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

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.