LEVERAGE AND THE COST OF CAPITAL IN A LESS DEVELOPED CAPITAL MARKET: COMMENT

Abstract

THIS PAPER PRESENTS the results of a comparative study of the effects of capital structure on the cost of capital in a less developed and less efficient capital market (Indian) and in a highly developed and efficient capital market (United States). Specifically, the effect of leverage on the cost of capital is tested on a sample of 28 Indian utilities and on a sample of 77 American utilities. The results for the American utilities are consistent with the Modigliani-Miller thesis after allowing for the tax advantage of debt financing the cost of capital is independent of capital structure. These results for the American utilities provide a useful benchmark in comparing the relative efficiency of the Indian capital market. The results for the Indian utilities are inconsistent with the Modigliani-Miller independence hypothesis and support the more traditional approach to valuation moderate amounts of debt will lower the firm's cost of capital. In a recent article L. V. L. N. Sarma and K. S. Hanumanta Rao [7] presented empirical results inconsistent with the Modigliani-Miller thesis and concluded that investors prefer corporate to personal leverage and, therefore, the value of a firm rises up to a leverage rate considered prudent. Their sample consisted of 30 Indian Engineering firms. Sarma and Rao do not consider the possibility their findings could be attributed to the fact the Indian capital market is less efficient than the United States capital market. Indeed they seem to imply their conclusions are general enough to be extended to the American capital market. The present study confirms their findings for the Indian capital market but avoids potential sources of bias in their study.' The results of the present study do not, however, support the generalization of their conclusions to the American capital market.