Financial Leverage and Firms Value: A Study of Agriculture Sector Firms

Abstract

The relationship between financial leverage and firm value is one of the central question in finance and has been investigated extensively both theoretically and empirically. The seminal work by Modigliani and Miller argues that financial leverage is irrelevant to firm value. Further studies by researchers have reached a paradoxical stage where an empirical issue has been raised that whether debt financing enhances or destroys firm value. The present study will rely on the data collected from secondary sources. The financial statements of the firms under study are collected from various sources such as Annual reports of the companies, CMIE (Centre for Monitoring the Indian Economy) and Capitaline database. This study is spread over a period of 9 years from 2001-2009 for the Agriculture Sector Firms, which are listed on the Bombay Stock Exchange (BSE-500). The total numbers of firms which are selected from Agriculture Sector is 18. The overall findings of the study show that there is a negative relationship existing between return on assets and financial leverage in case of Agriculture Sector Firms. The reason attributed for the same is that the return could not be maximized because it employed lower financial leverage to minimize the financial risk of the firms. The findings of the study suggest that debt to assets ratio in case of Agriculture Sector is negatively related to financial leverage. The operating profit margin in Agriculture Sector is positively related to financial leverage. The fixed assets turnover ratio revealed a positive relationship in case of Agriculture Sector and being positive is a good predictor of debt equity ratios. It is also concluded that the larger the proportion of fixed assets, the higher should be the debt equity ratio. In case of Agriculture Sector firms, the reason attributed for negative correlation of earning per share with financial leverage is because of the risk taking ability of owners and management. The negative correlation with financial leverage also depicts that successful companies do not need to place much dependence on external funding, since they can place reliance on internal reserves. The findings of this study does not support the theoretical foundation put forward by Modigliani and Miller in 1958 and corrected in 1963. The theory suggests that there is a positive relationship between the financial leverage and value of the firm by reducing the cost of capital and magnifying returns to owners.

Keywords: Financial Leverage, Capital Structure, Firm Value, Financial Ratio

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