Optimal mix of debt vs equity helps define the hurdle rate while taking capital expenditure decisions. Choice of capital structure; its optimal level compared to equity and how and when companies churn their capital structure has been researched widely in academic research.
While reviewing the relevance of capital structure for Indian companies due consideration to constraints to finance is important. Large and 'A' rated companies have a wide array to chose from while SMEs are highly constrained in terms of choices. Further, most of the SMEs in Indian are family-owned businesses who have a strong aversion to debt.
For SMEs, pecking order of financing (when internal accruals are not enough) are:
1) Unsecured loans from promoters/group companies;
2) Equity from promoter;
3) Secured borrowings from banks;
4) Equity/quasi-equity from non-promoters.
Working capital gap is funded by stretched trade credit and borrowings from non-market sources, as well. The quantum of borrowing usually depends on the nature of business and reputation the promoter enjoys in the business circle.
Traditionally, world over, family-owned businesses are known to re-deploy the retained profits to reduce debt and/or grow their business. Cost of capital is not a very important criteria for two reasons:
1) Promoters have reasonable return expectations and hence unlike an ROI of 20% and above for a PE, promoter is happy with a return of 10-12% spread for over a longer time horizon;
2) More than the cost of debt, control dilution is a far bigger reason for aversion to debt from banks.
In recent years- with what is observed by me in case of Indian firms- over-leveraging has become quite evident in the balance sheets of Indian companies, especially more alarming in case of SMEs. Increased competition and shrinking profit-margins have forced firms to resort to debt, to ensure enough liquidity to tide over trough phase of business cycle.
Hence, any attempt to comment on the relevance of capital structure for SMEs, we should look at them in a financing-need induced framework. Byoun (2007) has suggested to review capital structure changes under 4 scenarios:
1) Financial SURPLUS with MORE than optimal level of debt
2) Financial SURPLUS with LESS than optimal level of debt
3) Financial DEFICIT with MORE than optimal level of debt
4) Financial DEFICIT with LESS than optimal level of debt
* Byoun, Soku, How and When Do Firms Adjust Their Capital Structures Toward Targets?. Journal of Finance, Forthcoming.