Leverage, Risk & Choice Of Capital Structure: An Empirical Case From India

Abstract

The present empirical paper studies the leverage, risk and choice of capital structure in India through a case of MRF Ltd. from tyres & tubes industry of the Indian corporate sector which covers a time period of ten years (effective nine years) extending from the year 1982-83 to 1991-92 where the company is lying in the top of tyres & tubes industry of the Indian corporate sector on the basis of sales for the year 1991-92 for the purpose of our study. The study reveals that that debt-equity ratio 2 and leverage ratio 2 have been varying from 53.01 percent in the 1982-83 to 68.25 percent in the year 1985-86, each, with rising trend during the period under study, whereas, aggregate debt-equity ratio 2 and leverage ratio 2 of the company are worked out 63.71 percent, each, during the period under study. It is found that cost of debt on before and after tax basis (Kd bt & Kd at ) has been declining over the period under study, whereas, aggregate cost of debt on before and after tax basis (Kd bt & Kd at ) of the company is worked out 17.91 percent and 10.21 percent, respectively, during the period under study. It is observed that rate of return on net assets on before and after tax basis (ROI bt2 & ROI at2 ) and rate of return on total networth on before and after tax basis (RON bt & RON at ) have been rising during the period under study. On aggregate basis, aggregate rate of return on net assets on before and after tax basis (ROI bt2 & ROI at2 ) is worked out 25.18 percent 14.35 percent, whereas, aggregate rate of return on total networth on before and after tax basis (RON bt & RON at ) is worked out 38.42 percent and 21.90 percent, respectively, during the study period. Thus, it is concluded that the company is enjoying favourable leverage with regard to use of debt during seven out of nine years under study. Consequently, rate of return on total networth (RON bt & RON at ) is higher than cost of debt (Kd bt & Kd at ) and rate of return on net assets (ROI bt2 & ROI at2 ) on before and after tax basis in the above said seven years under study. It means that use of debt in the capital structure of the company has positive impact on the profitability of the company during seven out of nine years under study which consequently is contributing to the total networth of the company which ultimately is benefitting to the equity shareholders of the company. Leverage created through debt by the company is not generating risk for the company in the above said seven years under study because MRF Ltd. is able to cover the cost of debt (Kd bt & Kd at ) on before and after tax basis from the rate of return on net assets (ROI bt2 & ROI at2 ) on before and after tax basis in the above said seven years under study. However, on aggregate basis, the company has also been experiencing favourable leverage with regard to use of debt on before and after tax basis during the period under study which further means that debt is behaving favourably during the period under study. It is also found that spread and net gain are positive when leverage impact is positive and vice-versa during the period under study. It is also found that effective tax rate born by the company is high, i.e. 43 percent, during the period under study.