Impact of Financial Risk Ratios on Profitability of Multinational vs. Domestic Pharmaceuticals in India

Impact of Financial Risk Ratios on Profitability of Multinational vs. Domestic Pharmaceuticals in India

Kaushik Chakraborty (Department of Commerce, Netaji Mahavidyalaya, Arambagh, India)
Copyright: © 2014 |Pages: 15
DOI: 10.4018/ijrcm.2014040105
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Abstract

The impact of financial leverage on the profitability position of the business firms under different financing alternatives and with varying levels of overall profitability is one of the most crucial issues in modern finance to sustain continuous improvement in financial performance. In fact, framing an appropriate capital structure with flexible equity and disciplined debt financing is an integral part of the entire corporate strategy to gain shareholder confidence and stakeholder support to achieve long run sustainability. No firm can ignore this aspect in the context of today's high-tech competitive business environment. Unfortunately this issue has not been addressed with due importance in India and in particular, no significant study exists on the pharmaceutical sector comparing the linkage between financial leverage and profitability of multinational companies with that of the domestic companies. The pharmaceutical industry is acknowledged as one of the most promising industries in India; therefore this study should make a significant contribution to the practice. This paper examines the relationship between financial leverage and profitability of the Indian pharmaceutical industry during the period of March 2002 to December 2011 (N=20). The researcher compared the relationship between financial leverage and profitability of multinational companies with that of the domestic companies in the Indian pharmaceutical industry. The research found strong evidence of the negative contribution of financial leverage towards improving profitability for multinational and domestic firms. Hence, these results provide strong evidence of positive contribution of financial leverage towards improving profitability in a substantial portion of the sample companies during the study period.
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Literature Review

Some of the most important theoretical and empirical studies related to the relationship between financial leverage and profitability have been reviewed here. Donaldson’s (1961) Pecking Order Theory explains how firms make their financing decisions. Donaldson observes that managers prefer to finance new investment with retained earnings rather than debt. According to this theory, firms passively accumulate retained earnings and become less levered when they are profitable.

On the other hand, firms will become more leveraged by accumulating debt when they are not profitable. However, according to the Static Tradeoff Hypothesis, which is an extension of M-M proposition [M-M (1963), Miller (1977)], higher profitability denotes a larger absolute tax burden. Hence, to take advantage of tax shield on debt, firms prefer more leverage. According to the Information Asymmetry Hypothesis, more profitable firms being less burdened by debt restrictions, enjoy more levered capital structure. Researchers like Lev (1969), Scott (1974), Hovakimian, Opler and Titman (2002) observe profitability as a responsible variable for determining debt equity ratio.

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