CHAPTER I INTRODUCTION

Transcription

1 CHAPTER I INTRODUCTION The pattern and pace of long-term investment is crucial in the development of every economy. The rate of capital accumulation or business fixed investment is one of the key determinants of economy s long term growth rate and is indispensable for overall economic development. The role of Indian corporate sector has always been instrumental in this regard. Moreover, the same has become even more significant after the liberalisation, privatisation and globalisation measures post Industrial Policy 1991 in Indian economy. Investment as such contributes towards current demand, current employment and future output. It therefore becomes interesting to study investment at aggregate, industry and firm level. The investment pattern can also indicate impact of monetary and fiscal policy on the corporate sector. Investment spending is devoted to increasing or maintaining the stock of capital. The stock of capital consists of factories, machines, offices and other durable man-made products used in the process of production. The capital stock also consists of residential housing as well as inventories 1. Over the last decade and a half, Indian economy has witnessed a widespread change in its orientation towards the role of state and private enterprises in contributing towards economic growth. One of the primary objectives of liberalisation through Industrial Policy 1991 was to ensure that a market-oriented economy would infuse capital expenditures by corporate India to connect to the global economy and push the country s growth rate. This study confines itself to the consideration of business fixed investment (corporate capital expenditures). The primary aim of this study is to analyse the importance of various sources of finance in corporate capital expenditures in India. This chapter has been divided in seven sections. Section 1.1 discusses the concept of capital expenditures and Section 1.2 briefly deals with financing of capital expenditures. The next section, Section 1.3 explains the rationale of the study and Section 1.4 lays down the broad and specific objectives. Section 1.5 formulates 1 Dornbusch, R. and Fischer S., Macroeconomics, First Edition, McGraw - Hill, New York, 1978, Pg 175 1

2 hypotheses based on the objectives outlined in the previous section. Research methodology has been briefly discussed in Section 1.6 and the last section, Section 1.7 provides the plan of the study. 1.1 CAPITAL EXPENDITURES Every organization is required to commit a part of total funds permanently or for a long-term towards the accomplishment of its objectives. This includes setting up of infrastructure, review and up-gradation of infrastructure, entering new markets, launching new products, selecting from lease rentals or purchases and make or buy decisions. It represents a sizeable outlay of funds for the company. Capital expenditure decision making involves the scrutiny, review, analysis, implementation and follow-up of such long-term investments to achieve the goal of shareholders wealth maximization. In the words of Gitman (2001) 2, Capital budgeting is the process of evaluating and selecting long-term investments consistent with the firm s goal of owners wealth maximization. Capital expenditure decisions are made with different motives in mind by different firms. The growth plans of an existing firm require the acquisition of more fixed assets whereas a newly incorporated firm needs to build resources to implement its plans. Further, when a budding firm is progressing towards its goals, it requires replacing or renewing the obsolete or worn-out assets. Costs and benefits of repairs and replacements have to be compared. Renewal, an alternative to replacement, may involve rebuilding, overhauling or retrofitting an existing fixed asset to improve its efficiency. Some other capital expenditure decisions require long-term commitment of funds in expectation of a future return. The proposal of capital expenditure decision-making can be initiated at any level in the organization. The broad objective of all such decisions revolves around shareholders wealth maximization. In an attempt to make an optimal choice, due consideration has to be given to the quantum of investment involved. An 2 Gitman, Lawrence J., Principles of Managerial Finance, Ninth Edition, Pearson Education Asia, 2001, Pg 332 2

3 appropriate solution to the issue may originate after a thorough study of market, firm s resources and competitor s policy. However, the proposals have to be formally reviewed by the requisite authority in the light of firm s objectives and growth plans to evaluate their economic validity. First, a preliminary screening of all the capital expenditure proposals is done in light of the broad objectives. The outlay required and importance of decision depends on the level of capital expenditure budget. A stricter control is required after approval and funding. Further, the actual and estimated costs and benefits have to be compared. The firm has to study its relevant cash flow patterns that include initial investment, operating cash inflows and outflows and terminal cash flows of the project. The decision regarding acceptance or rejection is taken after evaluation of various proposals by using different capital budgeting techniques such as internal rate of return, net present value, payback period, discounted payback period, profitability index etc. The executives generally prefer to use a combination of these techniques along with personal experience to give a final approval to the project. Some supplementary tools of incorporating risks in capital expenditure proposals are sensitivity analysis, risk adjusted discount rate, certainty equivalent coefficient and decision tree. At times, the managers are faced with more than one feasible proposal but the funds may fall short of the requirements. Hence, the next step in capital expenditure decision making process is to ration the available funds among the feasible proposal(s) optimally. The controlling aspect comes into picture once the project is finally selected and implemented. Pre-completion control refers to the comparison of estimated and actual benefits of the project during its various stages. Lastly, post-completion audit is carried out to evaluate the total return from the project with the targets set in the beginning to improve the future analysis of capital expenditure proposals. 3

4 1.2 FINANCING OF CAPITAL EXPENDITURE PROPOSALS A newly established firm begins the business with a certain package of assets and liabilities. It usually comprises of capital on one side and cash/bank on the other. The structure of balance sheet of an existing firm is far more complex. However, every firm has the option of modifying the current structure by various transactions related to real or financial assets, more commonly known as investment or financing decisions. As the capital expenditures involve huge investment, availability of funds is a prerequisite in undertaking them. The companies usually have access to a wide array of funds for the said purpose but the choice of a particular source depends on the associated pros and cons. Purohit, Lall and Panda (1994) 3 have observed, Because of indispensability of adequate finance, it warrants that we should have sufficient knowledge about different sources of corporate financing. As no source of financing is an unmixed blessing, we should underscore the suitability of each source of finance. Hence, it can be interpreted that the success of capital expenditure depends in a large way upon the sources of finance used for financing the proposal. This is due to the fact that the net return from a project is calculated after considering the minimum required rate of return (which in turn depends on weighted average of cost of capital) of the project. The major sources of finance available to the companies include equity shares, preference shares, debentures, public deposits, assistance from financial institutions, short term loans from commercial banks and retained earnings. The sources may be broadly categorised as internal and external. Cashflows primarily make up for the internal sources of funds whereas external funds may be raised either in the form of fresh issue of equity or new debt. There are various factors involved in establishing the capability of a firm to raise fresh funds from the market such as economic conditions, inflation, and goodwill and so on. Due to the involvement of a multitude of factors, fresh external funds through equity route are 3 Purohit, Badri Narayan, Lall, Gouri, Shankar and Panda, Jagannath, Capital Budgeting in India, Kanishka Publishers Distributors, 1994, pg 35 4

5 not a readily available option for all companies. Moreover, to raise funds through borrowings, a number of pre-requisites have to be met apart from interest payment as a charge to profits. The cashflows therefore score an edge over other sources because of zero explicit costs attached. Empirical literature also supports the significance of cashflows in investment decisions. The present study also analyses the significance of flow of equity and borrowings in investment decisions. As frequent equity issues may widen the shareholder base and lower earnings per share, this may not be the feasible option for various capital expenditures and use of excess debt will increase the financial risk of the company. However, use of debt may be a favourable choice due to attached tax benefits. Additionally, as excessive equity issue may dilute control and generation of internal funds being dependent upon various endogenous and exogenous factors; borrowings seem to capture greater attention of firms for financing their capital expenditure plans. There are various theories about optimal mix of equity and debt and the same have been discussed in the next chapter. The relationship between investment and financing decisions is quite evident from the use of cost of capital in various capital budgeting techniques. McCabe (1979) 4 remarked that since the publication of the work of Modigliani and Miller (MM) 5 in the late 1950s there has been a recurrent controversy in the finance and economic literature about the interdependence of investment and financing variables. MM suggested that investment and financing decisions of a firm are independent of each other in perfect capital markets. Some others argue that market imperfection is a reality and it is necessary for the firms to consider financing options while making investment decisions. Even MM recognized this interaction of decisions after incorporating taxes in their model. As mentioned earlier, capital expenditure decisions involve a relatively huge amount of investment along with a high degree of risk. The companies require adequate financing for such projects because of their expected impact on long term 4 5 McCabe, George M., The Empirical Relationship between Investment and Financing : A New Look, The Journal of Financial and Quantitative Analysis, Volume 14, No. 1, March 1979, pp Modigliani, F. and M. Miller, The Cost of Capital, Corporation Finance and the Theory of Investment, American Economic Review, 48, 1958,

6 existence and profitability. As capital is one of the important elements to business growth, its efficient use requires acquisition in appropriate amounts at the right time and careful formulation of internal policies concerning the choice of the various sources of finance and the costs thereof. Broadly, the companies have to finance their investments through a mix of shareholders equity and liabilities. Myers (1974) 6 pointed out that the problem is to determine which set of current and planned future transactions will maximize the market value of the firm. Market value is taken to be an adequate proxy for the firm s more basic objective, maximization of current shareholders wealth. 1.3 RATIONALE OF THE STUDY The previous sections have emphasized the significance and impact of capital budgeting decisions on long-term performance of a company. Both financing and investment decisions involve huge stakes of the companies. Moreover, the rate of and trends in corporate investment help explain the future prospects of Indian corporate sector in a better manner. These decisions clearly leave an impact over the universally accepted objective of financial management, i.e., shareholders wealth maximization. The issue of interaction between investment and financing decision, more particularly financing of the investment (capital expenditure) proposals has long been in the loop at the international front but not much research work has been undertaken on this subject in India. Hence, there is a need to investigate the issue of financing capital expenditures and the preference in using various sources of finance in Indian context. Moreover, most of the Indian studies have based their conclusions with only private sector companies as the sample of study. This research aims to evaluate empirically the importance of various sources of finance used for the purpose of making capital expenditure decisions in public and private sector in India. The study covers manufacturing industries in both the sectors to draw comprehensive conclusions on this vital issue. 6 Myers, Stewart C., Interactions of Corporate Financing and Investment Decisions- Implications for Capital Budgeting, The Journal of Finance, Volume XXIX, Issue 1, March 1974, pp

7 1.4 OBJECTIVES OF THE STUDY The present study primarily aims to study the financing of capital expenditures in Indian corporate sector. Within this primary objective, the specific objectives of study are: a) To identify the trends about the frequency and size of capital expenditures. b) To study the significance of various sources of funds for financing long-term investment decisions. c) To analyze the importance of cashflows in firm s investment decisions and the nature of its relationship with corporate investment. d) To examine the relationship between financing and capital expenditure decisions. 1.5 HYPOTHESES OF THE STUDY The hypotheses of the study have been drafted in accordance with the specific objectives. The broad hypotheses of the study are as follows: a) Routine investments are more frequent than growth related investments. b) Borrowed funds are the most frequently used for financing capital expenditures. c) Investment decisions of firms are sensitive to cash-flows and there is a U- shaped relationship between investment and cashflows. d) Investment decisions are dependent upon financing sources. The above mentioned hypotheses have been revisited and elaborated in the chapter on research methodology. 1.6 RESEARCH METHODOLOGY Data Source The study is based on firm level data which in turn has been obtained from secondary sources for the purpose of analysis. The relevant data was available in 7

8 audited financial statements of the sample companies. This has been sourced primarily from a firm-level micro database; PROWESS administered by the Centre for Monitoring Indian Economy (CMIE). In India, CMIE has the largest database on the Indian economy and companies. Prowess is a database of large and medium Indian firms. It contains detailed information on over 23,000 firms comprising all companies traded on India's major stock exchanges and several others including the central public sector enterprises. Minor gaps have been filled with information from published annual reports and company websites Time Span of the Study The study focuses on Indian corporate sector. It aims to examine and accomplish the objectives stated above over a fourteen year period from to The period after liberalization has seen changes in the asset structure of all companies irrespective of industries. The requirement of consistent data for balanced panel was reasonably met from onwards. The study covers a fourteen year period till Besides, a study spread over more than a decade can be expected to give reliable and representative results Sample A sample of 176 large sized Indian companies spread across different industries has been analysed to test study objectives. These companies have been selected from top 500 companies of India (turnover basis) as per the ET500 list published by Economic Times Group in The aforesaid list is publicly available at The Economic Times website ( and attached as Annexure. The companies meeting the following selection criteria have been chosen for the final sample: Continuity of operations Consistent data availability Common and consistent accounting year from 1 st April to 31 st March. 8

9 Banking, finance and trading companies have been kept outside the purview of the study. Banking companies are governed by separate set of legislations apart from difference in factors influencing their investment decisions. Additionally, finance and trading companies do not primarily require huge capital expenditures for their growth and expansion plans. Further, as the data set is spanning over a fourteen year period, it is imperative to adjust variables against inflation to deduce reliable results. However, certain companies have been dropped due to non availability of suitable Wholesale Price Index as the same is available for manufacturing industries Statistical Tools Used The methodology comprises of varied econometric and statistical tools. Frequency and trends of capital expenditure decisions has been analysed with the help of tabulation of data, use of frequency distribution, simple percentages, correlation, and cross tabulation. Since this is a study of investment behaviour of Indian corporate sector, a cross-section comprising of 176 companies over fourteen years ( to ) has been analysed with the help of panel data models. LIMDEP (Version 7.0) software has been used for multiple regression analysis. The segregated analysis for various industry groups has been carried out on parallel lines as for aggregate sample. 1.7 ORGANISATION OF THE STUDY The present study has been divided into eight chapters. The brief description of all chapters is given below: CHAPTER 1: INTRODUCTION This chapter is introductory in nature and traces the various aspects of financing of capital expenditures. It explains the rationale and objectives of study. It 9

10 also includes the research methodology, the sample, sources of data, testable hypotheses, statistical tools used and the organization of the study. CHAPTER 2: CAPITAL EXPENDITURES A THEORITICAL FRAMEWORK In this chapter, the conceptual framework of capital expenditure decisions and sources of finance has been briefed. Further, various theories of investment have been presented along with the reasons behind choice of accelerator theory to test the study objectives. The relationship between financing and investment decisions has been dealt with to elaborate on the significance of various sources of finance in explaining investment behaviour. CHAPTER 3: REVIEW OF EMPIRICAL STUDIES Chapter Three outlines a brief review of relevant researches and empirical studies conducted in India and abroad about relationship between investment and financing decisions. Most of the empirical studies have been conducted in the United States, the United Kingdom, Canada and some other developed countries. A few studies have been conducted with developing country samples including India. However, these studies have span over different time frames under consideration and primarily cover private sector companies. CHAPTER 4: RESEARCH METHODOLOGY This chapter discusses in detail the research methodology adopted in the study to examine the trends of capital expenditures in Indian corporate sector. It also outlines the methodology followed for understanding the significance of various sources of finance in corporate investment along with limitations of the data used. 10

11 CHAPTER 5: TRENDS IN CAPITAL EXPENDITURES This chapter highlights the trends about frequency and size of capital expenditures and various sources of funds used to finance the same by the sample companies over the study period. The hypothesis pertaining to routine and growth investments has been tested in this chapter. CHAPTER 6: FINANCING PATTERN IN INDIAN CORPORATE SECTOR: COMPOSITE REGRESSION RESULTS In this chapter, empirical significance of various sources of funds for financing long-term investment decisions has been examined and the study of relationship between investment and financing decisions for the aggregate sample. CHAPTER 7: FINANCING PATTERN IN INDIAN CORPORATE SECTOR: INDUSTRY WISE RESULTS This chapter throws light on trends of major variables in the different industry groups and also presents industry-wise results for financing of capital expenditures. CHAPTER 8: SUMMARY AND CONCLUSIONS Finally, this chapter sums up the major findings of the study and makes several concluding observations. A mention has also been made about the scope of further study to enhance the understanding of capital expenditure decisions of Indian corporate sector. 11