Studies in Economics and Finance

Capital structure – does ownership structure matter? Theory and Indian evidence
Santanu K. Ganguli,
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SEF
30,1 Capital structure – does
ownership structure matter?
Theory and Indian evidence
56
Santanu K. Ganguli
Institute of Management Technology – Ghaziabad, Ghaziabad, India

Abstract
Purpose – Based on the agency theory, the purpose of this paper is to theoretically argue and
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empirically investigate how ownership structure impacts the capital structure of the listed mid-cap
companies in India and whether the capital structure as exogenous variable has a role in determining
ownership structure as well.
Design/methodology/approach – Simultaneity between capital structure and ownership structure
is checked through Hausman specification test on endogeneity. Fixed effect panel regression model is
used to analyze five years of data (2005-2009) on the sample units, to find the relation between leverage
and ownership structure after controlling for profitability, risk, tangibility, growth and size.
Findings – Empirical results on Indian firms suggest that the ownership structure does impact
capital structure but not the vice versa. Consistent with theoretical prediction empirical results reveal
that the leverage is positively related to concentrated shareholding and has a negative relation with
diffuseness of shareholding after controlling for profitability, risk, tangibility, growth and size.
The findings are consistent with “managerial entrenchment hypothesis” and “pecking order theory” of
capital structure.
Practical implications – The findings of the paper will enable the practitioners and analysts to
understand as to why, in the bank and financial institution-dominated debt financing system in India,
leverage is closely associated with concentrated ownership pattern and why retained earning is a
preferred vehicle of financing for the firms with diffused shareholding.
Originality/value – The results of the study enrich the literature on capital structure, agency cost
and corporate governance issues in several ways.
Keywords India, Corporate ownership, Capital structure, Ownership structure, Agency theory,
Concentrated shareholding, Diffused shareholding, Entrenched manager
Paper type Research paper

1. Introduction
Ever since publication of the seminal paper of Modigliani and Miller (1958) as regards
the role of capital structure decision on firm value, there have taken place phenomenal
research on the topic both theoretical and empirical – leading to creation of huge body
of literature in last 52 years.
The original simplistic assumption by Modigliani-Miller (MM) of no tax was altered
to factor in the impact of tax shield of interest expenses involved in debt financing.
This lead to evolution of “trade off” theory of capital structure. Besides trade off theory

JEL classification – G 32, G 34

Studies in Economics and Finance
Vol. 30 No. 1, 2013 The author wishes to sincerely thank colleague Debabrata Datta – Professor of Economics,
pp. 56-72 Institute of Management Technology, Ghaziabad (India), the Editor, Associate Editor and
q Emerald Group Publishing Limited
1086-7376
anonymous referees for their valuable comments and suggestion. The author takes responsibility for
DOI 10.1108/10867371311300982 any shortcomings and mistakes.
 the other two most important theoretical developments have been “pecking order” Capital structure
theory by Myers (1984) and “agency theory” of debt by Jensen and Meckling (1976).
Moreover, a number of empirical papers have come into existence in almost all the
countries (wherein private capital plays a major role in the economy) to investigate the
validity of the theories so far developed. Besides verifying theories, the empirical
studies have been able to highlight a range of major determinants of capital structure
like profitability, risk, tangibility, growth, size, corporate governance and agency cost 57
to the advantage of practicing finance professionals and analysts. In fact the field of
investigation is ever increasing.
In last two decades the role of corporate governance in finance has developed as a
distinct and dominant area of research. Empirical papers documenting relationship
between corporate governance and capital structure are comparatively more of recent
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origin. According to Shleifer and Vishny (1997) corporate governance deals with the
ways in which the suppliers of finance to the corporations assure themselves of getting a
return on their investment. Accordingly, the main and the long term supplier of finance
– that is, the outside equity shareholders must ensure themselves of getting return on
their investment in the company. The problem arises when there is separation of
ownership and management. The problem is one of principal and agent. When the
scattered outside investors provide fund to promoters or professional managers the
former have little to contribute afterwards, the latter can well run away with the money.
In sporadic cases they do but normally they do not. Most market economies have devised
system and mechanism by which the dispersed shareholders can monitor the managers.
“Agency theory” posits that debt acts as a disciplining mechanism as the lenders
monitor the action of the managers. Corporate governance literature is concerned with
the resolution of collective action problem confronted by the dispersed shareholding
pattern of the corporations. In all countries one of the most favored mechanisms for
resolving the collective action problem appears to be partial ownership and control
concentration in the hands of one or few large shareholders (block holding) as their
interest is more intensely aligned with the firm. Because of alignment of interest, the
block shareholders monitor the action and decisions of professional managers closely
and therefore may be looked upon as a mitigating device of agency problem in case of
separation of ownership and management. The argument leads to the research question
– if both debt and concentration of shareholding act as mitigating device of conflict of
interest issue between managers and share holders then what could be the possible
relation between debt (leverage) and concentration of shareholding?
On the other hand when the shareholding is dispersed the managers are subjected to
lesser monitoring and scrutiny by the shareholders. Managerial discretion is much
more in case of dispersed shareholding. In such case the management will take financing
decisions in a manner that prevents concentration of shareholding. If debt is raised for
financing, the managers can avoid insiders monitoring but subject themselves to
monitoring by the lenders. So what is preferable to entrenched managers, inside
monitoring by large shareholders or monitoring by the lenders? The question is of
paramount importance as Myers (2001) observes that firms presumably act in the
interest of some group or coalition of managers who make or are affected by the financial
decisions of the firm.
Elaborating on the above argument of agency issue we reason and empirically
investigate how and to what extent ownership structure impacts the capital structure
 SEF of the listed mid-cap companies in India. We also argue and explore (empirically)
30,1 whether the capital structure as exogenous variable has a role in determining
ownership structure as well. Our empirical models besides taking into consideration
concentration (and dispersion of shareholding) as determinants of capital structure
account for profitability, risk, tangibility, growth and size of the sample firms as other
control variables.
58 The results of the study enrich the literature on capital structure, agency cost and
corporate governance issues in several ways. First we provide a theoretical reasoning
based on corporate governance and agency theory literature that there should exist a
positive relation between leverage and concentration of holding. We argue that the
higher debt coupled with concentrated shareholding might help in resolving collective
action problem and reducing managerial discretion. Using the Indian context and data
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set we put the argument to empirical taste and find a positive relation between leverage
and ownership concentration. Margaritis and Psillaki (2010) record similar empirical
finding for French manufacturing companies. We provide an explanation for the result
as well. Pindado and De La Torre (2011) record that the larger debt increments are
promoted by outside owners when managers are entrenched. In Russian context Poyry
and Maury (2010) observe that the firms with owners having political influence or ties
to large financial groups have better access to debt.
Second we find a negative relationship between leverage and diffuseness of holding.
We provide a new line of reasoning for the negative relation in addition to “managerial
entrenchment” argument put forward by Kayhan (2008) in respect of lesser use of debt
by the self-interested entrenched managers. We argue that if the entrenched managers
are not subject to large shareholders’ scrutiny, they sought to avoid external scrutiny
by lenders as well using retained earning or issue of equity for investment rather than
going for debt financing. The result is likely to enhance agency problem as the
manager is neither subject to scrutiny by block shareholders nor lenders.
Third in the process of building our empirical model we blend ownership structure
that addresses collective action problem by the shareholders with other control
variables like profitability, risk, tangibility, growth and size determined empirically by
previous studies (the other control variables generally support “trade off” and “pecking
order” theory one way or other) to show the cumulative impact on capital structure.
Last though we extend theoretical reasoning from agency perspective that the
ownership structure as endogenous variable should be impacted by capital structure as
well, but we find little empirical support for the argument based on Indian data set.
The remainder of the paper is organized in the following way. Section 2 discusses
main theories, empirical determinants of capital structure and hypothesis. Section 3
describes the data and empirical model. Section 4 details the empirical result and
Section 5 concludes with summary of findings.

2. Theories, empirical determinants and hypotheses

The paper dealing with irrelevance of debt in capital structure for determining firm
value by Modigliani and Miller (1958) included a number of assumptions – one of
which was absence of corporate tax. Subsequently in 1963 when the corporate tax was
factored in the model by them (MM), it was found that theoretically the value of a firm
should increase with debt because of interest tax shield (Modigliani and Miller, 1963).
But monotonic increase of debt for higher tax shield increases bankruptcy cost
 specially when profitability is low and fluctuating. This leads to “trade off” theory of Capital structure
capital structure that postulates an optimum debt level or target level – at which
marginal increase of present value of tax saving is just offset by the same amount of
bankruptcy cost. Though exact target debt level may not be determined objectively in
a given situation, the theory explains the fact that there is a limit to debt financing and
the target debt varies from firm to firm depending on profitability, size, composition of
assets deployed, risk (fluctuation in profitability), growth and so on. A firm having 59
high and consistent profitability with lot of tangible assets that can be offered as
collateral security for debt should have a higher target debt ratio.
Consistent with the trade off theory Alderson and Betker (1995) using log (assets) as
proxy for firm size found a positive relationship between leverage and asset. Titman
and Wessels (1988) and Wiwattanakantang (1999) using log (sales) as proxy for firm
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size found positive but insignificant relationship between leverage and firm size.
Similarly, as far as tangibility is concerned Galai and Masulis (1976), Myers (1977) and
Myers and Majluf (1984) stressed the impact of asset structure on firm’s financial
policies. As the carrying amount of assets that can be offered as collateral security
increases – debt capacity increases. The asset composition may be broadly found
either by the ratio of liquidation value of tangible asset to total assets or by the ratio of
intangible asset to total assets. If the first one is considered then there should be a
positive relationship with leverage and in the second case there should be a negative
relationship. Consistent with trade off theory Rajan and Zingles (1995), Jordon et al.
(1998), Wiwattanakantang (1999) and Hirota (1999) found a positive relation between
tangible assets and debt. Titman and Wessels (1988) using the standard deviation of
the percentage change in operating income as proxy for risk found negative but
insignificant inverse relationship between risk and leverage. A recent study on
Brazilian firms by Correa et al. (2007) uses variance of operating profit to total assets as
proxy for risk and found a positive relation with leverage confirming the result found
by Jordon et al. (1998) and Wiwattanakantang et al. The findings run counter to trade
off theory. Increase of debt should enhance volatility of earning because of interest
expenses as such there should be a negative relation. Hirota (1999) found a negative
relation between the two. Rajan and Zingales et al., Wiwattanakantang et al. and
Hirota et al. using market to book value ratio as measure of growth found that with
decrease in growth opportunities, leverage increases. The finding is consistent with
trade off theory. Titman and Wessels et al. using percentage change in asset, capital
expenditure and R&D expenditure as proxy for growth find no significant relationship.
In reality it is found that a number of successful firms with high and consistent
profitability hardly goes for debt financing. This leads to an alternative theory of
finance called “pecking order” theory developed by Myers (1984). The origin of pecking
order theory is asymmetric information – implying that the managers know more
about a company’s prospect than the outside investors. The theory suggests that if a
firm issues equity shares to finance a project, it has to issue shares at less than the
prevailing market price. This signals that the shares are overvalued and the
management is not confident to serve the debt if the project happens to be financed by
debt. Thus, issue of shares is “bad news”. On the contrary if external borrowing is used
to finance the project, it sends a signal that the management is confident of the future
prospect of serving debt. Hence debt is preferred over shares in financing decision.
Nevertheless, pricing of debt instrument remains a problem in view of interest rate risk
 SEF and default risk. With regard to price of debt, investors may remain skeptical in the
30,1 same manner as pricing of the equity. To avoid controversy as regards information
content of pricing the management may wish to finance project by retained earning
only. Thus, financing follows an order, first – retained earning, then-debt and finally
when debt capacity gets exhausted – equity. This explains why the profitable firms
use less/negligible debt. Rajan and Zingles (1995) using earning before interest, taxes
60 and depreciation (EBIDTA) scaled by book value of assets as measure of profitability
found a negative relationship with the leverage. Titman et al. using operating income
scaled by total assets and margin as measure of profitability found a negative relation
with leverage. Hirota et al. found an inverse relationship between EBIDTA/total assets
and leverage. The findings are consistent with pecking order theory.
Though debt reduces agency conflict (and cost) between managers and
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shareholders but at the same time according to Jensen and Meckling (1976) it leads
to agency problem between the shareholders and debt holders.
The entrenched managers instead of pursuing value maximizing objective of
shareholders may indulge in self-dealing particularly when shareholding is scattered.
Indirect agency cost occurs when the managers do not strive enough to maximize the
shareholders’ value. In that case shareholders have to monitor the behavior of the
shareholders involving direct agency cost. Thus, there are both direct and indirect
agency costs arising from equity financing in case of separation of ownership and
management. Debt partly resolves this problem. When a firm is financed by debt, the
management is induced to minimize wasteful expenditure and optimize operating
efficiency for servicing debt as per covenant. Debt monitors action and behavior of the
manager. But when the debt is high and the company faces financial distress, if there
are two projects one is risky with high pay off and the other is less risky with low pay
off, the management may be induced to invest fund in risky projects having high pay
off. If the project is successful the shareholders will have residual cash flow after
paying off the debt. If the project fails, the loss is mostly borne by the creditors as the
liability of shareholders is limited. Thus, in case of debt financing, the shareholders
encourage management to take such decisions which, in effect, expropriate fund from
creditors to shareholders. The debt holders being aware of such risk will ask for higher
rate of interest and insist on inclusion of restrictive covenants in debt agreement to
mitigate the conflict of interest (agency problem between the shareholders and the debt
holders). Agency cost of debt arising from higher cost of finance and restriction
imposed by covenant having a bearing on future cash flow is to an extent compensated
by lowering agency cost (of equity financing) that arises from separation of ownership
and management. In an empirical paper Jiraporn and Gleason (2007) show an inverse
relation between leverage and shareholders right suggesting that the firms adopt
higher debt ratios where shareholders’ rights are more restricted. This is consistent
with agency theory which predicts that leverage helps alleviate agency problem.
Among some recent studies Margaritis and Psillaki (2010), Pindado and De La Torre
(2011) and Poyry and Maury (2010), respectively, record relationship between leverage
and various types of ownership pattern based on concentration, interest groups and
influence. Kose and Litov (2010) argue that firms with entrenched managers use more
debt contrary to earlier views that suggest entrenched managers employ less debt.
Among earlier studies Bernstein (1994) posits that the theory of agency cost and
imperfect information suggest that some types of firms may prefer to finance
 investment with internal funds. The results by Brailsford et al. (2002) in the context of Capital structure
49 Australian firms indicate a nonlinear inverted U-shaped relation between the level
of managerial ownership and leverage. They observe beyond a point there is potential
for increase in managerial opportunistic behavior associated with decrease of debt. The
study also indicates a positive relation between block ownership and leverage.
Drieffield et al. (2007) in their study on impact of ownership structure on capital
structure and firm value for the East Asian countries (Korea, Indonesia, Malaysia and 61
Thailand) distinguish owner managed family firms from non-family firms not being
owner managed. They find that the effect of concentration (of ownership) differ
between the two groups of firms. Higher concentration increases leverage in family
firms but tends to lower it among non-family firms in Indonesia, Malaysia and
Thailand.
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2.1 Shareholding pattern and capital structure

As far back as in 1932 in a classic paper Berle and Means (1932) envisioned a scenario
of extreme dispersion of shareholding pattern. They predicted that the diffused
shareholding of big corporations would progressively leave more power in the hands of
the managers. Individual shareholders would have little incentive to monitor the
managerial action and at the same time the managers’ ownership right in such
corporations would be so less that they would be hardly interested to enhance the firm
value. Thus, too much dispersion of shareholding leads to agency problem for lack of
control right by fragmented individual shareholder. As direct antidote the straight
forward way to align cash flow and control right is concentrated shareholding (Shleifer
and Vishny, 1997). If the voting control is concentrated in the hand of a few large
shareholders they can put pressure on the management to perform or else replace
through a proxy fight or take over. Large shareholder/s address the agency problem
and even can control the management directly specially when they hold more than
50 percent ownership right. Their interest is much more aligned for profit
maximization and they will force the management to take such strategic decision in
finance and non-finance matters so that their interest remains respected and protected.
Naturally the large shareholders will have an interest in establishing and continuing
with such capital structure that ensures their ownership right of control over
management. If fund is required for capital investment, the large shareholders prefer
debt financing as debt normally does not carry voting or control right till principal and
interest are served as per debt covenants.

2.2 Indian context

In India corporate debt market is yet to develop and flourish like its western
counterparts. India, after independence in 1947, for over four decades embraced
socialistic pattern of development where public sector banks and financial institutions
largely met the requirement of debt finance by the corporate sector. Since liberalization
in early 1990s, though equity segment of capital market has almost become as
developed as any other advanced market economy, corporate debt segment is yet to
catch up with the trend. Still today the public sector banks and financial institutions
play a major role in providing debt finance of the private corporate sector and such
financing is highly collateral security based. In case of concentrated shareholding, the
interest of the block shareholders being more aligned to the company – for raising loan
 SEF (from banks or financial institutions) they either mortgage their personal property
30,1 or property of the associate companies of which they are the principal
shareholders-managers as collateral security or stand guarantor for repayment of
loan. This aspect plays an important role in reducing overall agency cost of debt as
provision for collateral security reduces cost of finance as well as cost of monitoring.
There exist variations when it comes to selecting a proxy for measuring ownership
62 concentration. In measuring concentration on firm performance, Demsetz and Lehn
(1985) use fraction of shares held by five largest shareholders as a measure of
concentration of ownership structure as they are more likely to control professional
management. Morck et al. (1988) and Cho (1998) focus on fraction of shares owned by
the management consisting of board members, CEO and top management as measure
of concentration. Welch (2003) summarizes the situation by observing that both –
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fraction of shares owned by top five shareholders representing outside shareholders’

ability to control management action as well as fraction of shares owned by the
management representing latter’s ability to ignore former should be considered for
finding impact on firm performance.
In India promoters’ and non-promoters’ holding are two distinct group of
shareholders and may be considered as proxies for concentration and diffuseness of
ownership, respectively. According to the market regulator Securities Exchange and
Board of India (SEBI) – the promoter has been defined as a person or persons who are
in overall control of the company or persons, who are instrumental in the formulation
of a plan or programme pursuant to which the securities are offered to the public and
those named in the prospectus as promoters (www.sebi.gov.in). Hence, in Indian
context, by definition the promoters are the persons or group who continue to remain in
overall control over the resources of a company in the post public offering. For
protection of the investors SEBI requires that in post public offering the promoters
must continue to hold 20 percent shares for a minimum of three years. Obviously the
promoters may continue to hold more shares or off-load (shares) subject to above
statutory requirement. As per the companies law of India – one equity share carries
one vote. Over 50 percent holding of equity shares directly or indirectly through
pyramidal holding or cross holding gives direct right to determine composition of
board and legal control though cash flow right may be different. CEO and other
executive directors may either be direct representatives of the promoters or acting
merely in the professional capacity subject to the direction and control of the
promoters. Hence, shareholding by the promoters can be taken as proxy for
concentration. By implication non-promoters are those who are not promoters. In the
event of relatively more non-promoters’ shareholding, independent professional
managers are likely to enjoy more flexibility and freedom as they are not subject to
direct control by any dominant group (promoters). Non-promoters’ shareholding can be
considered as proxy for diffuseness of shareholding.
Given the Indian context we argue that the promoters’ shareholding increases
capacity of a firm to go for debt financing. On the contrary, issue of equity shares for
financing may lead to dilution of existing voting control. Hence, debt would be
preferred even if that leads to partial monitoring of managerial behavior by the lenders
as that does not impact shareholders’ voting control directly.
Diffuseness of holding gives managerial discretion which a manager is unlikely to
forego. Any change in the capital structure leading to concentration of holding may
 reduce such discretion. According to Jensen (1986) the managers of the firms try to Capital structure
finance investment by internally generated fund. If there is free cash flow, the managers
can either pay dividend or retain the fund for future investment. If free cash flow is
paid as dividend the manager has to approach either the capital market or debt market
for financing new investment. In either case he subjects himself to monitoring by
capital market or debt holder. Particularly debt reduces free cash flow in the hands of
the manager to fulfill commitment for interest payment and principal repayment. 63
In case of diffused shareholding where internal monitoring is negligible the manager
will try to avoid external monitoring also by funding projects internally through total
or partial restriction on dividend payout. Jensen (1986) terms the phenomenon as
agency problem of free cash flow as it creates opportunities for managers to spend
money on costly perks or misuse fund on acquisition that does not enhance value of the
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shareholders in the long run.

In case of dispersed non-promoters’ shareholding we are likely to witness less of
debt and more of financing through retained earning. If retained earning is not
adequate, there would be right issue of shares proportionate to existing ownership and
voting right in a manner that does not result in concentration of holding.
Thus, promoters’ shareholding (concentration) and non-promoters’ shareholding
(diffuseness) besides determinants like profitability, size, risk, growth, tangibility and
so on should play a role in determining capital structure or leverage. At the same time,
capital structure should also be a determinant of ownership structure as block
shareholders would be inclined to follow a financing pattern that would enable to
retain their control and in case of diffused shareholding, managers have an incentive to
maintain a capital structure that would not come in the way of upsetting managerial
discretion. There should be a two way relationship between capital structure (leverage)
and concentration or diffuseness.
In Indian context the article has the following hypotheses with regard to the
leverage, promoters’ and non-promoters’ shareholding:
H1. After controlling profitability, risk, tangibility, growth and size, leverage has
positive relation with promoters’ shareholding.
H2. Promoters’ shareholding as endogenous variable is impacted by leverage.
H3. After controlling profitability, risk, tangibility, growth and size, leverage has
negative relation with non-promoters’ shareholding.
H4. Non-promoters’ shareholding as endogenous variable is impacted by
leverage.

3. Data and empirical model

The study uses the list of CNX Midcap index companies as its sample. The list consists
of 100 companies representing diverse sectors of the economy. The index is calculated
by the National Stock Exchange (NSE) using market capitalization weighted method.
The process ensures exclusion of the first 50 biggest stocks in terms of market
capitalization. Similarly, small companies accounting for 75 percent of the market
capitalization from bottom are excluded. The sample selection process avoids inclusion
of outliers – too big and too small companies so far as size (in terms of market
capitalization) is concerned.
 SEF We collect relevant data to compute variables namely leverage, profitability,
tangibility, size, growth, promoters’ and non-promoters’ share holding from “prowess”
30,1 data base of the Centre for Monitoring Indian Economy (CMIE) for five financial years
from 2004 to 2009 for analysis. Out of 100 companies we exclude banks and
non-banking finance companies as per usual practice as their financial characteristics
are quite different from others. The sample size gets reduced to 81 companies
64 representing almost all the major sectors of Indian economy except banking and
finance sector.
We set two sets of simultaneous equation models consisting of two equations in each
set. In set 1 we take leverage as endogenous and promoters’ shareholding as endogenous
explanatory variable together with other control variables as exogenous or
predetermined. In second equation we take promoters’ shareholding as endogenous
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and leverage as endogenous explanatory variable. In set 2 we take leverage

as endogenous and non-promoters’ shareholding as endogenous explanatory variable
together with other control variables as exogenous or predetermined. In the equation (2)
we take non-promoters’ shareholding as endogenous and leverage as endogenous
explanatory variable. It is necessary to formulate two sets of regression equation
because inclusion of both promoters’ and non-promoters’ shareholding in the same
equation will lead to near-perfect multi-collinearity as by definition if promoters’ holding
is p, non-promoters’ holding will be (1 2 p). Our empirical results will not be robust
unless we report the impact of both forms of ownership structure (concentrated and
diffused) on capital structure.
To capture the relationship between leverage and ownership structure we formulate
two pairs of simultaneous equation models as under (Table I):
Set 1:
LEV it ¼ a1 þ a2 PROFIT it þ a3 RISK it þ a4 TAN þ a5 GROit þ a6 SIZE it ð1Þ
þ a7 PSH it þ uit
PSH it ¼ l1 þ l2 LEV it þ vit ð2Þ

Set 2:
LEV it ¼ b1 þ b2 PROFIT it þ b3 RISK it þ b4 TAN it þ b5 GROit
ð3Þ
þ b6 SIZE it þ b7 NPSH it þ 1it
NPSH it ¼ d1 þ d2 LEV it þ jit ð4Þ

In case of simultaneous equation models, econometricians argue that OLS method

should not be used because the estimators thus obtained lead to bias and
inconsistency in presence of endogeneity. In such case two stage least square (2SLS)
model resolves the problem. Again, according to Wooldrige (2009, Econometrics),
2SLS estimate is less efficient than OLS when explanatory variables are exogenous.
Hence, we perform endogeneity test in order to find whether 2SLS is at all
necessary.
Then we use fixed effect panel regression model to analyze data of five years
(2004-2009) on the sample units. In the fixed effect regression model, in equations (1)
and (3) we estimate two additional variables gi and Vt that, respectively, capture all
 Capital structure
Variables Definition and explanation

LEV Capital structure or leverage has been measured by dividing the book value of total of
secured and unsecured loan by the book value of total assets at the end each financial year
from 2005 to 2009. Total assets is the total of assets as per balance sheet minus deferred tax
asset and misc. expenses appearing on the asset side – both considered as arising out of
accounting adjustment only 65
PROFIT Profitability ¼ EBIT/Total Assets, where EBIT is the operating profit, that is, earning
before interest and tax during the study period 2005-2009
RISK Risk has been measured in terms of the variance of profitability during 2005-2009,
 2
EBIT EBIT
RISK ¼ 2
TotalAssets TotalAssets
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TAN Tan denotes tangibility measured as under:

PropertyPlant & Equipment þ Inventory þ Debtors
Tangibility ¼
TotalAssets
In a number of studies, only property plant and equipment together with inventory are
considered for measuring tangibility. We include debtors as well – as part of tangible
assets. In case of manufacturing and trading firms, debtor is nothing but inventory lying at
the risk of customers. For service providers debtor means service provided for which right
to receive payment has accrued. In both the cases, good debtors enable a firm to raise
finance through bill discounting and other modes, as such, is treated as a part of the
tangible assets
GRO GRO denotes growth. It is defined as growth of sales and is measured for the ith firm at
time t as under:
Salesit 2 Salesiðt21Þ
Growthit ¼
Salesiðt21Þ
SIZE Natural log of the book value of total asset at the end of each financial year during 2005-
2009 has been used as proxy for size
PSH The ratio of promoters shareholding to total shareholding at the end of each financial year
during 2005-2009. The ratio has been used as proxy for concentration of shareholding Table I.
NPSH The ratio of non-promoters shareholding to total shareholding at the end of each financial Definition of variables
year during 2005-2009. The ratio has been used as proxy for diffuseness of shareholding with explanation

unobserved firm specific time invariant factors and year specific unobserved factors
(but not varying over firms) along with the other explanatory variables impacting
leverage.
The sample altogether consists of 405 observations.

4. Empirical result
Out of 81 companies, promoters’ shareholding being overall more than 50 percent has
been witnessed in case of 48 companies. Putting differently in about 60 percent cases,
the promoters hold more than 50 percent of the total equity shares. Promoters’
shareholding for the sample companies averages 55 percent. The figures indicate
dominance of concentrated holding pattern in Indian context. The finding is consistent
with that of La Porta et al. (1998, 1999) and Ganguli and Agrawal (2009). In a recent
study, Holderness (2009) reports that the popular belief of comparatively more
 SEF diffuseness of US corporations is a myth. Block holders in US public companies on an
30,1 average own 39 percent of the shares.
Table II presents the descriptive statistics in respect of cross-sectional as well as
pooled data. Table III shows the correlation matrices (based on pooled data) among all
the variables.

66 4.1 Result of testing endogeneity/simultaneity (Hausman test of endogeneity)

In our set 1 of equations we have LEV and PSH as endogenous variables, the rest
are exogenous or predetermined variables (Hausman, 1976). We regress (by pooling
cross-sectional values) LEV on the reduced form of structural equation to get
the predicted value of LEV and residuals. Again, we regress PSH on predicted value of
LEV and residual. If the coefficient of residual is zero, then PSH is not endogenous.
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The result of regression of PSH on PLEVP (predicted value of LEV in case of

promoters holding) and RESIP (residual of leverage for promoters holding) is given
in Table IV.
In set 2 of equations we have LEV and NPSH as endogenous variables. In the same
way we produce the result of regression of NPSH on PLEVN (predicted value of LEV in
case of non-promoters holding) and RESIN (residual of leverage for non-promoters
holding) in Table V.
From the Tables IV and V above we find that the coefficients of residuals are not
significantly different from zero. We accept that promoters’ shareholding
(concentration) and non-promoters’ shareholding (diffuseness) are not endogenous.
We reject the H2 and H4. In other words ownership structure is not dependent upon
capital structure.

4.2 Fixed effect panel regression result

The result of the fixed effect regression showing the relation between leverage and
promoters’ shareholding is provided in Table VI.
The result of the fixed effect regression showing the relation between capital
structure and diffuseness is provided in Table VII.
The results of the fixed effect regression presented in Tables VI and VII reveal that
after controlling for firm and year effects, concentration is positively related to capital
structure whereas diffuseness is found to be negatively related. The result is
significant at 5 percent level. Profitability is negatively related to capital structure and
the relation is statistically significant at 1 percent level.
Tangibility is found to be negatively related to leverage and the result is
statistically significant at 10 percent level. The finding is counter-intuitive in the sense
that higher tangibility means availability of more collateral securities, hence there
should be a positive relation between the two. The coefficients of risk and size are
negative and the coefficient of growth is positive but all of them are insignificant
statistically. The finding of statistically insignificant relation of leverage with risk, size
and growth is consistent with that of Titman and Wessels (1988). Further our result is
robust and there seems to be no omitted variable bias.

5. Summary of findings and conclusion

Grounded on agency theory, in the present paper we have put forward an argument
as regards the likely relation between ownership structure and capital structure.
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2005 2006 2007 2008 2009 Pooled data

Variables MN MD SD SK MN MD SD SK MN MD SD SK MN MD SD SK MN MD MN SK MN MD SD SK

LEV 0.25 0.25 0.20 0.65 0.23 0.21 0.19 0.33 0.24 0.22 0.19 0.12 0.22 0.23 0.18 0.27 0.24 0.25 0.19 0.26 0.24 0.23 0.19 0.35
PROFIT 0.14 0.11 0.10 2.77 0.14 0.12 0.10 2.19 0.15 0.13 0.09 1.43 0.16 0.16 0.09 0.89 0.13 0.11 0.09 0.96 0.14 0.13 0.09 1.70
RISK 0.003 0.001 0.005 4.14 0.002 0.000 0.003 4.79 0.002 0.000 0.003 3.01 0.002 0.001 0.003 3.64 0.003 0.001 0.007 3.44 0.002 0.001 0.004 4.23
TAN 0.70 0.76 0.22 0.97 0.67 0.73 0.22 2 0.78 0.65 0.71 0.22 20.76 0.64 0.70 0.23 20.70 0.62 0.67 0.23 20.66 0.66 0.71 0.22 20.75
GRO 0.24 0.20 0.26 1.34 0.27 0.20 0.28 2.00 0.33 0.24 0.42 2.93 0.34 0.20 0.54 4.33 0.18 0.16 0.29 1.77 0.27 0.20 0.38 3.90
SIZE 7.07 7.07 1.04 0.04 7.36 7.25 0.91 0.62 7.68 7.59 0.81 0.76 7.97 7.95 0.81 0.66 8.16 8.13 0.81 0.58 7.65 7.61 0.96 0.13
PSH 0.56 0.54 0.18 0.23 0.55 0.52 0.19 0.28 0.54 0.52 0.18 0.30 0.54 0.51 0.18 0.29 0.55 0.51 0.18 0.27 0.55 0.52 0.18 0.27
NPSH 0.44 0.46 0.18 20.23 0.45 0.48 0.19 2 0.28 0.45 0.47 0.18 20.24 0.45 0.48 0.18 20.22 0.44 0.48 0.18 20.20 0.45 0.47 0.18 20.23

Note: MN – mean, MD – median, SD – standard deviation and SK – skewness

Capital structure

Descriptive statistics
67

Table II.
 SEF
Variables LEV PROFIT RISK TAN GRO SIZE PSH NPSH
30,1
LEV 1
PROFIT 20.39516 1
RISK 20.05201 0.31820 1
TAN 0.24798 2 0.01721 0.06625 1
68 GRO 0.04628 0.04307 0.06977 0.01210 1
SIZE 0.25573 2 0.32576 2 0.09875 0.14651 2 0.01675 1
PSH 20.12067 0.08526 0.15013 20.09166 0.02611 20.24527 1
NPSH 0.13158 2 0.0729 2 0.14032 0.10037 2 0.01823 0.22429 20.98743 1
Table III. Note: The figures in the table reflect no serious multicollinearity problems among the explanatory
Correlation matrices variables of the regression models used
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Variables Coefficient t-statistics

Constant 0.610 23.444 *

PLEVP 2 0.272 2 2.670 *
RESIP 2 0.0498 2 0.892
Table IV. R 2-value 0.019
Regression result of PSH
on PLEVP and RESIP Note: Significance at: *5 percent level

Variables Coefficient t-statistics

Constant 0.026 15.093 *

PLEVP 2 0.253 2 2.503 *
Table V. RESIP 2 0.068 1.223
Regression result of R 2-value 0.019
NPSH on PLEVN and
RESIN Note: Significance at: *5 percent level

Explanatory variable Coefficient t-statistics

Constant 0.216 1.257

PROFIT 2 0.288 2 3.177 *
RISK 2 0.945 2 0.794
TAN 2 0.089 2 1.695 * * *
GROWTH 0.017 1.271
SIZE 2 0.016 2 1.089
PSH 0.450 2.777 *
Table VI. R2 0.850
Fixed effect regression – F-value 19.618
capital structure and DURBIN-WATSON 1.727
concentration (promoters’
holding) Note: Significance at: *1, * *5 and * * *10 percent levels
 Capital structure
Explanatory variable Coefficient t-statistics

Constant 0.629 4.620 *

PROFIT 2 0.287 2 3.161 *
RISK 2 0.969 2 0.811
TAN 2 0.098 2 1.856 * * *
GROWTH 0.017 1.274 69
SIZE 2 0.019 2 1.254
NPSH 2 0.319 2 2.255 * *
R2 0.849 Table VII.
F-value 19.618 Fixed effect regression –
DURBIN-WATSON 1.727 capital structure and
diffuseness
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Note: Significance at: *1, * *5 and * * *10 percent levels (non-promoters’ holding)

We have argued that, ceteris paribus, firms having concentrated shareholding

should go for debt financing as a means of mitigating collective action problem
confronted by dispersed shareholding. Moreover, bank and financial institution
dominated debt financing system in India finds comfort level in concentrated
shareholding as interest of the block shareholding groups being more aligned – the
latter provides collateral security in personal capacity to address and mitigate
agency problem associated with debt financing. We have also reasoned that the
entrenched managers of the firms having diffused shareholding should go for
internal accrual for financing (if profit permits) to continue to enjoy managerial
discretion. If the profit is insufficient the entrenched managers should go for issue of
shares rather than debt financing to avoid monitoring by the lenders in a manner so
that concentration of shareholding can be avoided at the same time. We have also
argued that ownership structure impacts as well as gets impacted by capital
structure. That is there should be a two way relationship between debt and
ownership structure.
Our empirical result on Indian firms suggests that the ownership structure does
impact capital structure but not the vice versa. Consistent with our argument we
find that the leverage is positively related to concentrated shareholding but has a
negative relation with diffuseness of shareholding after controlling for profitability,
risk, tangibility, growth and size. Our result is consistent with what Kayhan (2008)
posits – “entrenched managers” may retain rather than pay out earning and show
preference for issue of equity over debt – in order to achieve a conservative capital
structure that improves their job security. We further provide an argument that in
case of dispersed shareholding, monitoring by the shareholders is less and
managerial discretion is more, hence entrenched managers motivated by
self-interest would like to avoid or prevent monitoring by creditors as well, and
therefore, would prefer internal funding over debt financing. Besides shareholding,
we also find in conformity with the pecking order theory – that the firms having
high profitability use less debt. We also incidentally notice that – tangibility is
negatively related to leverage. During the study period (2004-2009), India witnessed
a robust economic growth, the sample units earned steady profit till 2008 and had
narrow range bound leverage. In the backdrop, continuous decline of tangibility
 SEF of the sample units (evident from descriptive statistics in Table II) with no
30,1 significant decline in leverage may mean financial slack in the form of cash or cash
equivalents, investment in other companies, merger and acquisition and so on that
may not be value enhancing always – indicative of possible agency problem of free
cash flow in line with Jensen’s (1986) argument. However, the finding is only
incidental and leaves ample room for further research.
70
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 SEF About the author
Santanu K. Ganguli is a Chartered Accountant (FCA) and holds a PhD (Finance). He is a
30,1 Professor of Finance and Accounting at the Institute of Management Technology –
Ghaziabad, India. He has been a visiting faculty of the University of Warsaw, Poland (2010),
IIM – Calcutta (2001-2006) and Institute of Chartered Accountants of India. His research
interest lies in corporate governance, capital structure, dividend policy, market based
accounting research and firm valuation. He has conducted extensive management
72 development programmes on corporate finance, valuation and accounting standards and
has published and presented empirical papers, chaired sessions and acted as key note speaker
on corporate finance and firm valuation internationally. Santanu K. Ganguli can be contacted
at: skganguli@imt.edu
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