Optimal Capital Structure

The present study is an attempt to determine an optimal capital structure in an imperfect market. The objective of the study was to determine whether an optimal capital structure exists both at micro level and macro level. Two hypothesis that there is no significant relation between cost of debt, cost of equity, cost of overall capital, debt to equity ratio and debt to capital ratio and market price of shares at micro level and macro level were framed and tested. So, in the absence of a well defined model on optimal capital structure, bivariate correlation technique was used. Then, t-test was applied to test the significance of coefficient of correlation. 30 companies listed on BSE Index were selected in the sample. The data fora 10 year period (2001-02 to 2010-11) are used. The main source of secondary data is Capitaline plus database. Seven companies have been excluded. Four of them are banks and three are excluded due to non-availability of data for the last 10 years. Primary data was collected through a questionnaire, mailed to the sample companies through post and e-mail. The questionnaires were sent to all 30 companies but since their response was poor, so the officials were contacted personally. In this manner, the data could be collected for a total 12 companies. At micro level, no significant and defmite relationship was found between capital structure and value of the firm. This is because of the fact value of a firm is affected by a multiplicity of causes. At macro level, the relationship between capital structure and value of the firm was found to be highly positive. The external factors may result in overvaluation or undervaluation of shares at micro level, but at macro level their positive and negative effects neutralize each other. So the share prices are closely approximate to true indices of the aggregate fmancial and operating results. Thus we get a high degree of positive correlation between the two. Thus the results advocate that at macro level an optimal capital structure, i.e., D/C ratio do exist which is definitely higher than 0.25 because up to this level the value of 'r' was found to be 0.79 which is statistically significant. So issuance of additional debt will increase the value of the firm.