Research Proposal on "Capital Structure Does the Nature"

Research Proposal 4 pages (1302 words) Sources: 5 Style: Harvard

[EXCERPT] . . . .

Capital Structure

Does the nature of a company's asset base (tangible or intangible) affect capital structure choices: A recent examination using 21st century Indian data suggests this is not the case

Once upon a time, choices of capital structure were often presumed to be based upon narrow economic self-interest in a rational-actor model of firm behavior. This reflects the idea that "firms face financial constraints; their development heavily depends on debt issues, bank loans, venture capital, or other external equity investments that may have a variety of costs due, for example, to direct sources such as fees and indirect costs such as financial distress. Another critical assumption in traditional models is that the firm's manager always acts in the shareholders' best interest" (Xu & Birge 2008, p.1). However, social influences are now deemed to be of equal importance, especially in 'high context' cultures, such as that of the developing world, including India. Corporate managers may "deviate from value-maximizing operational and financing decisions and pursue their own self-interests" or must bow to political and social pressures, "hence, ignoring the effects of financial constraints and agency costs creates a gap between theoretical research and industrial reality" (Xu & Birge 2008, p.1).

It is likewise often believed that in the developing world, in particular, social considerations may affect profitability, such as nepotism and asymmetries of information based upon political connections of organizational leaders. For instance, in 2006, well after liberalization of financing and government regulations, a staggering 70% of India's 500 largest firms, accounting for roughly 87% of total market capitalization were affiliated with family business groups or the government party then ruling India (Rajagopal 2009, p.28). This would suggest that intangible assets, like social capital, government connections, and nepotism may play a more important role in financial decision-making in India, perhaps more so than questions of maximizing profitability regarding capital structure choices, regardless of the financial interest of the firm (Tangible assets, 2009, Money terms)

However, according to Sanjay Rajagopal's 2009 study "On the portability of capital structure theory," India offers a unique case study in what he calls the portability of capital financing theory across the borders of the developing and developed world. Rajagopal suggests that market structure and social factors may have less of an impact than previously believed upon decision-making. Traditional assumptions, such as the fact that "as profit margins increase, the firm tends to invest more; that high investment is in part financed with more debt, but, because production cost decreases and firm value increases, the market leverage does not grow" hold true cross-culturally when subjected to empirical study, regardless of the assumed political interests of firm leaders (Xu & Birge 2008, p.1).

For students of economics, this is somewhat of a relief: the difficulties of quantifying the value of intangible assets, particularly in terms of their amortization (versus the depreciation of tangible assets) makes studying nations such as India and taking into consideration its high-context cultural environment quite difficult. The vagueness of what constitutes an intangible asset makes "the case for excluding amortization from profit numbers…even stronger than that for excluding depreciation" even though one might assume intangible assets have a greater deal of influence upon industries in the developing world, more so than tangible, physical assets (Amortization, 2009, Money Terms).

Rajagopal notes that "using a sample of 1110 to 1163 manufacturing firms for the period 1998-2002, the study finds that the traditional explanatory variables (fixed asset ratio, firm size, profitability, market-to-book ratio, non-debt tax shields, and earnings volatility) play a significant role in explaining the cross-sectional variation in financial leverage, and broadly have the expected signs" one might have made about similar decisions regarding financing in the developed world alike (Rajagopal 2009, p.27). For example, according to data on all publicly held U.S. firms…the average debt-to-market value leverage ratio is 27.28%, while the debt-to-book value leverage ratio is even higher at 52.53% of total company value, and… READ MORE

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