decision plays a major role in the firm’s day to day
performance and operations. Firm’s financial decision affects nearly all
activities within the company. In the field of corporate finance, capital
structure decision is the most debated issue for academicians and practitioners
of corporate finance starting from a seminar work of Modigliani and Miller in
1958. Modigliani and Miller (1958) definite that the firm’s value is
independent from their capital structure decision, by assuming unrealistic
assumptions on the real world; such as no corporate taxes, no transaction cost,
and perfect capital market. However, Modigliani and Miller (1963) incorporated
corporate taxes into their earlier assumption and they stated that optimal
capital structure can be attained from 100 per cent debt financing through
getting tax saving advantage of using debt. However, the second proposition
also not considered the disadvantages of using more debts, such as bankruptcy
cost and default risk.


After the work of Modigliani and Miller
(1958 & 1963) a number of theories have been developed to explain optimal
capital structure of the firms. Agency cost theory, static trade-off theory,
and pecking order theory are the most popular theories of capital structure.
However, both debt and equity finance have their own merits and demerits. The
merits of debt financing are tax-shield, disciplinary tool and cheapest sources
of finance, while bankruptcy cost and default risks are its disadvantage. In
the case of equity share, its advantage is there is a low probability of
bankruptcy cost, while no tax advantage, costly and difficulty of controlling
free cash flow are its disadvantages.



Understanding the relationship between the
company debt and value could provide useful insights for investors for two
reasons. Firstly, shareholders would be able to target optimal debt-to-equity
ratios, which may improve discipline of the managers, but does not overburden a
firm with extraneous interest payments. Secondly, debt holders would have a
tool in hand to identify overleveraged and underleveraged firms. This may help
them allocate their funds more effectively.












of Literature




Income Theory


According to this theory, a company can
increase the value of the firm and decrease the weighted average cost of
capital by making maximum use of debt in the capital structure.


Figure 1: Net Income Theory: Ke, Kd, and
Ko in degree of leverage


Operating Income Theory


This theory is suggested by Durand. This
theory is totally opposite to the net income approach. This theory states that
changes in the capital structure of a firm will have no effect on the market
value of the company and irrespective of the method of financing, the overall
cost of capital for a firm remains constant.


Figure 2: Net Operating Income Theory:
Ke, Kd, and Ko in degree of leverage


Traditional Theory


It is also known as intermediate
approach. According to this theory, the best capital structure can be reached
with the help of a proper debt-equity mix.


Figure 3: Traditional Approach of Cost
of Capital and Leverage



and Miller Theory


One of the first works about the role of
debt is Modigliani and Miller (1958). They claim that owners of the firms are
indifferent about its capital structure, because the value of the firm does not
depend on debt-to-equity ratio. Authors consider “an ideal world” without taxes
and any transaction costs. Later Modigliani and Miller (1963) introduce taxes
into their model and show that the value of a firm increases with more debt due
to the tax shield.


Figure 4: MM Approach of Cost of Capital
and Leverage


off Theory


Modigliani and Miller’s work initiated
further discussions about optimal capital structure. Since their theory
predicts 100% debt financing (due to substantial corporate tax benefit), which
is not observed in practice1, there should be some trade-off costs against the
tax shield. The actual level of debt is determined by tax advantage and these
costs. Economists consider bankruptcy costs, personal tax, agency costs,
asymmetric information and corporate control considerations as possible
trade-off options against tax shield. This is the essence of the trade-off
theory, according to which higher profitability is related to higher leverage
due to the tax shield, but is not at the level of 100% of assets due to
trade-off costs.


Figure 5: Trade Off Theory of capital structure


Order Theory


Myers and Majluf (1984) developed a
“pecking order” theory of capital structure, according to which firms initially
use internal funds, then debt, and, if a project requires more funding, equity.
Therefore, firms which are very profitable and generate sufficient cash flows
will use less debt.




Ross (1977) came up with a model that
explained the choice of debt-to-equity ratio by a willingness of a firm to send
signals about its quality. The core idea of Ross (1977) is that it is too
costly for a low-quality firm to abuse the market and signal about its high
quality by issuing more debt. As a result, low quality firms have low amount of
debt, and the leverage increases with the value of a firm. That is why a risky
firm will end up with lower debt.

Cost Theory


The connection between capital structure
and firm performance through the agency costs theory, developed by Jensen and
Meckling (1976) and Myers (1977). Agency costs are related to conflicts of
interest between different groups of agents (managers, creditors,
stockholders). There could be two types of agency problems.


Firms, which are mostly equity financed,
have very low risk of bankruptcy. Managers of such firms are not penalized in
case of low profits and have no incentives to be more effective. Besides,
bankruptcy implies some personal costs for managers, such as loss of reputation
etc. To sum up, a rise of leverage is followed by improved corporate
performance according to this type of agency problem.


theory about managers acting in their own interests was suggested by Harris and
Raviv (1988). They describe higher leverage as an antitakeover instrument: –
firms with a large amount of debt will be less likely to become a target for
acquisition. That is why managers, who are afraid to lose their job after
takeover, may be willing to accumulate higher than necessary amount of debt.


An agency problem between stockholders
and debt holders. This type of a problem is rooted in the conceptual difference
between stockholders and debt holders. The former take more risks and demand
higher return, whereas the latter take less risk and agree with lower return.
Hence, shareholders may want to take projects with higher risk than debt
holders would prefer. In the case of success of these projects stockholders
will earn extra return, while in the case of failure all losses will be between
debt holders and stockholders (Jensen and Meckling, 1976). As a consequence,
more indebted firms take lower-risk projects. On the other side, Myers (1977)
showed that discrepancies in goals between debt holders and shareholders could
lead to underinvestment. Thus, higher leverage might as well lead to lower
corporate performance.














In order to find the relationship
between the capital structure and the profitability of a firm, a lot of
research has been undertaken by various researchers all over the world. The
review of some of the major studies has been undertaken so as to develop a
clear understanding about the relationship between capital structure and
profitability. The review of such major studies is as follows:


Modigliani and Miller (1958) theory of
“capital structure irrelevance” states that financial leverage does not affect
the firm’s market value with certain assumptions. These assumptions related to
homogenous expectations, perfect capital markets and no taxes.


Myers and Majluf (1984) concluded that
firms that use less debt capital comparing with equity are profitable and
generate high earnings than those that use more debt capital.


Sheel (1994) showed that all leverage
determinants factors that were studied, except firm size, are important to
explain debt behavior variations.


Gleason, et al., (2000) using data from
retailers in 14 European countries, which are grouped into 4 cultural clusters,
it is shown that capital structures for retailers vary by cultural clusters.
This result holds in the presence of control variables. Using both operational and
financial measures of performance, it is shown that capital structure
influences financial performance, although not exclusively. A negative
relationship between capital structure and performance suggests that agency
issues may lead to use of higher than appropriate levels of debt in the capital
structure, thereby producing lower performance.


 Graham (2000) integrates under firm-specific
benefit functions to estimate that the capitalized tax benefit of debt equals
9.7 percent of firm value. The typical firm could double tax benefits by
issuing debt until the marginal tax benefit begins to decline.


Chiang et al., (2002) undertake a study
and the findings of the study put forth that profitability and capital
structure are interrelated; the study sample includes 35 companies listed in Hong
Kong Stock Exchange.


and Zapatero (2003) found a positive relationship between leverage and

Abor (2005) investigates the relationship
between capital structure and profitability of listed firms on the Ghana Stock
Exchange and find a significantly positive relation between the ratio of
short-term debt to total assets and ROE and negative relationship between the
ratio of long-term debt to total assets and ROE.


Mendell, (2006) examines financing
practices in firms in the forest products industry by studying the relationship
between taxes and debt hypothesized in finance theory. In analyzing the
theoretical association between capital structure and taxes for 20 traded
forest industry firms for the years 1994-2003, the study discover a negative
relationship between debt and profitability, a positive relationship between
non-debt tax shields and debt, and a negative relationship between firm size
and debt.


Ahmad study talk over the effect of
capital structure on company performance of Malaysian firms listed in Malaysian
equity market from 2005 to 2010. In order to measure firm performance they used
return on equity (ROE) and return on asset (ROA), and to measure capital
structure they used long-term debt (LTD), short-term debt (STD), and total debt
(TD). The study results that each of debt level has important negative
relationship with ROE, while ROA has significant positive relationship only
with STD and TD.


Gill, (2011) seeks to elongate Abor’s
(2005) findings regarding the effect of capital structure on profitability by observing
the effect of capital structure on profitability of the American service and
manufacturing firms. The Empirical results of the study show a positive relationship
between short-term debt to total assets and profitability and between total
debt to total assets and profitability in the service industry. The findings of
this paper also show a positive relationship between short-term debt to total
assets and profitability, long-term debt to total assets and profitability, and
between total debt to total assets and profitability in the manufacturing industry.


A study was conducted in 2015 by D. K. Y
Abeywardhana in order to analyze the relationship between the profitability and
the capital structure of a firm. This study was conducted on the SMEs in the UK
and the results showed that there is a significant influence of capital
structure on the profitability of the firms.


The other major studies undertaken by
Mesquita and Lara (2003), Philips and sipahioglu

(2004), Haldlock and james (2002),
Arbabiyan and Safari (2009), Chakraborty (2010), Huang and Song (2006), Pandey
(2004) came up with the findings which were conflicting in nature as some studies
confirm positive relationship between capital structure and profitability while
other studies confirm positive relationship between the variables.


It is against this background that the
present study has been undertaken so as to facilitate the existing literature.









This research is conducted with the aim
to find out the probable influence of the capital structure on the Food
Processing firms listed on the Bombay Stock Exchange (BSE).



of the study:

1.      To
identify and analyze the capital structure of the selected companies.

2.      To
identify and analyze the profitability of the selected companies.

3.      To
analyze the relationship between the capital structure and profitability.


of Research:

The connection between profitability and capital
structure is very crucial to analyze. The long-term survivability of the firm
depends upon the improvement in the profitability. Interest payment on debt is
tax deductible; hence, the increase of debt in the capital structure will
increase the profitability of the firm. So, it becomes essential to find out
the relationship between capital structure and the profitability of the firm in
order to make appropriate capital structure decisions.

The absence of a consensus about what would qualify
as optimal capital structure in the food processing industries in India has
motivated me to conduct this research. This study requires knowledge about the
capital structure and the profitability indicators of the firm.



H0: There is no significant relationship between the
capital structure and profitability of selected firms.

H1: There is significant relationship between the
capital structure and profitability of selected firms.








The population for the study consists of
the Food Processing companies listed on the Bombay Stock Exchange (BSE) for the
study period (2012-2016). There are 61 food processing companies listed on the
Bombay Stock Exchange (BSE) as on January 2018.


Out of the above population, research
sample is selected on the basis of the given below criteria.


Availability of the data required to calculate
the study variables during the study period (2012-2016).

Elimination of firms having extremist
values for any of the study variable during the study period (2012-2016).


Based on the above selection criteria,
the below listed companies are selected for the study:


ADF Foods Industries

2.      Bambimo
Agro Industries Ltd.

3.      Britannia
Industries Ltd.

4.      Chaman
Lal Setia Exports Ltd.

5.      Freshtrop
Fruits Ltd.

6.      Foods
and Inns Ltd.

7.      GlaxoSmithKline
Consumer Healthcare Ltd.

8.      Hatsun
Agro Products Ltd.

9.      Heritage
Foods Ltd.

10.  Hindustan
Foods Ltd.

11.  Kohinoor
Foods Ltd.

12.  Kothari
Fermentation and Biochem Ltd.

13.  KRBL

14.  Kwality

15.  Milkfood

16.  MSR
India Ltd.

17.  Nestle
India Ltd.

18.  Tasty
Bite Eatables Ltd.

Umang Dairies Ltd.









The process of data collection is very simple
and straight forward. The data for this study is taken from the annual
financial statements of the selected companies. The ratios of the selected
companies are collected from the annual financial report analysis available on
the money control site. The data collected relates to the period of study i.e.
2012-2016. The reason for restricting to this period of study was the
availability of the latest data for investigation.


The required variable (of the selected companies for the study period
2012 to 2016) for the study are:


Total Debt

2.      Total Equity  

3.      Net Income

4.      Total Assets

5.      Total sales

Capital Employed



Measurement of


Independent variable (Capital Structure)

capital structure refers to the relationship between the various long-term
forms of financing such as debenture, preference share capital and equity share
capital. The independent variable fot the study is the Debt-Equity Ratio.


it is calculated using the formula:


Equity Ratio =   Total Debt

                                   Total Equity



Dependent variables (Firm Profitability)

There are various accounting based variables used
for measuring firm profitability such as gross

profit margin, net profit margin, return on
capital employed, return on assets, etc.

This study adopts the following three accounting
based measure of profitability:


Net Profit Margin

Return on Capital Employed

Return on Assets

Computation of independent


Net Profit Margin =  Net Income   x 100



Return of
Capital Employed =          Net Income       
x 100

Capital Employed


Return on
Assets =   Net Income       x

                                  Total Assets





Figure 6: Variables of the Study.










and Interpretation








































Suggestions and Conclusion











































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