Does Financial Leverage Influence Investment Decisions? The Case of Pharmaceutical Firms in India

Abstract

The theory of capital structure irrelevance developed by Modigliani and Miller (1958 & 1963) paved a path to the development of various theories. Although Modigliani and Miller (1958) proposed the theory of irrelevance by arguing that investors do not give considerable attention to financial leverage under the perfect market condition since financial risk could be diversified away by the marginal investors. Further, Miller (1977) modified the theory by introducing the same level of personal as well as corporate taxes into the model. In 1980, Deangelo and Masulis extended Miller’s work by examining the effect of tax shields other than interest payments on debts. In 1977, Ross has done research on the signalling role of debt. Another equilibrium theory of optimal capital structure is agency theory proposed by Jenson and Meckling (1976). Myers (1984) proposed pecking order theory i.e. consequence of asymmetric information. These theories motivated the researchers to do further research on this domain. Numerous studies have investigated the relationship between financial leverage and investment decisions by using various approaches in different geographical contexts and at different points in time. The results of these studies are inconclusive. The inconclusive results motivated the author to undertake a study on the relationship between financial leverage and investment decisions in Indian pharmaceuticals firms and the extent to which this relationship is explained by these theories.A quantitative analysis has been carried out over a panel data sample of 95 listed pharmaceutical companies of BSE for the period of 2000-2012. To understand the relationships proposed above, this study used five measures namely financial leverage, sales, cash flows, Tobin Q ratio, net investment to fixed assets ratio and net sales to fixed assets. These variables were used by McConnell and Servaes (1995); Lang et al (1996); Aivazian et al (2005); and Serrasqueiro, Mendes, and Nunes (2008). This study has adopted the same variables to test the theory of relevance and irrelevance of companies’ non-observable individual effects. Financial leverage is measured using two proxies. The first proxy of financial leverage is calculated by dividing the total long term borrowings by the total assets. The ratio emphasises the dominant role of long-term borrowings (Aivazian et al, 2005). The second proxy of financial leverage could be calculated by dividing the total liabilities by the total assets. Similarly, two proxies were also used for growth opportunities. First proxy for growth opportunities is Tobin’s Q which refers to the market value of total debt and equity of a company divided by the book value of debt and equity. The second proxy is sales growth which is defined as net sales deflated by net fixed assets. Cash flow is measured as the profit before extraordinary items and all non-cash items.The study employed panel data regression with pooled, fixed or random effect regression. Among the three methodologies, this study found that fixed effect model is more appropriate to understand the proposed relationships in relation to pharmaceutical firms over the sample period. This study found that pooled regression is not the best way to estimate the investment-financial leverage relationship as it fails to consider the relevance of cross section effects i.e. companies’ non-observable individual effects. The relationship between financial leverage and investments was negative as expected by agency theory and statistically significant at 10 per cent level. The cash flow was positively related to investment However, this study found that there is a change in estimated coefficients of parameters in terms of magnitude and statistical significance while performing fixed effect model with AR (1). It suggests that it is important to consider the impact of previous period for investment in the current period.