Capital structure in India: implications for the development of bond markets.

Author:Chauhan, Gaurav Singh


Unlike many other emerging markets, debt ratios in India remain low and falling over the years. While low debt ratios can be a conscious choice of firms in growth phase, firms in India seems to be deprived of the availability of credit through poor credit market infrastructure and its development. Low debt ratios coupled with higher tax rates entail higher tax payments by the firms in India. More importantly, government seems to rely heavily on these tax receipts to finance its fiscal expenditure. While development of debt markets would benefit the firms, it would seriously distort the magnitude of fiscal deficit in India. The article here highlights this moral hazard with government of India to develop debt markets in India.

Keywords: debt ratios; fiscal deficit; corporate financing; value creation; tax benefits.

JEL Classifications: E60; E62; G32; G38


    One of the core agenda in the Fiscal Responsibility and Budget Management (FRBM) Act, 2003 is to improve the management of public funds and achieve a sustainable level of fiscal deficit in India. While FRBM speaks of the responsibilities of the government to finance its expenditures largely through its receipts, it remains silent on the optimality of the ways to incur expenses and earn revenues. Quite pertinently, a wholesome legislative provision for sustain ability of fiscal deficit, in spirit, would certainly take care of the stability of the means of financing the deficit.

    Unfolding the data available on fiscal deficit, the break-up of government receipts shows that the percentage contribution of corporate taxes becomes significant overtime. Corporate taxes as a percentage of total government receipts were 7.51% in 1992, which steadily rose to 29.08% in 2012. Figure 1 shows the trend. While increased share of corporate taxes in total receipts may be an outcome of growing corporate sector overtime, it becomes imperative to systematically understand the source of this buoyancy. This is because the stability of fiscal deficit cannot be ascertained if the increased share of corporate taxes is not a natural evolution or could not be fully explained by growing corporate sector.


    Important determinants of the magnitude of taxes paid by the firms are their operating income, interest expenses and tax rates. While tax payments would increase with higher earnings and tax rates, firms could save taxes by incurring higher interest expenses for their borrowings. If increasing tax receipts in government exchequer is due to growing corporate sector or increased earnings alone, one would expect the ratio of tax paid to operating income to remain stable overtime, at a constant tax rate. However, the ratio of taxes paid by firms to their operating income increased almost consistently since 1992 in India. Importantly, tax rates in India remained fairly stable over this period. This is possible when firms would choose to incur lesser interest expenses owing to lesser borrowings as they tend to grow further.

    While there are several determinants which describe the optimal debt capacity of firms, any choice of capital structure (1) or leverage by a firm is a conscious choice of increasing value for its investors to the fullest extent possible. In other words choosing low or high leverage must be accompanied by increasing profitability or higher value creation by any firm.

    In Indian context, we see a trend where debt ratios (2) of firms show a steady decline over a period of time. Interestingly, such a trend is quite contrary to the trend in other emerging markets (3) where debt ratios are consistently increasing over time. While region specific characteristics might suggest varying pattern of debt ratios suited to their firm's requirements, our preliminary analysis in this article suggest that declining debt ratios in India is probably not supported by increasing profitability of firms. Moreover, other firm level characteristics which seem to explain increasing debt ratios in other emerging markets show a similar pattern, on an average, in India too. This suggests that low debt ratios in India may be primarily due to the restricted availability of credit to the firms. Such availability, in part, is attributable to the repressive policy regime of underdeveloped credit markets in India.

    A critical underpinning of the source of low debt ratios in India is important in order to appreciate the sensitivity of government receipts to the change in leverage structures of the firms in India. Further, non-endogenous choice of leverage for firms in India will have adverse implications regarding the sustainability of fiscal deficit and the competitiveness of Indian firms globally. Low debt ratios imply higher tax receipts for government which therefore faces a moral hazard to develop bond markets in India. Further, restricted credit to Indian firms looms large for their global competitiveness at a time where Indian markets are increasingly accessible to foreign players through measures such as systematic increase in FDI limits for several sectors including retail.

    In this article we will take a closer look into the issues discussed above as follows. Section 2 describes the theoretical discussion on choice of leverage structure by firms and empirical findings associated with major determinants of leverage. Section 3 elicits trends in the leverage structure and its determinants identified in section 2 for Indian corporate sector. This section explores the possible explanation for low debt ratios in India due to the plausible determinants of capital structure. Section 4, will highlight development of debt markets and availability of credit in India. Section 5, will take up important implications for low debt ratios in India. Section 6 provides the conclusion.


    According to Modigliani and Miller (1958), under certain conditions where there are no taxes and there is no asymmetry of information, capital structure does not matter for the value created by firms. However, in absence of such idealistic conditions, we see that firms devote excessive attention to the design of their capital structures. Firms can attribute their choice of capital structure to several factors. A prime reason for firms to choose different claims for their investors is to reduce agency costs involved with management (4). Owing to information advantage, managers may not exert adequate efforts so as to maximize value of the firm or its investors. Governance structures are enabled by issuing variety of claims. These claims are such that they can monitor or occasionally intervene in the management of firms.

    Other considerations in the literature (5) which describes the choice between debt and equity claims relates to corporate taxes, non-debt tax shields, size of the firm, nature of assets, profitability, availability of debt, growth opportunities and degree of investor's protection or enforcement of financial contracts. While there are several other variables being tested across time, the above mentioned factors are some of the determinants which have got considerable and consistent empirical support in the literature.

    Interest payments on debt claims are tax deductible in most of the countries. Thus, for the same level of operating income a firm having more debt would save more in taxes and hence more can be returned to the owners i.e. equity holders. This in turn leads to higher profitability for the owners as measured by return on equity. However, excessive debt can further lead to bankruptcy owing to the fixed nature of the claims. Thus, solely based on tax considerations, there is a tradeoff in choosing debt for more value creation for owners and the probability of default by a firm (6). In fact, theory suggests an optimal debt level where the value of the firm is maximized. The tradeoff between tax savings and financial distress is mentioned in the literature as static tradeoff hypothesis. Notwithstanding this tradeoff, we can generally infer that higher tax rates would induce firms to take on more debt for the same probability of default. Literature does provide evidences for such inferences. For example, Desai et al. (2004) document that higher local tax rates are associated with higher debt ratios in multinational firms.

    Firms can alternatively save taxes by incurring heavy depreciation, depletion, and amortization expenses for their assets. In such a case, these expenses tend to substitute interest payments (7) by firms and hence a negative relationship between the presence of non-debt tax shields and debt ratios can be expected (8). However, empirical tests on the relationship between the two variables seem to show inconclusive or mixed results. Some of the studies show insignificant or even positive relationship between these two factors (9).

    Empirically it has been found that larger firms have lower probability of default and are also able to economize on cost of financial distress in case of default. Further, asymmetry of information is less critical for large firms as compared to the smaller ones. This suggests that larger firms tend to have higher debt in their books. A positive relationship between size and debt is documented in Marsh (1982), Rajan and Zingales (1995), and Frank and Goyal (2003), while Titman and Wessels (1988) find a negative relationship.

    Nature of firm's assets or their degree of tangibility also seems to have significant effect on debt ratios for firms. Since tangible asset can well serve as good collateral, larger tangible assets in a firm is associated with higher debt ratios. A positive correlation between asset tangibility and debt has been shown in several studies including Scott (1977), Friend and Lang (1988), Harris and Raviv (1990), Rajan and Zingales (1995), and Frank and Goyal (2003).

    As per the pecking order hypothesis of Myers and Majluf (1984), owing to informational asymmetries firms will turn to debt financing when internal...

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