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CHAPTER 6
CAPITAL STRUCTURE AND COST OF CAPITAL
1. Capital Structure Theories
Introduction
Capital structure decision is a significant decision in financial
management. This decision in a private enterprise is directed towards the
achievement of maximization of the shareholders' wealth or value of the
firm. The value of an enterprise depends on expected earnings and cost
of capital. Capital structure influences the value of the firm by operating
on either expected earnings or the cost of capital or both. Due to tax
deductability of interest payments, recourse to debt financing generally
reduces the firm's tax liability, but increases the financial risk. The
management, therefore, has to choose that pattern of capital structure in
which the level of debt minimizes the overall cost of capital, maximizes
earnings available to owners and thus maximizes the total value of the firm.
Hence there exists a relation between capital structure and cost of capital.
This relation has been examined by many theorists and researchers. Theories
evolved out of such examination pertain to private enterprises. The objective
of this chapter is to study the nature and extent of relationship between
these two variables and the factors which influence the relationship in selected
cooperative enterprises. We also examine whether the private enterprise-based
capital structure theories are relevant to cooperative enterprises or not.
Capital Structure Theories
The debate on optimal capital structure that leads to maximum market
valuation and minimum cost of capital is perennial. There are two extreme
views on this. The traditional school, at one extreme, argues that there
is an optimum capital structure at which the value of the firm is highest
and the cost of capital is at its lowest. In extreme contrast to this, however,
Modigliani and Miller offer convincing arguments in support of their opinion
that there does not exist an optimal capital structure at any stage and the
market value of the firm is not influenced in any way by leverage factor.
In between these two extreme views, there is an intermediate version known
as net operating income approach which argues that risk content of the
firm is in no way affected by changes in composition of capitalization. As
a matter of fact they redistribute this risk among shareholders. Hence there
will be no leverage effect on value of the firm. However, owing to tax
benefit of debt financing and market imperfections, the management employs
a judicious mix of financial claims and chooses an optimum capital structure
which would minimize the cost of capital and maximize the market value
of the firm.
The Net Income and the Net Operating Income Approaches : Net
Income and the Net Operating Income Approaches were developed by David
Durand.1 The essence of net income approach is that the firm can lower
its cost of capital by using debt. The approach is based on the assumption
Durand, David, "Costs of Debt and Equity Funds for Business : Trends and Problems of Measurement", in Ezra Solomon (Ed.). The Management of Corporate Capital, New York : The Free Press, 1959, pp.91-116
1.
201
202
that the use of debt does not change the risk perception of the investor.
Consequently the interest rate on debt (Ki) and the equity capitalization
rate (Ke) remain constant. Therefore, wi th the increased use of leverage
overall cost of capital declines and the total value of f irm rises. The overall
cost of capital (Ko) under this approach is measured by :
Net Operating Income Total value of the f irm
The NI approach recognises that there exists an optimum capital
structure which is reached when the cost of capital is at the lowest. However,
a cr i t ica l point may be reached beyond which the cost of capital may start
rising because of the increase in the costs of debt and equity.
The net operating income approach, on the other hand, contends that
the capital structure does not matter, and that the f irm cannot affect i ts
overall cost of capi ta l through leverage. Thus overall cost of capital remains
constant. This results f rom the fact that as more debt is incurred, equity
investors, in order to compensate for the increased financial risk, increase
their capital izat ion rate of earnings in such a way as to cancel out the benefit
derived from the use of debt, and the average cost remains unchanged. But
it is possible that beyond a high level of leverage the cost of debt may
increase. In such a case, the cost of equity wi l l have to fal l to keep the
cost of capital function horizontal. Thus, there is no single point or range
where the capital structure is optimum.
203
Modigliani - Miller Approach : Modigliani - Miller thesis of capital
structure is akin to the Net Operating Income Approach. But, NOI approach
is purely definitional ; it Jacks behavioural significance.2 The NOI approach
does not provide operational justification for the irrelevance of capital
structure. M.M. Thesis does support the NOI approach relating to the
independence of the cost of capital of the degree of leverage at any level
of debt equity ratio. It provides behavioural justification for constant overall
cost of capital and therefore total value of the firm. In other words, the
M.M. approach maintains that the weighted average cost of capital does
not change with changes in the degree of leverage.
The M.M. theory is based on three basic propositions. They are :
1. Market value of any firm is independent of its capital structure and
is given by capitalizing its expected return at the rate appropriate
to its class. The average cost of capital to any firm is completely
independent of its capital structure and is equal to the capitalization
3 rate of a pure equity stream of its class.
2. The expected yield of a share stock is equal to the appropriate
capitalization rate for a pure equity stream in the class, plus a
premium related to financial risk equal to the debt equity ratio times /f
the spread between capitalization rate and yield on debt.
Van Home, James. C, Financial Management and Policy, New Delhi : Prentice Hall of India Pvt. Ltd., 1983, p.248
Modigliani, Franco and Miller, Merton. H., "The Cost of Capital, Corporation Finance and the Theory of Investment", The American Economic Review. Vol. XLVIII No.3, June, 1958, p.268
Ibid., p.271
2.
3.
3. The cut off point for investment in the firm in all the cases will
be the capitalization rate and will be unaffected by the type of
security used to finance the investment.
These propositions are based on a simple switching mechanism called
arbitrage. Arbitrage refers to an act of buying asset-security in one market
(at lower prices) and selling it in another (at a higher price). M.M. contend
that market value of those firms which are identical except for the difference
in the pattern of financing will not vary because arbitrage process will drive
the total values of the two firms together, Rational investors, according
to them, will employ arbitrage in the market to prevent the existence of
two assets in the same risk class and with same expected returns from selling
at different prices.
The theoretical validity of the M.M. proposition (as many authors
agreed) is difficult to counter. However, they have been criticized bitterly
by numerous experts questioning the very assumptions on which the edifice
of the theory is founded. The basic assumption of M.M. is that individuals
through use of leverage, can alter corporate leverage. Tlis argument cannot
be supported in a practical context for it is extremely doubtful whether
personal investor would substitute personal leverage for corporate leverage c
since they do not have the same risk characteristics.
Ibid., p.290
Walker, Ernest. W., Essentials of Financial Management, New Delhi : Prentice Hall of India, 1976, p.99
5.
6.
204
205
Another assumption of M.M. is that there is no corporate tax. Nowhere
in the world has corporate income remained untaxed. Further, taxation
laws have provided for deductability of interest payments on debt for calcula
ting taxable income. If this is so, debt becomes relatively a much cheaper
means of financing and the firm is naturally encouraged to employ leverage.
In view of this controversy, Modigliani and Miller in their subsequent article
in 1963 admitted that, given the tax factor, the overall cost of capital can
be lowered as more debt is inducted in the capital structure of the firm.
In spite of these limitations, M.M. thesis serves as an aid in understanding
the capital structure theories.
Traditional Approach : The traditional approach is midway between
the NI and NOI approaches. It partakes some features of both these
approaches. One of the foremost advocates of the traditional view is Ezra
Solomon. The crux of the traditional view relating to leverage and valuation
is that through judicious use of "debt to equity proportions", a firm can
increase its total value and thereby reduce its overall cost of capital. The
rationale is that debt is a relatively cheaper source of fund as compared
to ordinary shares. With a change in leverage, that is by using more debt
in the place of equity, a cheaper source of fund replaces a source of fund
which involves, by comparison, a higher cost. This obviously causes a decline
in the overall cost of capital and a rise in the market value of the firm.
Modigliani, Franco and Miller, Merton. H., "Corporate Income Taxes and the cost of Capital : A Correction". American Economic Review, Vol. n i l , June, 1963, pp.«3-*M
7.
206
Solomon, in his interpretation of the traditional view, says that the
impact of leverage on cost of capital and value of the firm can be studied
in three distinct stages as leverage is increased from zero.
In the first stage, cost of equity rises as debt is added but does not
increase fast enough to offset the advantage of low cost debt ; cost of
debt remains constant or rises modestly. As a result, the value of the firm
increases or the overall cost of capital falls with increasing leverage.
In the second phase, the addition of debt, after a certain degree of
leverage has been reached, provides only a moderate increase in market
value. As a consequence cost of capital remains relatively constant.
Finally, beyond the acceptable limit of leverage, the value of the
firm decreases or the cost of capital increases with the leverage. This
happens because investors perceive a high degree of financial risk and this
increases equity and debt capitalization rates.
The overall effect of these three stages suggests that the cost of
capital is a function of leverage.
Other Approaches : In addition to the approaches examined regarding
the effect of leverage on cost of capital and market value of the firm,
two additional concepts are useful in the formulation of an optimum capital
structure.
Solomon Ezra, The Theory of Financial Management, New Columbia University Press, 1963, pp.93-98
8.
207
The first, of these deals with a firm's ability to maintain adequate
cash to meet future fixed charges such as interest payments, lease charges,
repayment of principal on debt, and preferred stock dividends. This concept 9
is advocated by Donoldson. He establishes a refinement of the concept
by suggesting that cash flows should be examined under the most adverse
conditions. To determine debt capacity, management should compare these
flows with the cash required to meet the firm's fixed charges at each level
of debt. If there is no probability of being out of cash, the firm is said
to have unused debt capacity. If, however, there is a probability that future
cash flows will not meet the fixed charges during adverse periods, management
must decide, whether it wants to accept the risk involved ; if not, debt
must be reduced.
Childs has suggested another method in determining the proper
capital structure. He states that there are six determinants namely borrowing,
reserve, financial insurance, tax, savings and pools of capital which would
serve as a guide in determining the level of debt that a firm can afford.
Although each determinant must be considered, Childs thinks that the first
three are the most important, that is, debt should not be used in an amount
that will (i) destroy the firm's reserve to borrow (ii) eliminate financial
Donoldson, Gordon, "New Framework for Corporate Debt Policy", Hardward Business Review, March-April 1962, pp.117-32
Childs, John F., Long Term Financing, New York : Prentice Hall Inc., 1961, pp.7-37
9.
10.
208
insurance or (iii) cause cost of capital to increase. Childs believes that
the nature of the business and its inherent risks affect the firm's ability
to carry debt ; as a consequence, management must measure the risk
associated with the firm and relate it to the amount of debt that will be
employed.
Thus far, the discussion has touched on the theories of capital structure
as related to private enterprises. Now we make an attempt to find out
the relationship between capital structure and the cost of capital in the
selected larger cooperatives.
2. Relationship Between Capital Structure and the
Cost of Capital in Selected Cooperatives
The Nature of Relationship
We have seen that cost of debt is higher than the cost of share capital
and retained earnings and the behaviour of the weighted-average-cost of
capital is influenced by the proportion of debt in the capital. (See Chapter 5)
What is the nature of the relationship between capital structure and the
cost of capital ?
The relationship between the capital structure and the overall cost
of capital in both the cooperative sugar and spinning industries is that the
overall cost of capital increases as the proportion of debt in the capital
structure increases. When the proportion of debt in the capital structure
is less than 15 percent, the overall cost of capital is less than 1.5 percent.
209
But as the proportion of debt increases, the overall cost of capital also starts
rising. (See Tables 6.1 and 6.2)
The association between these two variables is tested by simple
correlation. The correlation co-efficient is positive for both the industries
and is significant at 1 percent level. (See Table 6.3) This confirms the
result of an earlier study made by P. Murali.
The results indicate two things. First, the use of debt in capital
structure affects the overall cost of capital and thus the cost of capital
is a function of leverage. Second, there is a direct relationship between
capital structure and cost of capital.
Why does the overall cost of capital increase, as the proportion of
debt in capital structure increases ? The cost of debt is higher, though
constant. The other two components of capital structure namely the share
capital and the retained earnings are less costly and they do not bear any
cost, whenever dividend is not paid. Thus when high-cost debt is introduced
in the capital structure, the overall cost of capital increases and the latter
decreases when debt is repaid. In brief with a change in leverage, a relatively
high-cost source of funds replaces a source of funds which involves relatively
a lower cost. This obviously causes a rise in the overall cost of capital.
Murali P., Financial Management in Cooperative and Private Sector Sugar Mills in Andhra Pradesh, Unpublished thesis, Tirupathi : Sri.. Venkateswara University, 1979, p.108
11.
Table 6.1
Relationship between Capital Structure and Cost of Capital in
Cooperative Sugar Mills
Table 6.2
Relationship between Capital Structure and Cost of Capital in
Cooperative Spinning Mills
212
213
Factors Influencing the Relationship between Capital Structure and Cost
of Capital
The focus of the preceding section is on examining the nature of
relationship between capital structure and cost of capital. The empirical
evidence reveals that the overall cost of capital increases as the proportion
of debt or leverage increases and decreases with a fall in the proportion
of debt or leverage. Thus, the use of debt leads to high cost of capital
which is detrimental to the sound growth of a cooperative organization.
A higher proportion of debt may lead to financial distress which includes
a broad spectrum of problems ranging from the relatively minor liquidity
12 shortage to the extreme case of bankruptcy. It also reduces commercial
profitability. All these may in turn deter the cooperatives in fulfilling their
very objective of rendering service to their members at a reasonable cost.
Leverage, thus, is detrimental to a cooperative organization. A cooperative
organization, therefore, should try to bring down the proportion of debt
and should augment equity to such an extent that it could bring down its
overall cost of capital. Theoretically it may sound good. In practice it
is a formidable task. As we have seen, there is no set capital structure
for cooperatives. (See Chapter 4) There are significant inter-intra industry
variations in respect of capital structures. This is because of the influence
of a host of factors, both quantitative and qualitative on the capital structure.
Solomon, Ezra and Pringle, John. J., Introduction to Financial Management, California : Good Year Publishing Co., 1977, pA70
12.
214
This section analyses empirically the factors which have a bearing on capital
structure of the selected cooperatives.
Factors influencing the capital structure are depicted in Exhibit - 2,
which shows that the 'Need for Funds' and the 'Internal Financing' are the
two immediate factors which have influence over the leverage. The 'need
for funds' depends on required initial investment, growth rate and social
cost, whereas 'internal financing' and profitability are interdependent. The
influence of 'need for funds' and 'internal financing' and the factors behind
each of these two variables are briefly stated here.
Need for funds : The need for funds is the first factor which has
a direct influence on the capital structure of a firm. A firm requires for
initial investment to start its manufacturing operations. The amount of
initial investment depends upon the proposed installed capacity and social
investments when the firm is established. Initially, a cooperative firm may
not be able to mobilize adequate equity capital from its members because
of their poor socio-economic background. Therefore, it has to rely on debt
for financing its assets. The need for additional funds arises when a firm
has steady growth rate. When a firm takes up expansion or modernization,
it involves a huge capital outlay. This could not entirely be met out of
owned funds. Hence a firm has to resort to debt to meet the additional
investment.
to
-1^
>
215
Apart from this a firm has its social obligations. The cost of welfare
measures such as education, health care facilities for members and employees
and housing for employees, etc. is called social cost. Social cost is un
productive in nature.
Internal Financing : Yet another factor which has a direct bearing
on the capital structure is internal financing. A firm with steady profitability
could easily meet and settle its fixed obligations at a quicker pace and could
generate its own internal funds. This would not only help such firms to
reduce the proportion of debt in their capital structure but also, would
obviate the need for external financing. Further a cooperative which
anticipates a stable profitability can boldly resort to debt capital _to- finance
its assets, for it may not have any difficulty in honouring its future fixed
obligations. Thus, profitability enables a cooperative to generate its own
internal funds and therefore it can modify its capital structure to its best
advantage. (See Chapter 4)
Profitability of a cooperative, in turn, depends on its degree of
operating profit to changes in sales. The profit of a highly leveraged
(operating) firm is likely to increase at a faster rate than the increase in
sales. But if sales fall, it will suffer a greater loss. Thus the degree of
operating leverage represents a firm's business risk. A cooperative with
a high degree of operating leverage resorting to debt capital to finance
its assets will expose itself to greater risk because superimposition of a
216
high financial leverage on an already highly operating leverage will result
in a higher combined leverage. This has an impact on the profitability.
(See Chapter k)
The degree of operating leverage is influenced by several factors.
One major determinant of operating leverage is the variability of sales
revenue. The variability in sales generally depends on the characteristics
of industry, effectiveness of market efforts, technological developments
and general economic condition. Another major determinant of operating
leverage is the variability in operating expenses. An increase in "supply-price"
of raw material and labour contributes to the variability of operating expenses.
The extent of the firm's fixed costs in operation also influences the degree
of operating leverage.
The Capacity Utilization plays a crucial role in determining the
profitability of a firm. A firm with a higher capacity utilization tends to
increase its production and productivity and this would contribute towards
higher profitability. On the other hand, under-utilization of capacity leads
to locking up of resources, high cost of production and therefore low
profitability.
The Operating efficiency, yet another determinant of profitability,
implies the efficiency with which capital employed is rotated in the process
of doing business. Effective rotation of capital would lead to higher
profitability. The operating efficiency of the firm can be determined by
the efficiency in utilising the total assets, fixed assets and inventory.
217
The Gross Operating Margin is also a measure of profitability. It
is an indicator of the efficiency of the operation of production. A firm
with a fairly higher percentage of gross margin is well on the way to higher
percentage of operating profit. The gross operating margin is influenced
by rate of change in cost of production and rate of change in selling price.
A stable or declining trend in the rate of change in cost of production would
help a firm to achieve a higher gross operating margin. On the other hand,
an increasing trend in cost of production would cause a reduction in gross
operating margin. The variability in sales may also affect gross operating
margin. If the sales revenue is fairly stable, then the firm's profit would
be stable. Such a stability paves the way either for going in for a higher
level of debt or for lessening the proportion of debt in the capital structure.
Bes.ides these, recovery of sugar from sugarcane in cooperative sugar mills
has an influence on the gross operating margin. A sugar mill with higher
percentage of recovery, other things being equal, could bring down the cost
of production and thereby could enhance the gross operating margin.
From the foregoing analysis it is clear that the "need for funds" and
the "internal financing" are the two factors which directly influence the
leverage. Internal financing depends on profitability, which in turn is
influenced by a host of factors. Similarly the 'need for funds' is also
influenced by a host of factors.
We will now present the empirical evidence to show the influence
of various factors on leverage.
218
We will begin with 'need for funds' and the factors which influence
the 'need for funds'.
'Need for Funds' and Leverage
A firm requires fund for capital investment. The quantum of investment
depends on the nature of the industry. Firms with low capital intensiveness
may require less amount of funds whereas firms which are of a high capital-
intensive nature may require large funds. Funds required at the time of
establishment of a firm are called initial investment. Investment in expansion
and modernization is called additional investment. The growth rate of
company determines the quantum of additional investment. Funds rquired
to honour social commitments are called social cost. Thus the need for
funds depends on initial investment, growth rate and social cost. (See Page 214)
In this section we will see how these factors affect the 'leverage' in the
selected cooperatives.
Initial Investment : Cooperative sugar and spinning mills are capital-
intensive mills. The project costs of these mills increase year after year.
The project cost of a cooperative sugar mill with a capacity of 800 to 1000
TCD established in the middle of 50*s was Rs.110 lakhs. The mills
commissioned in 60's, 70's and 80's had to incur very high project cost because
of the sharp escalation in the cost of machinery, building material and land.
For instance, the cost of establishing a cooperative sugar factory with a
13 crushing capacity of 1250 TCD was only Rs.256.26 lakhs in 1971-72.
Data were drawn from the Annual Reports and Working
the Cooperative Sugar Mills.
13.
219
This increased to Rs.660 lakhs in 1976-77 and shot upto Rs.1020 lakhs in
1983-'84. Thus, wi th in a period of 12 years there has been a four-fold increase
in the cost of establishing a cooperative sugar factory. Similarly the cost
of establishing a cooperative spinning mil l with a capacity of 12,000 spindles
has increased f rom Rs.66 Jakhs in middle 60's to Rs.265 lakhs in middle
80's recording around a four- fold increase in the project cost over a period
14 of 20 years. Thus the establishment of the cooperative sugar and spinning
mills involves a huge capital outlay.
Such huge in i t ia l capital expenditure could not be financed out of
owned funds of the selected cooperatives, because of two reasons : First,
the share capital col lected from members at the time of establishment is
meagre, because a majori ty of the members subscribe just the minimum
amount of share capital to fu l f i l l membership eligibil ity. Second, there
are no reserves. Thus the equity capital is meagre. Hence the mills, at
the t ime of their establishment, have to rely heavily upon debt. An analysis
of the mode of f inancing of the sample sugar mil l reveals that the proportion
of debt in the i n i t i a l . to ta l capital varies between 60 to 75 percent and that
of equity ranges between 25 percent and 40 percent. It should be pointed
out that the major chunk of the equity contribution comes from the
government. Similarly in cooperative spinning mills the debt financing of
init ial investment varies from 60 to 67 percent and that of equity from 33
to 40 percent. Here also the major part of equity is from the government.
Data were compiled f rom Inaugural Reports and Annual Reports of the Cooperative Spinning Mil ls.
14.
220
In the case of recently established cooperative spinning mills, 50 percent
of the capital cost was financed by debt and the rest by equity. The equity
contribution from members constituted 5 percent of the total project cost
16 and the Government's contribution was 45 percent. Thus the proportion
of debt is very high at the time of establishment of cooperative sugar and
spinning mills, (also see Chapter 4)
Further, if the project is not completed within the time schedule
there would be escalation in cost and the original estimate has to be revised.
For instance, the project cost of the mills with identical capacity established
at the same time was found to have varied by 5 to 10 lakhs in both cases.
The reasons for such variation are shortage of capital resources, longer
erection period and escalation in the cost of machinery. Such variations
from the original estimate will force cooperatives to go in for more debt
capital. Further it would also affect the working of the mills and most
of the mills would not be in a position to honour the fixed obligations on
their long-term loans. This in turn would keep the proportion of debt in
17 the capital structure at a higher level.
Growth rate and Leverage : A firm with a stable growth rate calls
for more funds and a greater proportion of these incremental funds may
Cooperative Spinning Mills established after 19S3-'84 do not come under the purview of the study.
Data were drawn from the project reports of the newly established Cooperative Spinning Mills.
Kadvekar S.V., Management of Cooperative Spinning Mills in Maharashtra, New Delhi : Indian Book Gallery, 1980, p.160
15.
16.
17.
221
be derived from debt sources. The growth rate depends on expansion and
modernization. If the company does not go in for expansion or modernization
the need^for long-term funds would be almost nil. A higher debt component,
other things being equal, comes with an expanding industrial activity and
the debt component of the capital structure as a whole will be small if
18 companies have hardly any expansion plans. Thus there is a positive
19 association between growth rate and the need for funds.
The measurement of growth rate poses a problem. This is because
different authors have used different criteria for measuring the growth.
20 Gupta measured the growth of the firms in terms of annual compounded
21 growth rate in sales. Singh and Whittington have used book value of net
22 assets as a measure of growth rate. Archer and Faerher have used the
18.
19.
20.
21.
22.
Pendse, "Financing New Industrial Ventures : Some Inhibiting Factors", Economic and Political Weekly, Vol.XII, No.3, July 23, p.1190
Toy N. et.ai. , "A Comparative International Study of Growth, Profitability and Risks as Determinants of Corporate Debt Ratios in Manufacturing Sector", Journal of Financial and Quantitative Analysis, Vol.9, Nov. 1974, pp.875-86. They found positive association between growth rates and debt ratios.
Gupta M.C., "The effect of Size, Growth and Industry on the Financial Structure of Manufacturing Companies." The Journal of Finance, Vnl.?fc. No.2, June 1969, p.584
Singh D and Whittington G., Growth, Profitability and _Vs London : Cambridge University Press, 1968, p.22
Archer S.K. and Faerher H.L., "Firm Size and the Cos Secured Equity Capital", Journal of Finance, Vol.21, No p.73
222
23 amount of to ta l assets as a measure of growth rate. Breen and Lerner
have used the market value of the share outstanding as a measure of a f irm's
growth rate. We, in our study use the amount of gross fixed assets as a
basis for measuring the average annual growth rate. The rationale behind
the selection of this cr i ter ion is that it reflects the production capacity
of the organization. Sales cannot be considered as a criterion for measuring
the growth rate, because sales are controlled by government especially in
• i i 2 ^ cooperative sugar mi l ls .
The relationship between average annual growth rate and the leverage
is analysed. It is seen that mills with lower growth rate have lower proportion
of debt in their capi ta l structure and the mills with higher growth rate
have higher proportion of debt in their capital structure. For instance,
the proportion of debt in a cooperative sugar mi l l with an average annual
growth rate of 6 to 7.5 percent was less than 30 percent in many of the
years under review, whreas the proportion of debt in cooperative sugar mills
with an annual growth rate of more than 7.5 percent ranged between 30
to 75 percent. Similar trend could' be seen in cooperative spinning mil ls
too. (See Tables 6A and 6.5)
Breen W.J. and Lerner E.M., "Corporate Financial Strategies and the Market Measures of Risk and Return" Journal of Finance, Vol.28, No.2, May 1973, p.342
See for example, Misra R.K., "Sales Forecasting and Financial Management in Sugar Industry", Management Accountant, Vol.20, No.3, March 1985, pp.HU-145
23.
24.
Table 6.*
Relationship between Average Annual Growth Rate of Gross Fixed Assets and Leverage
in Cooperative Sugar Mills
Note : i) Figures in brackets indicate precentage to row totals .
ii) Data are given only for six mills. Remaining four mills are not included because they are younger and have not gone in for expansion/modernization.
hO tsj OJ
Table 6.5
Relationship between Average Annual Growth Rate and Leverage in
Cooperative Spinning Mills
KJ 1SJ -c-
*4
225
This association between growth rate and leverage is tested by
correlation technique. The correlation coefficient is positive as expected.
But it is insignif icant. This means that growth rate and leverage are not
well correlated. (See Table 6.6)
This might possibly be due to financing expansion and modernization
partly through internal ly generated funds. For instance, a major chunk of
the funds required for expansion of the cooperative sugar mills was met
through internal ly generated funds. Similarly percentage of contribution
by the internal ly generated funds to the tota l sources of finance for expansion/
modernization represents 30 percent in cooperative spinning mills. (See
Tables 6.7 and 6.8) Thus in i t ia l ly , when the cooperatives do not have internal
funds they rely more upon debts. But when they go in for expansion or
modernization, the dependence on debt is less because of generation of internal
funds.
Social Cost and Leverage : Cooperatives are committed to social
justice. They cannot afford to operate in isolation from the community
in which they perform their business activit ies. They have social responsi
bilities which they must fu l f i l l . Realising this, cooperatives undertake
activit ies pertaining to dif ferent aspects of social development. Of the
two categories of mills covered under the study, cooperative sugar mills
were found to have bestowed much attention upon social development than
the cooperative spinning mills. In this section we wi l l see some of the social
welfare act iv i t ies undertaken by the cooperative sugar mills and examine
the mode of f inancing such activi t ies.
226
Table 6.6
Results of Correlation between Average Annual Growth Rate and
Leverage in Cooperative Sugar and Spinning Mills
227
Table 6.7
Capital Expenditure for Expansion of Capacity in
Cooperative Sugar Mills : Sources of Finance
(Rupees in Lakhs)
228
Table 6.8
Capital Expenditure for Expansion and Modernization in
Cooperative Spinning Mills ± Source of Finance
(Rupees in Lakhs)
229
Cooperative sugar mills in Tamil Nadu have contributed significantly
to the creation of welfare facilities particularly in the fields of education
and health. To quote a few instances :
The Salem Cooperative Sugar Mill has established a matriculation
school with a student strength of 803 and has spent an amount of Rs.55.94
lakhs towards the construction of school buildings. It has also started a
polytechnic at a cost of Rs.1.5 crores in 1984-85 under the self-financing
scheme with a student strength of 180. The mill has constructed buildings
for 12 Noon Meal Centres at a cost of Rs.5 lakhs, established a library at
a cost of 3.06 lakhs and a veterinary dispensary at a cost of Rs.2.00 lakhs.
The mill has also proposed to construct a hospital with 50 beds at a cost
of Rs.30 lakhs. Welfare measures of similar nature undertaken by the other
cooperative sugar factories are also too well known to need a separate
mention. During emergencies and natural calamities the cooperative factories
take up relief and rehabilitation measures. Sugar factories have liberally
contributed funds to eye camps, the nutritious noon meal scheme and other
welfare scheme launched by the government.
These social commitments do require funds. These requirements
(in the case of cooperative sugar mills) are generally met from net earnings
and from Area Development Fund. Mills with higher profitability were
found to have spent much on such social development activities. Therefore
investment in such activities does not affect leverage.
230
Factors Influencing Profitability
Profitability is the dependent variable. The independent variables
which have influence over the profitability are capacity utilization, degree
of operating leverage and operating efficiency measured through total assets
turnover, fixed assets turnover, and inventory turnover. The influence of
these five variables on the dependent variable is analysed at three stages.
Firstly, the relationship between independent and each dependent variable
is studied through simple correlation technique. Secondly, there is a possibility
of inter-correlation among the independent variables. Hence simple correlation
matrix is used to study the inter relationship among independent variables.
Finally all the five variables are put into multiple correlation and regression
analysis in order to determine their contribution to the total variance of
the dependent variable.
Capacity Utilization and Profitability : Capacity has a direct relation
ship with profitability. The higher the utilization of capacity, the higher
is the profitability. The correlation coefficients are positive and significant
at 5 percent level. This leads to the conclusion that there is a positive
relationship between capacity utilization and profitability.
The factors which determine the full capacity utilization in the case
of sugar mills are regular cane supply and avoidance of mechanical breakdown.
The major factors which determine full capacity utilization in spinning
mills are uninterrupted power supply, discipline among the labourers and
effective plant maintenance. (See Chapter 3)
231
Degree of Operating Leverage and Profitability : The degree of
operating leverage is the percentage change in profits resulting from a
percentage change in sales. A high degree of operating leverage implies
that a large change in profits occurs due to a relatively small change in
sales. But if the sales fall, the firm with high degree of operating leverage
suffers a greater loss.
To study the relation between the variables, correlation test was
applied. Correlation coefficients are negative and are highly insignificant.
This means that degree of operating leverage does not influence profitability.
This may be explained. The percent change in sales should result in a percent
change in profit. This is possible only when there is stability in sales and
in operating expenses. But the stability of sales depends on various factors
like characteristics of the industry, effectiveness of market efforts and
general economic condition. Sugar and spinning, being agro-industries, find
their production and sales tied to the seasonal vagaries of agricultural
production. We have seen (Chapter 3) that a unique feature of sugar and
spinning industries is a production variance cycle of 4 to 6 years - two to
three years of higher production followed by two to three years of low
production. Such a trend is the result of rise or fall in production of raw
material. The fluctuations in production tend to affect the stability of
sales. Besides this the government policy of control over sugar price and
on release of sugar for sale in the open market greatly influences the price
of sugar and therefore the sales. Similarly government control on the sale
of yarn in the open market affects sales in the cooperative spinning mills.
The stability in operating expenses depends on supply price of raw
material or labour. The supply price of raw material especialy in the case
of cooperative sugar mills is decided by the government. Sugar mills have
no say over i t . Thus the two important factors namely stability of saies
and operating expenses cannot be controlled or manipulated. Hence a given
percentage change in sales does not always lead to percent change in profit.
This would have caused negative and insignificant relationship between the
degree of operating leverage and profitability.
Operating Efficiency and Profitability : The operating efficiency
is an indicator of managerial capabilities in effectively utilizing the firm's
assets. It can be measured through efficiency ratios like total assets turnover,
fixed assets turnover, and inventory turnover. The influence of these ratios
on profitability is analysed here.
The total assets turnover ratio indicates the sales generated per rupee
of investment in total assets. It shows the firm's ability of generating sales
from all its financial resources. As this ratio increases, there is more revenue
generated per rupee of total investment in assets. Idle or improperly used
assets increase the firm's need for costly financing and the expense of
maintenance and upkeep. Thus the higher the total assets turnover, the
higher is the profitability.
The correlation coefficient of total assets turnover with profitability
is positive in both the sugar and spinning industries as expected. But
correlation is rather very weak especially in cooperative spinning industry.
The weak association between these two variables may suggest high level
of under-utilization of assets.
233
The fixed assets turnover ratio measures the efficiency with which
the firm is utilizing its investment in fixed assets. It also indicates the
adequacy of sales in relation to investment in fixed assets. A high fixed
assets turnover indicates efficient utilization of fixed assets in generating
sales, while a low ratio indicates inefficient management and under-utilization
of fixed assets. Thus fixed assets turnover tends to have a positive association
with profitability.
The correlation coefficient of fixed assets turnover with profitability
is positive and significant at 1 percent level. This means that there is a
close positive association between the two variables as expected. Therefore,
it can be said that the higher the fixed assets turnover the higher is the
profitability.
The inventory turnover shows how rapidly the inventory is turned
into receivables through sales. Generally a high inventory turnover is
indicative of good inventory management and a lower inventory turnover
suggests an inefficient inventory management. A low inventory turnover
implies excessive inventory levels than warranted by production and sales
activities, or a slow moving or obsolete inventory. A high level of sluggish
inventory amounts to unnecessary tie-up of funds, impairment of profit and
increased costs. Thus inventory turnover ratios are likely to have positive
association with profitability.
234
Table 6.9
Simple Correlation of Selected Factors with Profitability
(Cooperative Sugar Mills)
235
Table 6.10
Simple Correlation of Selected Factors with Profitability
(Cooperative Spinning Mills)
236
To study the relationship between inventory turnover and profitability,
correlation' test was applied. The correlation coefficient is positive and
significant at 1 percent level in cooperative sugar mills and it leads to
the conclusion that there is positive relation between inventory turnover
and profitability. The correlation coefficient in the case of cooperative
spinning mills is also positive but insignificant. Hence, inventory turnover
in cooperative spinning mills does not influence profitability. One possible
explanation may be that the cooperative spinning industry might have too
high inventory turnover ratios which in turn might, possibly be the result of
very low levels of inventory. Low level of inventory results in frequent
stockout. This might have caused a weak association between the variables.
To sum up, capacity utilization, fixed assets turnover and inventory
turnover have positive association with profitability in cooperative sugar
mills, whereas capacity utilization and fixed assets turnover have positive
association with profitability in cooperative spinning mills. (See Tables 6.9,6.10)
Inter-correlation between Independent Variables : Are there significant
inter-correlations among independent variables under study ?
In order to find an answer to this question, the correlation matrices
were computed.
The analysis of Inter-correlation among independent variables reveals
that capacity utilization is positively associated with total assets turnover
and fixed assets turnover and is significant at 1 percent level. The association
237
between capacity utilization and inventory turnover was negative and
significant at 1 percent level. The negative sign suggests that the higher
tne capacity utilization, the lower is the inventory turnover and vice-versa.
The association of total assets turnover with that of fixed asset turnover
and inventory turnover is positive and significant at 1 percent level. The
association of degree of operating leverage with other variables is very
weak. Thus, inter-correlation was found to be significant among capacity
utilization, total assets turnover and inventory turnover. (See Table 6.11)
An analysis of inter-correlations among independent variables in
cooperative spinning mills presents a slightly a different picture. The relation
of capacity utilization with fixed assets turnover and inventory turnover
is more or less similar to that of cooperative sugar mills. Capacity utilization
and total assets are positively associated ; but the association is weak and
insignificant. The association between total assets turnover and fixed assets
turnover is positive and significant at 1 percent level. Thus the results
of inter -correlations among the variables are mixed and they demonstrate
the lack of internal consistency. (See Table 6.12)
Having studied the inter-relations among the independent variables,
we now present a multiple correlation and regression analysis in order to
determine the contribution of independent variables to the total variance
of the dependent variable.
238
239
Table 6.12
Inter-Correlation between Independent Variables in
Cooperative Spinning Mills
240
The multiple regression test is significant at 1 percent level. It indicates
that three variables namely capacity utilization, fixed assets turnover and
inventory turnover together have a positive significant relationship with
profitability. The first one is significant at 5 percent level and the last
two at 1 percent level. The degree of operating leverage and the total
assets turnover did not make much of a contribution to profitability. The
value of multiple correlation coefficient is 0.461 and is significant at 1
percent level. This means that all the five variables have a significant • • 2
positive relationship with profitability. The value of R is 0.213. This shows
that the contribution of the above five variables to profitability was 21.30
percent. (Table 6.13)
Leaving the insignificant variables, the three significant variables
were put into a fresh multiple regression analysis.
The multiple regression test is significant at 1 percent level. Out
of three factors, capacity utilization does not make any significant contri
bution to profitability but the other two factors have a significant relationship
with profitability. The total contribution of these three factors to profitability
works out to 20.5 percent which is only 0.80 percent lower than the total
contribution (21.30 percent) of all the five factors put into multiple regression
analysis. Thus the influence of degree of operating leverage and total assets
turnover is quite negligible. The value of multiple correlation coefficient (R)
was 0.453 and was significant at 1 percent level showing that the above
three variables together have a significant positive relationship with
241
Table 6.13
Contribution of Independent Variables to the Total Variance of Profitability
Results of Partial Regression and Multiple Correlation Analysis
(Cooperative Sugar Mills)
tea..
242
prof i tabi l i ty . The standard regression coeff ic ient indicates the f ixed assets
turnover is the most important factor fol lowed by inventory turnover in
influencing prof i tab i l i ty . (See Table 6.14)
Turning to cooperative spinning mil ls, barring f ixed assets turnover,
no other variables had any significant association wi th prof i tabi l i ty . The
value of mult iple correlation coeff ic ient was 0.267 and significant at 1 percent
2 level. The value of R is 0.072. This indicates that the contribution of
the above factors to prof i tabi l i ty was only 7.2 percent. (See Table 6.15)
Relationship of Gross Operating Margin wi th Prof i tabi l i ty : Yet
another variable which has a strong association wi th prof i tab i l i ty is gross
operating margin. Since gross operating margin has a direct relat ion wi th
prof i tabi l i ty , it is separated from other identi f ied variables and the association
of gross operating margin wi th prof i tabi l i ty is analysed separately.
We have seen that the higher the gross operating margin, the higher
would be the prof i tab i l i ty . The nature of this relationship was studied by
applying the correlation technique. The correlat ion coeff icient is signif icant
at 1 percent level which shows that gross operating margin is strongly and
positively related to prof i tabi l i ty . (See Table 6.16)
243
Table 6.14
Contribution of 3 Independent Variables to the Total Variance of
Profitability : Results of Partial Regression and Multiple Correlation Analysis
(Cooperative Sugar Mills)
2* *
Table 6.15
Contribution of Independent Variables to the Total Variance of Profitability
Results of Partial Regression and Multiple Correlation Analysis
(Cooperative Spinning Mills)
245
Table 6.16
Correlation Between Gross Operating Margin and Profitability
Factors Influencing Gross Operating Margin
The factors which are identified and are expected to have influence
over the gross operating margin are the rate of recovery, the rate of change
in cost of production, the rate of change in selling price and the variability
in sales. In the case of cooperative spinning mills only two variables, namely,
the rate of change in cost of production and the variability in sales were
studied. The other two factors - recovery of yarn and rate of change in
selling price - could not be included for want of data.
The principal technique employed in studying the factors influencing
the gross operating margin is the same as that used to study the factors
influencing profitability.
Relation of Recovery with Gross Operating Margin : Recovery of
sugar from sugarcane helps in reducing the cost of production and therefore
246
leads to higher gross operating margin. It is expected that higher recovery
would lead to higher gross operating margin.
The relationship between recovery and gross operating margin is tested
by the correlation technique. The correlation coefficient is positive and
significant at 1 percent level. This indicates that as the recovery increases,
gross operating margin also increases. (See Table 6.17)
The Rate of Change in Cost of Production and Gross Operating Margin :
A change in cost of production is likely to bring a change in gross operating
margin. A fall in cost of production may result in higher gross operating
margin, whereas a rise in cost of production may cause a decline in the
gross operating margin. Thus there is an inverse relation between rate of
change in cost of production and gross operating margin. The nature of
the relation was studied by applying the correlation technique.
The correlation coefficient is negative and significant at 1 percent
level. That is, an upward trend in the rate of change in cost of production
results in lower gross operating margin and a downward trend in the rate
of change in cost of production helps to increase the gross operating margin.
(See Table 6.17) The results in cooperative spinning mills show a very
weak positive association and thus it runs counter to expectation. (See
Table 6.18)
247
Rate of Change in Selling Price and Gross Operating Margin : A
rise or fal l in selling price affects the gross operating margin. A higher
and upward rate of change is l ikely to increase the gross operating margin,
whereas a fa l l in rate of change of selling price may result in lower gross
operating margin. The nature of this relationship was studied by applying
the correlation technique. The correlation coeff icient of rate of change
in selling price and gross operating margin is positive as expected but it
is insignif icant. (See Table 6.17) The reason might be government control
on sugar price.
Variabi l i ty in Sales and Gross Operating Margin : A steady growth
in sales tends to increase the gross operating margin, whereas a fa l l
in sales is l ikely to adversely af fect the gross operating margin. Therefore,
it is expected that var iabi l i ty in sales would positively relate to gross
operating margin. The relationship between these two variables was tested
by correlat ion technique. The correlation coefficient is negative in co
operative sugar mills and is significant at 5 percent level. (See Table 6.17)
The negative association may be explained. Sugar production being a seasonal
industry, the production is confined to roughly f ive months in an year. The
sugar produced during the f ive months has to be stored and released in the
market, over the fu l l year. Unless the releases from the factories to the
market are properly regulated, there are l ikely to be wide fluctuations in
availabil i ty and prices. Sugar, being an essential commodity, the government
ensures its avai labi l i ty at reasonable prices throughout the year through
levy system and control on release of open market sugar. Such a control
248
Table 6.17
Simple Correlation of Selected Factors with Gross Operating Margin
(Cooperative Sugar Mills)
249
Table 6.18
Simple Correlation of Selected Factors with Gross Operating Margin
(Cooperative Spinning Mills)
250
may not cause much variation in sales. This confirms an earlier conclusion
25 arrived at by Chakraborthy. Hence the negative association.
The association between variability in sales and gross operating margin
is positive and is significant at 1 percent level in cooperative spinning mills.
That is, a steady growth in sales increases the gross operating margin of
the mills.
Inter -Correlation Among Independent Variables.-
Inter-correlation among independent variables indicate that there
is positive and significant association between recovery and rate of change
in selling price. Such a positive association may be attributed to fixation
of levy price on the basis of recovery. A positive association is also seen
between rate of change in cost of production and rate of change in selling
price. This may be explained. A component in cost of production is
conversion cost. Conversion cost is influenced by the recovery of sugar
from sugarcane. The price of levy sugar is mainly based on conversion cost.
Hence the higher the conversion cost, the higher would be the levy price.
Thus, the rate of change in cost of production is positively associated with
the rate of change in selling price. The association between rate of change in
Chakraborthy S.K., Corporate Capital Structure and Cost of Capital, Calcutta : Institute of Cost and Works Accountants, 1977, p.84. He says that •''• when there is an external control on sales, sales value figure will have different relation with gross operating margin.
25.
251
the cost of production and the variability in sales is negative and significant
at 5 percent level. This means a rise in cost of production affects the sales.
The association among other variables are insignificant. (See Table 6.19)
Table 6.19
Inter-Correlation Among Independent Variables
(Cooperative Sugar Mills)
252
Table 6.20
Inter-Correlation Among Independent Variables
(Cooperative Spinning Mills)
Significant at 1 % level.
In the case of cooperative spinning miiis onJy.two independent variables,
namely, the rate of change in cost of production and the variability in sales
were considered. The inter-correlation between these two variables is positive
and significant. That is, the higher the rate of change in the cost of
production, the higher is the variability in sales. (See Table 6.20)
All the four factors, namely, recovery, rate of change in cost of
production, rate of change in selling price and variability in sales in the
case of cooperative sugar mills were put into multiple correlation and
regression analysis in order to determine their contribution to the total
variance of the dependent variable namely gross operating margin.
253
The multiple regression test is significant at 1 percent level. It shows
that recovery, rate of change in cost of production, variability in sales-
together have a significant relationship - the first one positive and the last
two negative - with gross operating margin. The variables, rate of change
in selling price, did not make any significant contribution to gross operating
margin, when the effects of all other variables were controlled. The value
of multiple correlation (R) is 0.449. The coefficient is significant at 1 percent
level. This means that the above four variables together had a significant
2 positive relationship with gross operating margin. The value of R is 0.249.
(See Table 6.21)
With a view to estimating the contribution of the three significant
factors only, a fresh multiple regression equation was fitted with them.
Recovery, ra te of change in cost of production and variability in sales
together account for 23.6 percent of the variation in gross operating margin 2
(R = 0.236). This is only about 1.3 percent lower than the total contribution
(24.9 percent) of all the four factors put into multiple regression analysis.
Thus the influence of rate of change in selling price on gross opperating margin
is quite negligible. The value of the multiple correlation coefficient (R)
was 0.4857. The coefficient is significant at 1 percent level, showing that
the above three variables together have a significant positive relatinship
_with gross operating margin.
254
Table 6.21
Contribution of Independent Variables to the Total Variance of Gross Operating Margin .- Results of Partial Regression and Multiple Correlation
Analysis (Cooperative Sugar Mills)
The standard regression coefficient indicates that recovery is the
;most important factor followed by the rate of change in cost of production
__ahd_y_ariability in sales. (See Table 6.22)
The multiple regression test for cooperative spinning mills reveals
that the test is significant at 1 percent level. Of the two factors, variability
255
Table 6.22
Contribution of 3 Independent Variables to the Total Variance of
Gross Operating Margin - Results of Partial Regression and
Multiple Correlation Analysis
(Cooperative Sugar Mills)
256
in sales has a significant positive relationship with gross operating margin.
The value of multiple correlation coefficient is 0.272. The coefficient is
significant at 1 percent level. This means that the two variabiles together
have a significant positive relationship with gross operating margin. The
2 value of R is 0.074. This indicates that the contribution of the above two
variables to gross operating margin is 7'A percent (See Table 6.23)
So far our discussion has centred around the profitability and the
factors influencing profitability. Now we will present the relationship between
profitability and leverage. Profitability may not directly influence the
leverage. If at all it has to influence leverage it has to do only through
26 retained earnings. Retained earnings is the off-shoot of profitability.
A firm with steady and sound profitability would be in a position to generate
more internal funds. If a firm has a high volume of retained earnings then
it should have to rely less on external debt financing. The relationship
between retained earnings (internal financing) and leverage is tested by simple
correlation technique.
Charleton W.J. and Silberman I.H., "Joint Determination of Rate of Return and Capital Structure : An Economic Analysis", Journal of Finance, Vol.32, No.2, June 1977, pp.811-21. The authors are of the opinion that high profitability will automatically reduce debt ratios through retentions. Also see, Harold, Peterson, "Risk and the Capital Structure of the firm" Journal of Finance, Vol.XIX, No.l, March 1964, pp.120-21.
26.
257
Table 6.23
Contribution of Independent Variables to the Total Variance of Profitability
Results of Partial Regression and Multiple Correlation Analysis
(Cooperative Spinning Mills)
258
The correlation coefficient is negative and significant at 1 percent
level for both cooperative sugar and spinning mills. (See Table 6.2k) That
is, higher retained earnings lead to low level of leverage and vice-versa.
Table 6.2f
Relationship between Retained Earnings and Leverage
Thus far, we have seen factors affecting leverage given in the model
with empirical evidence. Now we will present two more factors which are
not included in the model but have a steady influence on the leverage.
Age and Leverage : Newer firms to-day may find it necessary to
have a large recourse to loans because of the high capital outlay and in
adequacy of owned funds. An older firm, on the other hand, may have enough
accumulated profit to reduce its reliance on debt. Some authors suggest
259
a positive correlation between age and fund availability, because age implies
27 a record of successful operation and solvency. This means, as age increases
the proportion of debt in the capital structure decreases. This relationship
is explored in the sample cooperatives.
Some of the sample cooperative sugar factories are younger. But
all the cooperative spinning mills are long standing ones. The relation between
age and leverage in cooperative sugar mills indicates that debt level is more
than t+5 percent in older cooperatives in many of the years under review
(See Table 6.25) Cooperative spinning mills provide a different picture.
In spite of age, many of them have not been able to bring down the proportion
of debt in their capital structure because of low profitability or losses. (See
Table 6.26)
The relationship between age and leverage is tested by the correlation
technique. The correlation coefficient is negative and is significant for
cooperative sugar mills. The indication is that old age cooperatives tend
to be associated with lower proportion of debt. Thus the hypothesis that
the higher the age Qf.ih.e:roill,ithe lower may be the level of leverage is proved
in cooperative sugar mills. In th<? case of cooperative spinning mills, the
correlation coefficient is positive and significant at 1 percent level. The
result thus runs against the hypothesis. This is due to unsuccessful operations
, 28 ol many of the cooperative spinning mills.
3acoby N.H. and Weston J.F., "Factors Influencing Managerial Decision in Determining Forms of Business Financing" in Financial Management Eds., Corrigan F.J. and Ward H.A., New York : Houghton Miffin, 1963, p.75
Chakraborthy S.K., Op.Cit., p.96
27.
28.
260
Table 6.25
Relationship between Age and Leverage in Cooperative Sugar Mills
Leverage
Age 0 - 1 5 15 - 30 30 - 45 45 - 60 60 - 75 75 - 90 Total
261
Table 6.26
Relationship between Age and Leverage in
Cooperative Spinning Mills
262
Table 6.27
Results of Correlation between Age and Leverage
in Cooperative Sugar and Spinning Mills
263
Successful Cooperatives and Leverage : It is hypothesised that a
successful cooperative enterprise may attain low leverage in a lesser number
of years than an unsuccessful cooperatives. The criterion to judge the success
of a cooperative enterprise is profitability. Based on profitability, the mills
selected for the study were classified into successful and unsuccessful co
operatives. (See Chapter 2 for the definition) According to the classification
cosugars 1, 2, k, 7, 9 and 10 cospins 1 and k fall under the category of
successful cooperatives and the rest are unsuccessful cooperatives.
The leverage was low in the case of successful cooperative sugar
and spinning mills, whereas it was high among the unsuccessful cooperatives.
The association between success and leverage was further analysed
by chi-square test . The test is significant at 1 percent level The results
lead to the conclusion that successful working is associated with leverage ;
and the hypothesis relating to this association is proved. That is, a successful
cooperative enterprise may attain low leverage in a lesser number of years
than an unsuccessful cooperative enterprise.
Conclusion
The relationship between capital structure and the cost of capital
and the factors influencing the relationship for cooperative sugar and spinning
mills were analysed and the analysis leads to the conclusion that the cost
of capital is a function of leverage and there is a positive significant
correlation between the degree of leverage and the cost of capital.
264
Table 6.28
Relation of Success to Leverage in
Cooperative Sugar Mills
265
Table 6.29
Relation of Success to Leverage in
Cooperative Spinning Mills
266
Table 6.30
Significance of Relationship of Success to Leverage
w
267
The proximate factors affecting the relationship between capital
structure and the cost of capital are the need for funds and the internal
financing.
Initial investment tended to increase the degree of leverage. Additional
investment necessiated by the growth rate tended to have positive association
with leverage. But the association was found to be weak. Social cost is
mainly funded out of net earnings and Area Development Fund and so it
did not influence leverage.
Internal finance is the off-shoot of profitability. Profitability, in
turn, was determined by gross operating margin, fixed assets turnover and
inventory turnover in sugar mills. In cooperative spinning mills the profita
bility is determined by gross operating margin and fixed assets turnover,
as revealed by multiple regression analysis. The multiple regression analysis
was further carried out to locate the factors affecting gross operating margin.
The. factors influencing gross operating margin in cooperative sugar mills
are recovery, rate of change in cost of production and variability in sales.
In cooperative spinning mills variability in sales was found to influence gross
operating margin to a certain extent. The entire analysis reveals that
profitability via internal financing influences the degree of leverage. This
is corroboratedwnen profitability in successful cooperatives is related to
leverage. (Success is measured on the basis of profitability)
Age is also found to be related to leverage ; but the results are not
the same in all cooperatives.
