A study on earnings volatility and capital structure decisions

Abstract

This research delves into how companies make decisions about their financial structure and explores the connection between these choices and fluctuations in profitability. Two prominent theories, the pecking order theory and the trade-off theory, are explored to understand how companies lean towards either debt or equity financing in response to earnings volatility. The aim is to understand how human decision-making in the corporate realm responds to the dynamic nature of financial circumstances. Additionally, an example of Reliance Industries and Adani Enterprises is used to explain how a company should make decisions regarding its funding.

Introduction

In today’s business landscape, the choices companies make regarding their capital structure are crucial and strategic decisions orchestrated by the organization’s leadership. These decisions revolve around how a company secures funds for its day-to-day operations and future expansion, weighing the utilization of both debt and equity financing. The management’s choices in this realm shape the overall performance of the company and align with shareholder interests to optimize wealth. Earnings volatility, which measures how much a company’s earnings can fluctuate over time, plays a significant role in shaping capital structure decisions. Companies with higher earnings volatility face increased uncertainty and risk, impacting their engagement with capital markets and their ability to maintain a stable capital structure.

Literature reviews

Several studies have sought to understand the relationship between earnings volatility and capital structure decisions. Franks et al. (2012) found no discernible relationship between earnings volatility and leverage in European companies. They argued that other factors, such as development prospects and the impact of the financial crisis, may play a more important role in influencing capital structure decisions. Demirgüç-Kunt and Maksimovic (1999) suggested that the relationship between earnings volatility and debt is stronger for firms with greater development potential. They assume that these companies, which are more likely to suffer from financial problems, are at risk of debt financing. De Jong et al. (2004) suggested that less profitable firms have a more pronounced correlation between earnings volatility and debt. They argued that these companies lack internal financing options and are therefore increasingly reliant on external financing. Barclay and Smith (1995) found that firms with higher earnings volatility typically have higher leverage ratios. They find that companies facing significant fluctuations in revenue have limited internal financing and are forced to rely more on debt and other external financing options to sustain operations and expansion. Rajan and Zingales (1995) found a negative correlation between earnings volatility and leverage in a sample of large U.S. companies. They concluded that firms with high earnings volatility should rely more on equity financing to maintain an optimal capital structure. Titman and Wessels (1988) found that firms with more volatile earnings often had lower leverage ratios than firms with more stable earnings. They suggested that equity financing becomes a more attractive option for companies with high volatility in earnings.

The trade-off hypothesis serves as a central framework for explaining the relationship between earnings volatility and the debt component of a firm’s capital structure. This theory assumes that companies face a choice between the tax benefits of debt financing and the risk of financial distress due to excessive debt. Because of the higher risk of financial crisis, firms with more volatile earnings may be less likely to use debt financing (Myers, 1984). Support for the trade-off hypothesis is evident in several empirical studies. Huang and Song (2006) found a negative relationship between the debt ratio and earnings volatility of Chinese listed companies. Similarly, Li, Li, and Wang (2011) found that Chinese firms with higher earnings volatility generally have lower debt ratios. However, some studies have yielded inconsistent or equivocal results. Huang and Song (2006) found that the relationship between earnings volatility and debt ratio is weaker for firms with greater development potential. This means that companies with stronger growth prospects may be more willing to take on debt, despite the increased risk due to fluctuations in profitability. Similar results were reported by Fischer, Heinkel, and Zechner (1989), who found that firms with higher earnings volatility had higher debt ratios. They speculated that these companies could use debt financing as a safety net against instability in profitability.

Objectives

The objectives of this research are as follows:

• To explore how earnings volatility influences the decisions companies make regarding their capital structure.
• To delve into the nuances of the trade-off theory and pecking order theory in the context of capital structure decisions.
• To scrutinize the impact of factors like growth opportunities and profitability on the intricate relationship between earnings volatility and the choices companies make regarding their capital structure.

Methodology

This research paper utilizes pre-existing data from two different companies, Reliance and Adani Enterprises Limited. The debt and equity structures of these companies are analyzed to determine which one is more profitable based on its chosen capital structure.

Data analysis

Examining the provided statistics sheds light on the debt and equity structures of Reliance and Adani Enterprises Limited. Reliance holds a substantial debt of 3,35,134 crores alongside an equity of 8,17,400 crores. In comparison, Adani carries a debt of 53,000 crores and an equity of 53,200 crores. However, the stark difference emerges when considering the market capitalization of these companies. Reliance outshines with a market capitalization of 16,51,992 crores, while Adani lags behind with a market cap of 2,18,914 crores. This data highlights the importance of a balanced mix of debt and equity for companies. It is crucial for companies to take on debts only to an extent where they can feasibly meet their commitments to shareholders, investors, or lenders. This approach ensures sustainable growth and continuity in the foreseeable future.

Conclusion

In conclusion, there is a correlation between earnings volatility and capital structure decisions, but this connection is contingent on various factors. The trade-off theory suggests that companies with high earnings volatility may prefer equity funding over debt, while the pecking order theory proposes that companies may opt for debt financing more promptly in the face of drastic changes in earnings volatility. The literature reviews presented in this paper provide a mixed set of results, with some studies arguing for a negative link between earnings and capital structure, while others posit a positive connection. This study emphasizes the intricate nature of this relationship and the necessity for a comprehensive understanding that takes into account the dynamic interplay of factors influencing capital structure decisions in the business realm.