Under the literature of corporate finance, capital structure is one of the most riddling topics. Myers (1984) adds stating that 'the capital structure puzzle is tougher than the dividend one'. In the past, theorists have spent a considerable amount, understanding the pattern using SMEs and large firms. In this paper, the whole research is focused only on micro, small and medium firms of India. Drucker, (1985 cited in Banerjee, A. no date:1) says that SME's are the paradigm of innovation. Indian SMEs have a tight competition from their global counterparts post liberalization in 1991, transformation of manufacturing strategies and vague current market scenario. The sources of finance either debt or equity is not available on affordable terms, which is restricting success and even growth by limited access to advanced and new technologies (Kacker, 2005).
Largely, the capital structure of an organisation is influenced by the 'economic environment', corporate governance policies, taxation systems, the lender-borrower relationship, 'exposure to capital markets', stock market activities and the kind of 'investor protection' in the country (Antoniou et al., 2008). Beck et al. (2002 cited in Deesomsak et al., 2004:4) confirms that firms in developed countries have better and easy access to external finance. However, from this we can assume that in contrast, developing countries like India, firms rely heavily on internal finance.
Influence
The whole objective behind this paper is to determine the factors which influence MSMEs to opt for a particular capital structure during the start ups and during expansion. As per Pinegar and Wilbricht (1989 cited in Anand, 2002:44) firm value, stable cash flows, and financial independence significantly influence the setting up of the capital structure of the firm. Looking at the research objective, the primary research would help to build the theory that how significant are these factors for MSME sector. Myers (1984) states that our available theories are not that well equipped to direct and 'explain actual financing behaviour of the firms. He adds that rather it is presumptuous to assist firm and advice them over capital structure because genuine decision cannot be explained.
Source of Finance
Accessible finance facilitates firms to grow, compete and prosper. Dalberg (2011) claims that as per Investment Climate Surveys of the World Bank, access to finance improves performance of the firms. Dalberg added a vital point stating that, firms with greater and easy access of finance are more likely to 'exploit growth' and 'investment opportunities'.
Debt Finance
Dalberg (2011) adds that MSMEs in developing countries face significant barriers to finance; the constraints are such as high collateral securities, information asymmetry, 'high administrative costs', and 'lack of experience within financial intermediaries'. Banerjee, A (No date) adds a noticeable point that especially during start ups, MSMEs posses low equity and free cash flow visibility, and if they still acquire a loan then it becomes difficult for them to sustain it.
Usually SME's have little or no proper and accurate financial statements. Furthermore, there is hardly any general market data available on the SME market. Such imperfections and asymmetry in the information limits the possibility for lending which is based on financial statements or credit rating or cash flow lending. Berger and Udell (2004) add that under financial statement lending, the lender lends viewing the expected future cash flow of the company and treats it as a primary source of repayment. Therefore, banks are seen lending based on relationship or collateral securities. The dilemma of MSMEs increase, when they are even restricted from working capital loans (Dalberg, 2011).
He adds, banks either get reluctant to lend MSMEs due to high administrative costs, lack of skills and high risk of investment or lend them at high interest rates and collateral security. Certain times, banks have been recorded for charging more than 150% of the loan amount in collateral security and 5 to 6% interest rates higher than large firms. Nevertheless, Banerjee (no date) replies that a large portion of the capital required by MSMEs come from lending by NBFCs (Non Banking Financial Institutions) and it is seen that in the absence of collateral security, firms are even ready to pay higher interest amount than banks just in order to gain access to finance. Hence, changes in the interest rate can affect the capital structure decision of the firms because they are more likely to use debt when the cost of borrowing is low (Deesomsak et al. 2004).
Further Theorist has taken the stream of debt finance to a positive side, Antoniou et al., (2008) explains that increase in debt ratio justifies the quality of the firm, and lenders get ready to lend. Therefore, the free cash flow theory implies a positive relation between leverage and profitability. Jensen (1986) advocates that the fear of non repayment of the loan becomes an effective striving force to make organizations efficient.
Equity Financing
The equity financing is varied in its own nature, starting from own share capital to partners to private equities to public equity. Scott (1977) proclaims that companies which are unable to provide collateral security, either need to pay higher interest amount, or have to issue equity. However, in this paper, it shall be interesting to know that how business owners in India deal with such stiff conditions. Till now, we have read that debt finance is already tough for MSMEs, and if similar situation is with equity financing then what assist them to sustain?
Historically, a few external equity providers were there in developing countries. Whether it was business angels or venture capital, this industry still looks comparatively new, and most players in this industry have not globalised yet. Furthermore, equity financing is also affected due to similar reasons as of debt financing, such as asymmetric information, easy market access etc. Interestingly, entrepreneurs in developing countries have little familiarity, literacy and affinity with the equity model or equity financing. Nevertheless, in this last decade a private equity sector has risen (Dalberg, 2011). In India's case, I assume SIDBI (Small Industrial Development Bank of India) and SME Chamber of India have contributed to this sector of India.
The company's ability of fund raising in its early stages of development in the capital market is noticeably beneficial because companies tend to increase their equity base and can grow quickly. Subsequent effect of this growth paces up the 'dissemination of new technologies' throughout the industry and boosts economy (Banerjee, no date). Raising IPO's or raising capital through stock exchange is not easy for MSMEs. The prerequisites are above SME's reach and oppose them to participate publicly.
Banerjee (no date) claims that organisations tend to become leveraged while on the growth path. At a certain point, banks become reluctant to lend further loan. Because equity capital brings strength to the leveraged statements therefore either the entrepreneur will have to himself induce the requisite level of equity or through promoters or need to do without the capital. However, Shirai, S. (2004) adds that MSMEs, find it difficult and expensive to issue equity and therefore raise through banks.
Equity financing through the access to equity market, not only helps the firm to raise long term capital but also gives extra credit because of additional 'equity cushion' being available (Banerjee. A, no date).
Debt vs. Equity
Pandey's (1984 cited in Anand, 2002:44) study of 30 Indian firms probes corporate managers' conceptual understanding of the cost of capital and optimum capital structure. Most of the respondents consider equity share capital as the most expensive and long-term debt as the least expensive source of finance. The low cost of debt due to tax advantage of interest and long procedures involved in the issue of equity capital led to strong preference for debt by the managers. In contrast, Banerjee, (no date) blames high debt to be the reason behind low figures of M & A. He pointed out highly leveraged balance sheets as the significant reason for the same, which means high on debt and low on equity. Therefore he fears that unless there is a strong balance between debt and equity, it would be difficult to promote M&A activity in India.
As per the Anand (2002), Loans from financial institutions and private placement of debt are the commonly used sources of finance. He stated that as per the time of survey, Fifty-nine per cent and Thirty Three per cent of the respondents have pointed loans from financial institutions and private placement of debt as the most significant source of finance respectively. He further added that the large firms more likely to use bonds issue in the primary market in comparison to small firms. He further stated that the loans from DFIs like SIDBI(Small Industries Development Bank of India) in India or private placement of debt or bonds issue in the primary market is preferred more by the low growth firms than the high growth firms. In this paper, it is further discussed in the findings that what MSMEs prefer while acquiring loans.
The aim of this paper is to closely identify the base of the decision made by MSMEs in India. The capital structure theories play a vital role in setting the capital source of an organisation. It forces companies to plan and decide the best suitable source considering firm specific or country specific factors. However, as per capital structure literature, these determinants vary in case of comparison between SME's and large firms.
Capital Structure Theories
Trade off theory
Scott (1977) says that optimal debt ratio of a firm is suppose to be determined by a trade-off made between interest tax shield and bankruptcy cost. The firm need to balance the value of tax advantage of debt against various costs of financial distress (Myer, 1984). I assume that the balance criterion depends upon lot of factors. Myers (1984) adds that the firm needs to proxy debt for equity, or equity for debt, until the firm attains the maximised value.
Scott (1977) continues that expected cost of financial distress decreases with rise in profits and it let firms raise their leverage and increase their tax benefits. Which reflects that Firms would prefer debt over equity till the point financial distress doesn't start affecting the firm. The cost of financial distress is determined by the type of assets a firm has. A firm with more tangible assets like land and equipments shall have low cost of financial distress in comparison to a firm with more intangibles. During bankruptcy, tangible assets will have more market value, than intangibles, as they will 'lose their value'. Risk reckoned while lending to firms with higher tangibles is lower. Therefore, a positive relationship is anticipated between leverage and tangibility (Antoniou et al., 2008). Same has been even supported by (Deesomsak et al., 2004). This highlights that a firm with high intangibles should have a bent towards bankruptcy cost than tax advantage while making the trade-offs. This research paper has a focus on MSMEs, therefore, Berryman (1982) advocates that MSMEs are considered risky because they have higher probability of insolvency as compared to large firms.
Whereas, tax advantage is more rightly related to large firms as they are more likely able to generate high profits. Micro and small firms are less likely to have high profits, the tax advantage may not be the beneficial reason to choose debt financing for the interest tax shield (Pettit and Singer, 1985). The same is even supported by Graham and Harvey (2001), the interest tax shield is important and suitable for large, regulated, and listed firms, and such organisations have high corporate taxes and therefore they lean to use debt. Large firms can borrow more because of their high debt capacity, and it can maximize their tax benefits. They have low asymmetry in information and have easy access to debt market. This reflects a positive relation between leverage and size of the firm (Antoniou et al., 2008).
'The magnitude of this effect should be related to the size of the tax burden' (Brounen and Eichholtz, 2001). However, Deesomsak et al. (2004) adds nevertheless firms can imply non-debt tax shields like depreciation to reduce corporate tax. This implies that high NDTS tends to reduce the tax benefit and low NDTS tends to increase the tax benefit. Demirguc-Kunt and Maksimovic (1996) complemented by stating that countries like US, and Japan have very few Non Debt Tax Shields in comparison with European countries. Hence, NDTS has a significant influence in determining the capital structure of European countries. India's rate of depreciation on general machinery and equipment is twenty five percent.
The paradox is, it is obvious that high tangibility will lead to high NDTS, and as discussed in the previous paragraph, high NDTS tends to reduce the tax benefit. It means that because high tangibility is positive to leverage, will basically reduce the tax benefit upon taking the debt.
Therefore, collateral is positively related to leverage for both MSMEs and large companies, whereas tax advantage posses positive relation to leverage for only large firms and not for MSMEs (Bas et al. 2009).
Pecking order Theory
Myers and Majluf (1984), states that capital structure is the framework the way a firm require to finance its investments, he ranks the requirement in three steps, first internally, then with debt which is low at risk, and finally with equity as a last option. Therefore, the firms financing pattern move from internal to external.
Nevertheless, Myers and Majluf (1984) using the Pecking Order theory, claims that firms prefer internal funds rather than debt in case, the internal equity is sufficient enough. This anticipates high profitability of the firm, because it can sustain on retained earnings. Hence, profitability is expected to have negative relation with leverage with large firms. At the same time, firms with high profits prefer not to raise external equity in order to avoid dilution of ownership. Therefore, an inverse relationship is expected between profitability and leverage (Deesomsak et al. 2004). Other studies including Rajan and Zingales (1995) have found the negative relationship too by referring listed firms.
The pecking-order theory claims that managers prefer internal finance because of the informational asymmetry anticipated between managers and outside investors. Such asymmetric information is expected in MSMEs. However, Sogorb-Mira, (2005) says that MSMEs also imply pecking order theory in their structure. The owners of the micro, small and some medium firms are also the managers and mostly they do not prefer to dilute the ownership of the organisation. It results in internal financing to external resources of finance. Therefore, as per Bas et al. (2009) profitability is inversely related to leverage for small and large firms.
Agency Theory
Agency theory is about the costs which occur due to conflicts of interest between shareholders and managers (Jensen and Meckling, 1976). Bas et al. (2009) argues that mostly small have more concentrated ownership and shareholders likely to run the firm also and this decreases the conflicts between shareholders and managers. Deesomsak et al. (2004) argues that if concentrated ownership and management is handled by few same people, then there is a strong chance of expropriating 'minority stakeholders'. Bas et al. (2009) says that however, low debt is not just due to low agency problems but also due to the presence of other factors like size of the firm, absence of any tangible assets in the case of micro and small firms which are service based or consultancy based and those with low repaying capacity due to tight cash flow. Therefore, having low debt is not just because of low agency problems but also the absence of other resources mentioned above.
Jensen and Meckling (1976) identify one more conflict under agency cost, i:e conflicts of interest between debtholders and equityholders. It says that if a firm acquires a debt, then the equityholders tend to invest sub optimally. It explains further that, if there are large return yield from the investment, equityholders will detain the profits, on the other hand, if the investment yield low returns or it fails then the consequences will be borne by debtholders. In short, under both the consequences, equityholders will gain. Nevertheless, he further debates that if the investment made in a risky project fails, so it will decrease the value of the equity. The loss in equity value from the poor investment can be more devastating than gain in the equity.
Institutional Characteristics
Rajan and Zingales (1995) found that the firm specific factors, such as size, profitability, and tangibility of assets are important in US as well as in other countries. They have also highlighted that there is a stark disparity across G-7 countries in terms of institutional factors or called as country specific factors, such as bankruptcy law, creditor's rights, ownership concentration and taxation will be able to help in explaining the fluctuation in the capital structure decision across countries.
Franks and Torous (1993) explains that U.K. and U.S.A. bankruptcy codes have a major difference in their nature. For instance U.S.A. bankruptcy code has a strong determination to keep the firm as a 'going concern'; whereas, in contrast U.K. code stresses and secures the rights of creditors claim and this 'leads to premature liquidations'. Anon (no date) The author states that Indian bankruptcy code is alike U.S.A. and India's system is run by the Sick Industrial Companies Act (SICA) (1985), which declares a company sick when its 'entire net worth has been eroded' and it is further recommended to the Board for Industrial and Financial Reconstruction (BIFR). BIFR states that as soon as a company registers with us, it will immediately get protection from creditors' for a period of atleast four years. Deesomsak et al. (2004), considering four countries Thailand, Malaysia, Singapore, and Australia, have empirically shown that firms in countries with better protected creditors' right are more leveraged. He further claims, Australia has the lowest level of creditor's protection and therefore it is obvious for Australian lenders to ask for added collateral security.
Firms in the Asia pacific regions are highly family owned and it reduces the asymmetric information between lenders and owners. This leads to 'lower transaction cost' and easy access to debt market. Hence, there is a positive relation anticipated between ownership and leverage (Anon, no date). However, Deesomsak et al. (2004) in contrast claims that there is a negative relationship between ownership concentration and leverage, because debt can mitigate the problems like 'moral hazard' and 'adverse selection problems'.
Anon (no date) author says that Indian firms are mostly family owned like other Asia Pacific regions therefore ownership concentration may be able to clarify the variation in the capital structure decision.
Is future Bright?
Banerjee (no date) describes the past stating that OTCEI Initial Public Offering (IPO) norms were difficult and tough for SME's, policies and procedures were too demanding and stringent. He compared the efforts with AIM (Alternative Investment Market), the sub market of LSE (London Stock Exchange), which is altered and tailored for SME's growth. AIM provides the combination of a public quotation with a flexible and suitable regulation; it allows SME's to trade shares with a more flexible regulatory system than the main market (Banerjee, A. no date). It was launched in 1995, AIM has more than three thousand companies listed currently raising more than sixty billion pounds and companies are not required to have a particular financial track record or any trading history to enter AIM (AIM, 2012).
Banerjee (no date) further argues that one of the major reasons behind OTCEI's failure was the apathy of the promoters. After the failure of OTCEI setup, in India again after almost two decades an effort can be seen to assist growing companies to stabilise the economic development. BSE SME Exchange would provide a great opportunity and a platform to the entrepreneurs and investors to raise equity capital at a faster rate for the growth and expansion of MSMEs. Its success is directly proportionate to India's economic stability. It would provide immense opportunity for big and small investors to identify and invest in promising MSMEs (BSESME, no date). It also claims that it will simplify and unleash the valuation of companies and shall create wealth for all stakeholders along with income tax benefits.
Graham and Harvey (2001) say that it's an interesting fact that financial managers are much less likely to follow the academically proscribed factors and theories when determining capital structure. He further says that there are relatively weak supports for many capital structure theories at the moment and it indicates that it is time to critically re-evaluate the assumptions and implications of these mainline theories. Alternatively, perhaps the theories are valid descriptions of what firms should do but corporations ignore the theoretical advice. While the survey of this paper as well, I promised to share the findings of my research, however, it's imperative to know that how many firms would even refer and shall make efforts to remodel the capital structure. Nevertheless, I differ to the last possibility stated by Graham and Harvey (2001) that business schools might be better at teaching capital budgeting and the cost of capital than at teaching capital structure because if we refer to above mentioned literature there is no set pattern or base to set capital structure, however there can be certain business indications to make it optimum.
