CHAPTER 2

REVIEW OF LITERATURE AND

THEORETICAL FRAMEWORK
2.1 REVIEW OF LITERATURE
The purpose of this chapter is to provide a detailed review of relevant literature in order

to frame the study. As far as the study on capital structure is concerned, a lot of

research has been undertaken so far by various researchers all over the world. The review

of some of the major studies has been undertaken so as to develop a clear understanding

of the significance of capital structure and also to be acquainted with the existing

knowledge in the area in which the study on the proposed topic is going to be conducted.

Chen et al. (2024) explored the impact of capital structure on profitability across various

industries, revealing significant variations in how different sectors respond to debt and

equity financing. Their study found that in the technology sector, firms with higher

equity financing outperformed those with higher debt due to the industry's volatile nature
and the need for flexible capital structures. Conversely, firms in the utilities sector

benefited from higher leverage because of stable cash flows and lower financial risk.

This research underscores the necessity for industry-specific capital structure strategies

to optimize profitability, indicating that what works in one sector may not be effective in

another.

Kumar and Singh (2024) conducted an in-depth analysis of the manufacturing sector in

Asia, focusing on how leverage influences corporate profitability in the current economic

climate. Their research highlights that moderate levels of debt can positively impact

profitability by providing tax shields and reducing the agency costs associated with

equity financing. However, they also caution that excessive debt can lead to financial

distress, which outweighs the benefits of leverage and negatively affects profitability.

The study emphasizes the importance of maintaining an optimal capital structure to

maximize profitability, suggesting that firms with a strategic balance between debt and

equity tend to perform better.

Miglo, A. (2023) This review synthesizes recent developments in capital structure

theories, emphasizing the integration of behavioural finance and corporate governance

perspectives. Miglo discusses how traditional theories like the pecking order theory and
trade-off theory have evolved to incorporate insights from psychology and governance
practices. The review highlights empirical findings that challenge conventional wisdom,

such as the impact of managerial overconfidence on capital structure decisions.

Baltagi et al.. (2013) explored the dynamics of capital structure decisions using panel

data analysis. Their study focused on analysing how firm-specific characteristics,

macroeconomic factors, and industry conditions influence firms' leverage choices over

time. Baltagi et al.. employed advanced econometric techniques to examine the

determinants of capital structure across different sectors and countries, providing

empirical evidence on the factors driving optimal financing decisions. Their research
contributed to understanding the complex interactions between financial variables and

economic environments in shaping corporate capital structures.

Bebchuk et al. (2009) examined the impact of corporate governance practices on firm

behaviour and performance. Their study focused on the mechanisms through which

governance structures influence capital structure decisions, executive compensation, and

overall corporate strategy. They emphasized the role of shareholder rights, board

independence, and managerial incentives in shaping optimal governance frameworks that

enhance shareholder value. Bebchuk et al.'s research contributed to the understanding of

how governance reforms can mitigate agency conflicts and improve corporate decision-making
processes.
Frank and Goyal (2009) conducted an extensive analysis of capital structure decisions,

focusing on the factors that consistently influence firms' financing choices. Their study

synthesized empirical evidence to identify key determinants such as profitability, growth

opportunities, and firm size in shaping optimal capital structures. They emphasized the

importance of understanding these factors in the context of both theoretical models and

real-world corporate finance practices. Frank and Goyal's work has been pivotal in

refining our understanding of how firms navigate financial markets to achieve optimal

capital structures.

Kaplan and Stromberg (2009) investigated the role of leveraged buyouts (LBOs) and

private equity in influencing capital structure decisions and firm behaviour. Their study
examined how LBOs affect corporate financing choices, including debt levels and capital
allocation strategies. They highlighted the impact of private equity ownership on
corporate governance, operational efficiency, and financial performance. Kaplan and

Strömberg's research provided insights into the mechanisms through which financial

restructuring and private equity investments reshape corporate capital structures and

strategies.

Chava and Roberts (2008) investigated how financial constraints impact the

relationship between capital structure and firm performance, highlighting the varying

effects across different market environments. Using a regression discontinuity design,

they find that capital expenditures decline by approximately 1% of capital per quarter in
response to covenant violations.

Kisgen (2006) examined the relationship between credit ratings and capital structure

decisions in firms. His study explored how firms' credit ratings influence their access to

debt financing, the cost of capital, and overall capital structure choices. Kisgen found

that firms with higher credit ratings tend to maintain lower levels of debt and enjoy lower

financing costs due to reduced perceived credit risk. His research provided empirical

evidence on the strategic importance of credit ratings in shaping optimal capital

structures and financial policies of corporations.

Gaud et al. (2005) conducted a study on the capital structure of Swiss companies using

dynamic panel data analysis. Their research aimed to understand the determinants of

capital structure decisions across different sectors and firm sizes in Switzerland. They

explored factors such as profitability, growth opportunities, and industry characteristics

in shaping firms' leverage choices over time. Gaud et al.'s findings provided insights into
the complexities of capital structure dynamics in a specific national context, contributing

to the broader literature on corporate finance and capital structure theory.

Almeida et al. (2004) This review examines how macroeconomic conditions influence

capital structure decisions, emphasizing the role of economic uncertainty and interest rate

fluctuations in shaping firms' financing choices. They hypothesized that the constrained

firms should have a positive cash flow sensitivity of cash, while unconstrained firms‘

cash savings should not be systematically related to cash flows. They empirically
estimated the cash flow sensitivity of cash using a large sample of manufacturing firms
over the 1971 to 2000 period and the robust support for the theory

Gompers et al. (2003) examined the relationship between corporate governance

practices and firm performance, with a focus on how governance structures influence

capital structure decisions. Their study analysed a large sample of firms to assess the

impact of various governance mechanisms, such as board composition and shareholder

rights, on capital structure choices. They found that stronger governance practices tend to

lead to more conservative capital structures, reflecting better alignment between

managerial actions and shareholder interests. Gompers et al.'s research underscored the
importance of effective corporate governance in shaping firms' financial policies and

overall performance.

Baker and Wurgler (2002) introduced the market timing theory of capital structure,

which posits that firms adjust their capital structures based on the perceived valuation of

their equity. According to this theory, firms tend to issue equity when their stock prices

are high relative to their intrinsic values, and they repurchase shares or issue debt when

stock prices are low. Their empirical analysis provided evidence that market timing

influences capital structure decisions, suggesting that firms exploit market mispricing to

optimize their financing choices over time. Baker and Wurgler's research highlighted the

dynamic nature of capital structure decisions in response to market conditions and

investor sentiment.

Chan et al.. (2001) investigated structural breaks and the applicability of capital asset

pricing models (CAPM) within Taiwan's electronics industry. Their study explored how
market dynamics and industry-specific factors influence capital structure decisions and

asset pricing models. They highlighted the importance of understanding structural

changes and market anomalies in financial modelling and strategic financial management.

Chan et al.'s research provided insights into the complexities of capital structure

determination in dynamic economic environments.

Graham and Harvey (2001) conducted a survey study to assess the factors influencing

corporate financial policies, including capital structure decisions. Their research

collected responses from financial executives regarding their perceptions of capital
structure theories and practices. Graham and Harvey found that factors such as tax

considerations, firm-specific characteristics, and market conditions significantly

influence capital structure choices. Their study provided valuable insights into the

practical application of capital structure theories in corporate finance and highlighted the
importance of managerial perceptions and decision-making processes in shaping

financial policies.

Hirshleifer (2001) explored the influence of investor psychology on asset pricing and

financial decisions. His research focused on how psychological biases, such as

overconfidence and herding behaviour, affect capital structure choices and market

outcomes. Hirshleifer's work highlighted the role of psychological factors in shaping

investor perceptions of risk and return, impacting firms' financing decisions and overall
market dynamics. His insights contributed to the understanding of behavioural finance and

its implications for corporate finance theory and practice.

Ozkan (2001) examined the relationship between corporate profitability and capital

structure decisions. Her research focused on how variations in profitability influence

firms' preferences for debt versus equity financing. Ozkan's study provided empirical

evidence suggesting that profitable firms tend to use more debt in their capital structure

to leverage their earnings and enhance shareholder returns. Her findings contributed to
understanding the strategic considerations and trade-offs involved in determining optimal

capital structures based on firm profitability levels.

Graham (2000) investigated the tax benefits of debt financing and their impact on

corporate capital structure decisions. His study analysed how tax shields provided by

interest expense affect firms' optimal mix of debt and equity financing. Graham

highlighted that tax advantages incentivize firms to use debt to reduce taxable income,

thereby lowering the overall cost of capital. His research emphasized the strategic use of

debt in maximizing shareholder value through tax-efficient financing strategies.

Rajan and Zingales (1995) explored the impact of firm-specific characteristics on

capital structure decisions across international markets. They found that factors such as
growth opportunities, profitability, and asset tangibility influence whether firms choose
debt or equity financing. Their study highlighted the importance of institutional and

market differences in shaping capital structure choices, providing empirical evidence that

challenged traditional theories like the pecking order and trade-off theories. Rajan and

Zingales' work remains influential in understanding the diverse factors that determine

optimal capital structures in various economic environments.

Leland (1994) proposed a model emphasizing the value of financial flexibility in capital

structure decisions. His theory suggests that firms should maintain a balance between debt and
equity to preserve flexibility in financial distress, thereby maximizing firm

value. Leland's framework highlights the strategic importance of liquidity management

and the ability to adjust capital structure dynamically in response to changing economic

conditions. His work contributed to understanding how financial flexibility can enhance
resilience and long-term performance in corporate finance.

Harris and Raviv (1991) developed a comprehensive theory of capital structure that

integrates informational asymmetries between managers and investors. Their model

explores how the availability and reliability of information impact firms' financing

decisions, suggesting that debt can serve as a signalling mechanism to mitigate adverse

selection problems. They highlight the informational role of debt in conveying firm

quality and influencing investors' perceptions of risk and profitability. Harris and Raviv's
framework has been influential in understanding the strategic use of debt and equity

financing to manage informational asymmetries in corporate finance.

Titman and Wessels (1988) investigated the determinants of capital structure choices

among firms. Their study empirically analysed factors such as profitability, growth

opportunities, and asset tangibility, finding that these variables influence firms'

preferences for debt versus equity financing. They proposed that firms choose capital

structures that balance tax advantages of debt with costs such as bankruptcy risk and

agency costs. Titman and Wessels' research contributed to the understanding that firms'

financial decisions are shaped by a combination of internal factors and external market

conditions.
Bradley et al. (1984) investigated the existence and implications of an optimal capital
structure for firms. Their study provided empirical evidence that firms tend to deviate

from theoretical debt ratios, influenced by factors such as industry characteristics, tax

considerations, and managerial preferences. They argued that while firms may target an

optimal capital structure, market imperfections and firm-specific conditions often lead to

deviations from these targets. Bradley et al.'s findings contributed to the understanding

that capital structure decisions are influenced by a complex interplay of internal and

external factors, rather than conforming strictly to theoretical models.

Myers S.C. (1984) introduced the pecking order theory of capital structure, which
suggests that firms prefer internal financing over external financing (debt or equity) due

to the costs associated with asymmetric information. According to this theory, firms tend to
issue debt only when internal funds are insufficient, and equity issuance is seen as a
last resort to avoid sending negative signals to investors. This theory has had a profound

influence on understanding how firms finance their investments and manage their capital

structures in the presence of information asymmetry.

Jensen and Meckling (1976) developed the agency theory of capital structure, which

explores the relationship between principals (shareholders) and agents (managers) in a

firm. Their seminal work suggests that managers, acting in their own interests rather than

in shareholders', may prefer less optimal capital structures to maximize their own utility.
This agency conflict motivates shareholders to monitor and structure managerial

incentives to align with shareholder interests, thereby influencing capital structure

decisions. Jensen and Meckling's theory has been instrumental in understanding how

agency costs affect corporate governance and financial decisions within firms.

Modigliani and Miller (1958) proposed that in perfectly efficient markets without taxes,

the capital structure of a firm—whether it is financed through debt or equity—does not

affect its overall value or profitability. Their theory asserts that investors can replicate the

firm's financial structure through their own choices, eliminating any advantage from

altering the mix of debt and equity. This concept fundamentally changed the

understanding of capital structure by suggesting that financial decisions related to

leverage have minimal impact on a firm's profitability in ideal market conditions.
2.2 THEORETICAL FRAMEWORK
Capital structure is defined as the decision about the proper balancing of cash inflows
between equity capital and debt capital through which the business finances its assets and
day-to-day operations. From a tactical perspective, it impacts everything from the firm‘s risk
profile, how expensive to float it up, how easy it is to acquire, return to the investors and
lenders, and the degree of insulation from both micro and macroeconomic downturns
Decision about capital structure is crucial to the firm since it has a direct impact on its
financial performance, and hence, the financial executives should emphasize various aspects
of capital structure. After deciding a firm‘s investment policy, it should plan the various
possible sources from which the required fund is to be procured. Firms having not a well-
planned capital structure are likely to have an uneconomical and imbalanced capital structure
and could face unforgivable difficulties and problems in raising capital on favourable terms in
the long-run and produces an adverse impact on its financial performance

THE CONCEPT OF OPTIMUM CAPITAL STRUCTURE

The optimal capital structure is one that offers a balance between the ideal debt-to-equity
ranges that minimizes the cost of capital while maximizing the value of the firm. The optimal
capital structure is also defined as that ―combination of debt and equity that minimizes the
firm‘s overall cost of capital‖3. Thus, an optimum capital structure tries to optimize two
variables at the same time, i.e., cost of capital and market value of the firm. In other words,
an optimum capital structure facilitates to maximize the firm‘s value through minimizing the
weighted average cost of capital (WACC) of the firm. Theoretically, debt financing generally
offers the lowest cost of capital due to its tax deductibility, relatively low rate of interest, and
low cost of issue. Therefore, when a company employs more debt in capital structure, it will
lead to decrease the overall cost of capital

POTENTIAL DETERMINANTS OF CAPITAL STRUCTURE

The management policy regarding the capital structure decision of a concern largely
influenced by many factors such as trading on equity, nature of the business, interest in
retaining control, flexibility, conditions in the capital market, costs of floatation, liquidity,
size of the business, growth, corporate tax rate and regulatory framework. Since the capital
structure determines a firm‘s fiscal and organizational health, financial management has to
study the pros and cons of the various sources of finance to frame an optimum capital
structure by diversifying company debts and outstanding shares. .

Leverage

Leverage is an important term in capital structure. It can be defined as the use of available
fund or sources of funds from which a business must incur certain expenses. The impact of
leverage is felt more strongly in the case of debt because (i) the cost of debt is generally
lower than the cost of preference share capital, and (ii) interest paid on debt is a deductible
amount from profits when calculating taxable income. The two types of leverage are financial
leverage and operational leverage. Financial leverage is an important consideration when
planning a company's capital structure because it has an impact on earnings per share. If
companies have high level of earning then it contributes more profit and vice versa. Financial
leverage exists whenever a firm has debts or other sources of fund that carry fixed charges.

b. Growth and stability of sales

A company's capital structure is heavily influenced by the growth and stability of its sales. If
a company's sales are expected to be fairly consistent, it may be able to incur more debt.
Sales stability ensures that the company can meet its fixed obligations such as interest
payments and debt repayments. Similarly, the rate of sales growth influences the capital
structure decision.

c. Control

When a company requires additional funds, the management of the company wants to raise
the funds without losing control over the company. Equity share capital is kept minimum and
it is mostly subscribed by promoters, relatives, and their friends and therefore, whole voting
power is with them. in this way they do not lose control over the business.

d. Requirement of Investors

Another aspect that influences a capital structure of the company is investor requirements.
When debt financing is used, it is vital to suit the needs of both institutional and private
investors. Investors can be divided into three groups: bold investors, cautious investors, and
less cautious investors.

f. Capital Market Conditions

The existence of the market condition to which the company belongs is the next determinant
of its optimum capital structure. If the market is weak and business conditions are bleak, the
corporation should not issue equity shares because investors choose safety. Whereas during
inflation profit potentiality is high and demand of ordinary share rises and in such condition
equity share is issued and some of them issued at premium.

THEORIES OF CAPITAL STRUCTURE

 Net income approach

 Operating income approach
 Traditional approach
 Modigilani-Miller approach
 Trade-off theory
 Static trade-off theory
 Dynamic trade-off theory
 Agency cost theory
 Market timing theory
 Pecking order theory
 Free cashflow theory
PROFITABILITY
The main objective of a company is to earn profit because profit is necessary to survive and
grow over a period of time. The word profitability comprises of two words: Profit‖ and
―Ability‖, which means the company should have the ability to earn profit. There are various
methods for determining profitability. Profitability ratios are monetary ratios that address a
firm‘s profit associated with various business transactions or projects. They are very useful
tools for recognizing the inefficiencies/wasteful projects of a company and, as a result,
assisting management and owners in taking corrective steps. Profitability is the ability of a
firm or business to generate revenue over and above its expenses, and it is usually measured
using ratios such as gross profit margin, net profit margin, EBITDA, and so on

METHOD OF ANALYSING PROFITABILITY

Profitability ratio is used to evaluate the company‘s ability to generate income as compared to
its expenses and other costs associated with the generation of income during a particular
period. This ratio represents the final result of the company.
The following methods are used to analyse the profitability of any business:

1. Margin (or profitability) ratios

2. Break-even analysis (based on revenues and on units sold)

3. Return on assets and on investment

RELATIONSHIP BETWEEN CAPITAL STRUCTURE AND PROFITABILITY

a. Capital structure decisions are critical because they have a direct impact on a company's
profitability. As profitability grows, the amount of investment fund from retained earnings
increases over time, while the amount of debt in the capital structure decreases. Profitability
clearly has a positive relationship with business value.

b. The capital structure has an impact on the performance of the firm which should allow us
to identify potential quality and capital structure difficulties. In a highly complex and
competitive business climate, the modern industrial company must conduct its business. As a
result, these types of research findings will help in the selection of the capital structure in
order to reach the firm's optimal level of profitability.

c. Profitability can be boosted by debt capital. Debt allows firms to leverage their existing
funds, which helps them to expand faster. When debt financing is correctly used, it generates
revenue that exceeds the cost of interest payments.

d. Although debt is less expensive than equity, both capital financing have a substantial
impact on the profitability of the firm. A business with a very high debt capital structure pays
more interest each year, which helps to reduce net profit.

TECHNIQUE FOR CAPITAL STRUCTURE ANALYSIS

Capital structure analysis involves evaluating how a company finances its operations and
growth through a combination of equity and debt. Techniques include quantitative metrics
like debt ratios, equity ratios, and interest coverage ratios, which provide insights into the
proportion of debt versus equity used, financial leverage, and the company's ability to meet
interest obligations. Qualitative factors such as industry dynamics, management strategy, and
regulatory environment are also considered to assess the appropriateness and sustainability of
the chosen capital structure.

1. RATIO ANALYSIS
Ratio analysis stands out as one of the most widely embraced techniques in financial analysis.
It is considered among the earliest financial tools developed for the systematic examination
and interpretation of financial statements. By utilizing financial statements such as balance
sheets and income statements, ratio analysis provides a methodical approach to assess a
company's financial health across critical dimensions such as profitability, liquidity, and
market [Link] analytical method is particularly valuable because it allows external
observers to gauge internal business dynamics using publicly accessible financial data. By
comparing a company's financial metrics against industry standards or its own historical
performance, ratio analysis offers insights into its relative financial position and performance
trends over [Link] its core, ratio analysis involves quantitatively interpreting a company's
financial performance

ADVANTAGES OF RATIO ANALYSIS

1. It makes it easy to grasp the relationship between various items and helps in understanding
the financial statements.

2. Ratios indicate trends in important items and thus will help in forecasting.

3. Ratio may be used as a measure of efficiency.

4. Ratios are very useful for measuring the performance and very useful in cost control.

5. Ratios can effectively communicate what has happened between two accounting dates.

6. Standard ratios may be computed. Comparison of actual ratios with standard will help in
control.

7. It throws lights on the degree of the management and utilization of the assets and that is
why it is called surveyor of efficiency. They help the management in decision making.

8. It helps in the simple assessment of liquidity, solvency, profitability and efficiency of the
firm.

LIMITATIONS OF RATIO ANALYSIS

1. Ratio can be useful only when they are computed in a sufficient large number. A
single ratio would not be able to convey anything. At the same time if too many
ratios are calculated, they are likely to confuse.
 2. Ratio analysis gives only a good basis for quantitative analysis of financial
problems. But it suffers from qualitative aspects.
3. Ratios are computed from historical accounting records. So they also process
those limitations of financial accounting.
4. It is not possible to calculate exact and well accepted absolute standard for
comparison.
5. In the ratio Analysis Arithmetical window dressing is possible and firm may be
successful in concealing the real position.
6. Ratios are only means of financial analysis, but not an end in themselves. They
can be affected with personal ability and bias of the analyst.
7. Ratio analysis helps in providing only a part of information needed in the process
of decision making.

2. PROFITABILITY RATIO

NET PROFIT RATIO

The Net Profit Ratio, also referred to as Net Profit Margin, measures the profitability
of a company by indicating how much of each dollar of revenue translates into profit
after all expenses are deducted. It is calculated by dividing the net profit (total
revenue minus all expenses, including taxes and interest) by the total revenue and
multiplying by 100 to express it as a percentage. A higher net profit ratio indicates
better profitability and efficient management of costs relative to revenue, making it a
crucial metric for assessing a company's financial health and performance.
Net Profit Ratio = Net Profit / Total Revenue

RETURN ON INVESTMENT RATIO

Return on Investment (ROI) is a financial metric that measures the profitability of an
investment relative to its cost. It is calculated by dividing the net profit or gain derived
from the investment by its initial cost and then multiplying by 100 to express it as a
percentage. A higher ROI indicates a more profitable investment, where the returns
exceed the initial investment.
Return on Investment = Net Profit / Shareholder’s fund

 REGRESSION ANALYSIS
Regression analysis is a statistical method used to examine the relationship between a
dependent variable (response variable) and one or more independent variables (predictor
variables). It is a fundamental tool in data analysis and is widely used in various fields,
including social sciences, economics, finance, medicine, and engineering, among others.
The main objective of regression analysis is to model and understand the relationship
between the dependent variable and the independent variables. This understanding
enables researchers to make predictions, infer patterns, and draw insights from the data.
By quantifying the relationship between variables, regression analysis allows us to
estimate the effect of changes in the independent variables on the dependent variable.
COMPONENTS OF REGRESSION ANALYSIS
1. Variables
2. Assumption
3. Model specifications
4. Interpretation of Coefficients
5. Goodness of fit
6. Hypothesis testing
7. Model assumptions checking
8. Causal inferences
9. Multicollinearity
10. Model Validation and Diagnostics

TYPES OF REGRESSION ANALYSIS

There are several types of regression analysis, including:
1. Simple Linear Regression
2. Multiple Linear Regression
3. Polynomial Regression
4. Logistic Regression
5. Ordinal Regression
6. Time series Regression

ADVANTAGES OF REGRESSION ANALYSIS:

Regression analysis is a powerful statistical tool that offers several advantages, but it
also comes with limitations. Understanding both the advantages and disadvantages is
crucial to appropriately interpreting the results and drawing meaningful conclusions.
Additionally, regression analysis holds significant importance in various fields due to
its versatile applications.
Let us explore these aspects:
1. Quantifying Relationships
2. Prediction
3. Hypothesis Testing
4. Model fit assessment
5. Controlling for confounding variable

DISADVANTAGES OF REGRESSION ANALYSIS:

Regression analysis is a powerful statistical tool that offers several advantages, but it
also comes with limitations. Understanding both the advantages and disadvantages is
crucial to appropriately interpreting the results and drawing meaningful conclusions.
Additionally, regression analysis holds significant importance in various fields due to
its versatile applications.
Let us explore these aspects:
1. Assumptions
2. Correlation v/s Causation
3. Over fitting
4. Multi collinearity