Capital Structure and Capital Budgeting: An Empirical and Analytical Study of the Relationship

Abstract

Due to operational constraints researchers in the field of financial management study one finance function in an isolated manner and leave other functions untouched; it creates an impression that finance decisions are disjoint sets of functions. Contrary to this, in the light of systems approach to management, the paper asserts that different finance functions are inter-related; it stresses on development of comprehensive model encompassing various components of financial management so that the decisions can be taken more objectively. As a first step, the paper examines the relationship between capital structure and capital budgeting with the use of three different methodologies, - theoretical, experimental and empirical. The paper points to the mistaken beliefs prevailing in the area and presents the true relation with experimental verifications. Empirical tests fail to prove the validity of the conventional belief that there is positive relation between leverage and value of the firm. Data and the results obtained from data analysis indicate that the actual relation between capital structure and capital budgeting is diametrically opposite to what is conventionally understood. The paper asserts that the relation, which is getting shaped under accounting and legal framework of the land should be duly complied with; otherwise, firms may be exposed to severe financial risks.