Low leverage policy: a boon or bane for Indian shareholders
| DOI | https://doi.org/10.1108/JABS-01-2017-0002 |
| Published date | 10 December 2018 |
| Date | 10 December 2018 |
| Pages | 489-507 |
| Author | Soumya G. Deb,Pradip Banerjee |
| Subject Matter | Strategy,International business |
Low leverage policy: a boon or bane for
Indian shareholders
Soumya G. Deb and Pradip Banerjee
Abstract
Purpose –This paper aims to explore whether following an apparently sub-optimal ‘‘almost zero
leverage(AZL)’’ policy by some Indian firms actually createsincremental value for their shareholdersor is
detrimentalfor them.
Design/methodology/approach –The paper investigates the relative equity market and operating
performance of a sampleof Indian firms adopting an AZL policy between 1998 and 2014, vis-a-vis,their
leveraged peersfrom the same industry. The authors also look at the dynamictime variability of patterns,
if any, in such relativeperformance and explore whether such patternsare explained primarily by investor
perceptionsor there are other factors to it.
Findings –The study show that Indian firms following post AZL policy exhibit superior equity
performance compared to their leveraged counterparts, particularly during market downturns. The
authors also find that this superior equity market performance is not merely because of the positive
investor perceptionabout the potential benefits of a robust debt-free balance sheet.The authors’ results
show that the AZL firms register higher businessrisk and significantly superior operating performance,
post beinglow leverage.The results hold even after using several robustness checks.
Practical implications –The study concludesthat the managers of AZL firms take full advantageof the
increasedfinancial flexibility available with them and ventureinto riskier but more rewarding avenues and
actuallycreate incremental value for their shareholders.
Originality/value –The study highlights an apparently counterintuitive pattern in Indian context,
counterintuitive particularly because choosing an AZL policyleads to forgo the availability of significant
tax shield for firms. The results, the authors believe, can have significant implications for lenders and
investorsin the Indian capital markets in particularand emerging markets in general.
Keywords Leverage, Capital structure, Interest tax shield, Zero debt policy
Paper type Research paper
1. Introduction
This paper studies whether a low-leverage policy can create incremental value for
shareholders of Indian firms. We do this by looking at the relative performance of all Indian
firms that followed an almost-zero-leverage (AZL henceforth) policy during the period from
1998 to 2014, vis-a
`-vis their leveraged peers fromthe same industry. We specifically try and
answer the following questions:
Q1. Do Indian managers create incremental value for their shareholders by following a
low-leveragepolicy, regarding enhanced stock market performance?
If yes, what could be the possible reasons for such superior performance? Is it merely
because of the positive investor perception about potential benefits of a debt-free balance
sheet, or are there other plausible reasons? Are these visible patterns in firm performance
post being AZL, if any, contingent on factors like natureof the industry or market swings?
The finance theory highlights that debt can have both positive and negative impacts on the
prospects of a firm. There are potential benefits of debt, like interest tax shield and
Soumya G. Deb is based at
the Indian Institute of
Management Sambalpur,
Sambalpur, India.
Pradip Banerjee is based at
Accounting and Finance,
Indian Institute of
Management Indore,
Indore, India.
Received 5 January 2017
Revised 2 June 2017
12 September 2017
Accepted 14 November 2017
DOI 10.1108/JABS-01-2017-0002 VOL. 12 NO. 4 2018, pp. 489-507, ©Emerald Publishing Limited, ISSN 1558-7894 jJOURNAL OF ASIA BUSINESS STUDIES jPAGE 489
enhancement of return-on-equity (ROE) (Modigliani and Miller,1958, 1963: MM henceforth).
External debt financing also serves as a disciplining device for managers because, if a firm
fails in servicing debt properly, the debtholders may force it to liquidation (Harris and Raviv,
1990). Hence, following a very conservative debt policy can sometimes be detrimental to
shareholder’s interest. However, beyond a certain level, fixed interest and principal
commitments of debt can hurt the ability of a firm to operate freely and effectively. Debt
beyond an optimal level can cause a default on interest or principal payments, leading to
financial distress or even bankruptcy. It may cause a “debt overhang” problem (Myers,
1977) or limit the ability of a firm to take up new investment projects with positive NPV. It
may reduce the ability of a firm to pay dividends, as most of the surplus cash is utilized to
servicing debt. Debt also implies increased volatilityof net cash flows to shareholders. From
a signaling perspective, low debt in the balance sheet typically implies that the firm is
expecting to generate a lot of surplus cash internally to maintain its growth prospects, thus
commanding enhanced financial flexibility and increased debt capacity. Given both
positive and negative perceptions about debt as mentioned above, some finance theories
generally advocate usage of an “optimum” amount of debt (MM, 1963), while othersoppose
that concept (Myers, 1977[1]; Myersand Majluf, 1984[2]).
The issue addressed in this study is, however, not to explore the reasons why firms might
choose to follow a low-leverage policy in the Indian context. We explore whether a sizeable
number of Indian firms, which do follow an AZL policy, actually create incremental value for
their shareholders. The question is particularly interesting in the current Indian context
because of the following reasons. First, the cost of debt in India is pretty high compared to
the developed nations, though it is somewhat comparable to the rates prevailing in some of
the other BRICS and emerging countries (see Appendix 1). At the same time, the corporate
tax rate in India is one of the highest among the Asian countries and also much higher
compared to the world average (see Appendix 2). This implies that a significant interest tax
shield can be exploited by Indian firms for their shareholders, particularly for profitable
firms. Following an AZL policy seems to be suboptimal in this context and should be
manifested through a negative impact on stock market performance of such firms. Second,
the shareholding pattern in India is marked by the presence of a large number of family-
owned firms[3] having a few large promoter shareholders. These largeinsider shareholders
typically are involved in operating and strategic decision-making by the firm. So, what
prompts them to adopt an AZL policy, despite the presence of a lucrative tax shield, and
whether such a policy is successful in the long run, become relevant questions. The
questions becomes even more interesting because research in other Asian countries in
recent times shows that majority of firms in the Asian countries are also family-controlled
(Claessens et al.,2000). However extant research (Yasser and Mamun, 2015, for Pakistan,
for example) shows no significant association between ownership concentration and firm
performance.
India is one of the largest and fastest growing economies in Asia; inferences from the Indian
market on this issue should provide interesting and relevant insights for most stakeholders
in the Asian and emerging markets in general. Third, most banks in India are currently
sitting on an enormous amount of deployable fund and are desperately looking forward to
lending opportunities. Which factors influence some Indian firms to adopt an AZL policy,
and to what extent that strategy is successful,can be of particular interest for them.
We believe the relevance of findings of this study shall not remain limited to India only.
Gupta et al. (2002) identify 10 cultural clusters across 61 nations using data collected on
cultural values and beliefs. In their paper, they highlight two broad clusters into which most
Asian nations can be included: Confucian Asia (including Taiwan, Singapore, Hong Kong,
South Korea, China and Japan) and Southern Asia (including India, Indonesia, Philippines,
Malaysia, Thailand and Iran). The basis of this clustering is mostly intercultural similarities
and differences. In the similar line, Tung (2014) shows that there is a tremendous cultural
PAGE 490 jJOURNAL OF ASIA BUSINESS STUDIES jVOL. 12 NO. 4 2018
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