International Journal of Management and Social Sciences Research (IJMSSR) ISSN: 2319-4421 Volume 2, No. 8, August 2013 i-Xplore International Research Journal Consortium www.irjcjournals.org 55 Interrelationship between Capital Structure and Profitability with Special Reference to Manufacturing Industry in India Prof. Gurmeet Singh, Ph.D. Research Scholar, N.R. Institute of Business Management, Gujarat Technological University, Ahmedabad ABSTRACT The determination of a company’s capital structure constitutes a difficult decision, one that involves several and antagonistic factors, such as risk and profitability. That decision becomes even more difficult, in times when the economic environment in which the company operates presents a high degree of instability. Therefore, the choice among the ideal proportion of debt and equity can affect the value of the company, as much as the return rates can. This study analyses how far the capital structure (cs) affects the Profitability (p) of corporate firms in India. The study tries to establish the hypothesized relationship as to how far the cs affect the business revenue of firms and what the interrelationship is between cs and Profitability. This study is carried out after categorizing the selected firms into three categories based on two attributes, viz. business revenue and asset size. First, firms are grouped into low, medium and high based on business revenue. Second, firms are classified into small, medium and large based on asset size to establish the hypothesized relationship that cs has significant impact on Profitability of Manufacturing firms in India. Regression Analysis in addition to descriptive statistics such as Mean, Standard Deviation, and Ratios has been used. The study proves that there has been a strong one-to-one relationship between Capital Structure variables and Profitability variables, Return on Assets (ROA) and Return on Capital Employed (ROCE) and the Capital Structure has significant influence on Profitability, and increase in use of debt fund in Capital Structure tends to minimize the net profit of the Manufacturing firms listed in Bombay Stock Exchange in India. Keywords: Capital structure, Profitability, ROA, ROCE, Manufacturing, India INTRODUCTION Investment opportunities have expanded and financing options have widened in a wake of liberalization and globalization of economic policies across the world, and above all dependence on capital markets has increased. A new business requires capital and still more capital is needed if the firm is to expand. The required funds can come from many different sources and by different forms. Firms can use either debt or equity capital to finance their assets. The best choice is a mix of debt and equity. One of the most perplexing issues facing financial managers is the relationship between capital structure (cs), which is the mix of debt and equity financing, and stock prices. The debt is advantageous (relative to equity) if Debt Equity Ratio (der > 1), otherwise it is harmful. A pecking order framework is intended to explain variations in Capital Structure (Myers 1984). The issue of external equity is seen as being the most expensive and also dangerous in terms of potential loss of control of the enterprise by the original owner-managers. The information advantage of the corporate managers will be minimized by issuing debt. Optimistic managers, who believe the shares of their firms are undervalued, will prefer immediately to issue debt and to avoid equity issue. As the requirement for external financing will increase, the firm will work down the pecking order, from safe to riskier debt, perhaps to convertible securities or preferred stock and finally to equity as a last resort (Myers and Majluf 1984). The modern theory of cs began with the paper of Modigliani and Miller (1958). They (mm) pointed out the direction that such theories must take by showing under what conditions the cs is irrelevant. Since then, many economists have followed the path they mapped. Now, some 50 years later, it seems appropriate to take stock of where this research stands and where it is going. Some other recent surveys include Taggart (1977), Masulis (1983), Miller (1988), Ravid (1988) and Allen (1991) and comments on Miller (1977) by Bhattacharya (1979), Modigliani (1982), Ross (1977), and Stiglitz (1974) and Masulis (1980), which are general surveys. Allen (1991) focuses on security design, and Ravid (1988) concentrates on interactions between cs and product market. STATEMENT OF THE PROBLEM, SIGNIFICANCE AND SCOPE The present study mainly analyses how far the cs affects the profitability of corporate firms in India. Asset size and business revenue would appear to be the important factors in determining the profitability of corporate firms. First, firms are grouped into low, medium and high based on business revenue. Second, firms are classified into small,