Author Topic: Impact of Leverage on Firms Investment Decision  (Read 9471 times)

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Impact of Leverage on Firms Investment Decision
« on: April 23, 2011, 05:42:39 pm »
Author : Franklin John. S, Muthusamy. K
International Journal of Scientific & Engineering Research, IJSER - Volume 2, Issue 4, April-2011
ISSN 2229-5518
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Abstract - The present paper is aimed at analyzing the impact of leverage on firmís investment decision of Indian pharmaceutical companies during the period from 1998 to 2009. To measure the impact of leverage on firmís investment decision, pooling regression, random and fixed effect models are used by taking, leverage, sales, cash flow, Return on Asset, Tobinís Q, liquidity and retained earnings as independent variable and investment as dependent variable. In addition , we demarcate between three types of firms (i) Small firms, (ii) Medium firms and (iii)Large firms. The results reveal that a significant positive relationship between leverage and investment, while we found a negative relationship between leverage investment for medium firms and positive relationship between leverage and investment in large firms. Our econometric results reveal an insignificant relationship between the two variables for medium and large firms.

Index Terms-- Investment, Tobinís Q, Cash flow, Liquidity, ROA, Size and Retained Earnings.
Investment is a crucial economic activity in the corporate financial management. Such an activity leads to the countryís economic development provide employment to the people and to eliminate poverty .This paper investigates the effort of debt financing on the firms investment decision on pharmaceutical industry in India. It plays a significant role in the countryís economic and industrial development and trade and to prevent diseasesí for increasing the life of people. This industry is providing a basic material to other industrial sectors. It requires capital for financing firmís assets. Among the different sources of fund, debt is a cheaper source because of its lowest cost of capital. The investment decision of the firm is of three categories that can be adopted by firmís management besides the financing decision and the net profit allocation decision. The investment decision has a direct influence on the firms asset structure, more over in their degree of liquidity and consists of spending the financial funds for the purchase of real and financial assets for the firm. In  order to gain cash and the growth of the wealth of firms owner. The investment decision and the financing decision are interdependent that is the investment decision is adopted in relation to the level of financing source but the option to invest is also crucial in order to calculate the level of financing capitals and the need for finding their sources.
As far as the hierarchy of financing sources as it exists in the economic literature, is concerned, cash flow is the cheapest financing sources followed by debts and in the end, by its issuing of new shares. Debts can be cheaper than the issue of new shares because the loan contract can be created as to minimize the consequences of information problem. Giving the fact the degree of information asymmetry and the agent costs depend on the peculiarities of every firm, such firms are more sensitive to financial factors than other. The debt limit of the firms is determined in the view, since interest payment is tax deductible, the firm prefers debt financing to equity and it would rather have an infinite amount of debt, However, this leads to negative equity value in some status so that the firm would rather go bankrupt instead of paying its debt. Therefore debt to remain risk-free, lenders will limit the amount of debt. They can limit the debt by accepting the resale value of capital as collateral and ensuring that this value is not lower than the amount of debt, so that they can recover their money in case of bankruptcy. Alternatively, lenders may limit the amount of debt in order to ensure that the marker value of equity is always non-negative and bankruptcy is sub-optimal for the firm.
While there is by now a rapidly expanding literature on the presence of finance constraints on investment decisions of firms for developed countries , a limited empirical research has been forthcoming in the context of developing countries for two main reasons. First until recently, the corporate sector in emerging markets encountered several constraints in accessing equity and debt markets. As a consequence, any research on the interface between capital structure of firms and finance constraints could have been largely constraint- driven and have less illuminating. Second, several emerging economies, even until the late 1980s, suffered from financial depression, with negative real rates of interest as well as high levels of statutory pre-emption. This could have meant a restricted play of market force for resource allocating.
Issues regarding the interaction between financing constraint and corporate finance have, however, gained prominence in recent years, especially in the context of the fast changing institutional framework in these countries. Several emerging economies have introduced market-oriented reforms in the financial sector. More importantly the institutional set-up within which corporate houses operated in the regulated era has undergone substantial transformation since the 1990s. The moves towards market-driven allocation of resources, coupled with the widening and deepening of financial market, have provided greater scope for corporate house to determine their capital structure.
The rest of the paper unfolds as follows. Section II discuses the historical background of the study. Section III explains methodology, data, variable description and the data employed in the paper. Section IV presents the results and discusses robustness check followed by the concluding remarks in the final section.

Several authors have studied the impact of financial leverage on investment. They reached conflicting conclusions using various approaches. When we talk about investment, it is important to differentiate between overinvestment and under-investment.   Modigliani and Miller (1958) argued that the investment policy of a firm should be based only on those factors that would increase the profitability, cash flow or net worth of a firm. Many empirical literatures have challenged the leverage irrelevance theorem of Modigliani and Miller. The irreverence proposition of Modigliani and Miller will be valid only if the perfect market assumptions underlying their analysis are satisfied   .However the corporate world is characterized by various market imperfections costs, institution restrictions and asymmetric information.  The interaction between management, shareholders and debt holders will generate frictions due to agency problems and that may result to under-investment or over-investment incentives. As stated earlier one of the main issues in corporate finance is whether financial leverage has any effects on investments policies.
Myers (1977), high leverage overhang reduces the incentives of the shareholder-management coalition in control of the firm to invest in positive net present value of investment opportunities, since the benefits accrue to the bondholders rather than the shareholders thus ,highly levered firm are less likely to exploit valuable growth opportunities as compared to firm with low levels of leverage a related under investment theory centers on a liquidity affect in that firm with large debt commitments invest less no matter what their growth opportunities . Theoretically, even if leverage creates potential underinvestment incentives, the effect could be reduced by the firm corrective measures. Ultimately, leverage is lowered if future growth opportunities are recognized sufficiently early.
Another problem which has received much attention is the overinvestment theory. It can be explained as investment expenditure beyond that requires to maintain assets in place and to finance expected new investment in positive NPV projects where there is a conflict between manager and share holder. managers perceive an opportunities to expand the business even if the management  under taking poor projects and reducing shareholders welfare .The managersí abilitiesí to carry  such a policy are restrained by the availability of cash flow and further tightened by the financing of debt. Hence, leverage is one mechanism for overcoming the overinvestment problem suggesting a negative relationship between debt and investment for firm with low growth opportunities. Does debt financing induce firms to make over-investment or under-investment? The issuance of debt commits a firm to pay cash as interest and principal. Managers are forced to service such commitments .too much debt also is not considered to be good as it may lead to financial distress and agency problems.

Hite (1977) demonstrates a positive relationship because given the level of financial leverage an investment increase would lower financial risk and hence the cost of bond financing. In contrast Deangels and Masulis (1980) claim a negative relationship since the tax benefit of debt would compete with the tax benefit of capital investment. Dotan and Ravid (1988) also show a negative relationship because investment increase would raise financial risk and hence the cost of bond financing how the investment increase affects financial risk and the sub suitability between tax shields and hence; financial leverage may depend on firm-specific factors.

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