Introduction. By issuing debt instruments, a firm is able


The purpose of this paper is to point out the relationship
between capital structure and a firm’s performance and profitability. Firms can
be broadly classified into financial and non-financial. There is no significant
difference in the capital structure of the two types of firm mentioned even
though due to the unique nature and financial risk of each firm’s business as
well as variations in intra-firm business there is a considerable inter
industry differences in firms’ capital structure. This essay will also attempt
to answer two main questions; Does it matter if finance comes from stocks or
debt? and What determines choice between stocks and debt? (These questions were
taken from the lecture slides).

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Financing decisions basically has to do with how a firm utilizes
different sources of finance to maximize shareholders’ wealth with minimum
risks as well as improve its competitiveness. Debt and equity financing are the
two primary sources of capital. By issuing debt instruments, a firm is able to
obtain fund to finance its operation. The purchasers of these instruments are
in return promised a stream of payment as well as a variety of other covenants
relating to the firm’s behavior. Through the covenant, the purchaser has the
right to repossess collateral presented by the issuer or force the issuer into
bankruptcy in situations where the firms fails to fulfill its obligation by not
making payments. However, debt refinancing allows shareholders to retain
ownership and also the firm turns to enjoy the tax advantage that comes as a
result of interest being tax deductible. On the other hand, through the sale of
its shares or ownership interest a firm avoids the obligation of making regular
payments and the risk of being forced into bankruptcy even though it leads to
dilution of ownership. In regards to the question does it matter if finance
comes from equity or debt, this decision is ultimately influenced by the type
of firm in question. However these sources of finance are not substitutes for
each other, they are different in nature and their impact of profitability

The concept of capital structure as described by Besley and
Brigham 1 is blend of
long-term debt, preference shares and net worth used as a means of permanent
financing by any firm. Van Horne and Wachowicz 2 also described capital
structure as a method of long term financing which is a mixture of long-term
debt, preference shares and equity. The concept of capital structure can be
said to be a mixture of debt and equity by a firm to finance its operation and

Optimal capital structure is the right mix of debt and equity
that maximizes a firm’s return on capital thereby minimizing cost of borrowing
and maximizing profit and its value. One of the crucial decisions that affect
the profitability (the ability of a firm to yield profit or financial gain) of
a firm is capital structure choice. A wrong mix of debt and equity may
profoundly affect the performance and long term survival of the firm. The
decision of how a firm is financed is of vital importance to both the insiders
and outsiders of the firm hence they devote a lot of attention to its structure.

Capital Structure Theories

Due to the importance of capital structure, many studies and
scholars have tried to inspect and find evidence for the relationship between
capital structure and the performance of a firm. Among these is Modigliani and
Miller 3 (M&M), according to them in a world without taxes, bankruptcy
costs, agency cost and under a perfectly competitive market conditions, the
value of a firm is free from the influence of how that firm is financed but
rather the value of a firm depends solely on its power of earnings. The
reasoning behind the irrelevance capital structure principle is that, since
there are no taxes and therefore no tax advantage for interest paid on debt
there is no special reason why a firm should go for debt financing so firms
become indifferent as to the sources of finance. Shortly after making this
hypothesis, Modigliani and Miller 4 restated that if we move to a world where
there are taxes with all other things being equal, due to tax advantage of debt
thus interest on debt is tax deductible, the firm’s value is positively related
to debt meaning a firm can increase its value by incorporating more debt into
capital structure. Based on the second hypothesis of M, optimal capital
structure is one that has 100% of debt.

However, there are debates on the fact that the assumptions
made Modigliani and Miller 3 by are unrealistic and unpractical in the real
world. In light of this, other researchers have come up with several theories
to explain the relationship between capital structure and firm’s profitability.
Peking order theory by Myers 5 believes that due to information asymmetry
between firms and investors there is no optimal capital structure rather firms
have particular preference of financing. Information asymmetry is the situation
in which management have more knowledge and information about the value of a
firm than investors since they work in the firm. Firms prefer to use internal
source of funding i.e. retained earnings to external financing and external
financing is only employed when the internal funds have been fully utilized.
Debt is preferred as external finance to equity in such cases according to
Muritala 6. Based on this theory, profitable firms will use less debt since
they will have enough funds internally from retained earnings. However this
analogy also affected by the dividend policy and the fact firms want to signal
the market of the good performance. If based on the dividend policy firms pay
out more dividend, even though they are profitable they might end up using more

According to Jensen and Meckling 7 who developed agency
theory, debt and equity should be mixed in a proportion that minimizes total
agency cost. Agency cost can be divided into agency cost of debt and agency
cost of equity. Agency cost equity arises from the fact the goals of manager
may differ from maximizing shareholder’s fund so in order to keep managers in
check shareholders engage monitoring and control activities which comes at a
cost. Debtholders in order to prevent management from favoring shareholders at
their expense also give rise to agency cost. Actions of management that may
favor investors at the expense of shareholders could include embarking of risky
investments and project which yields high returns for which shareholders turn
to enjoys majority of the gains when the investment succeeds but debtholder
suffer the consequences of the failure of such investments.

 As a result of the
debates with respect to the assumptions by Modigliani and Miller 3, static
trade-off theory was developed.  
According to this theory by including tax in Modigliani and Miller 3,
earnings can be protected by taking advantage of tax benefits from interest
payments. Firms therefore seek to achieve optimal capital structure by taking
into consideration the pros and cons of debt financing.  Citing from (Myers, 2002, P.88) firms
will use debt until the marginal gain of tax advantage on additional debt is
nullified by the increase in the present value of realizable costs of financial
discomfort.   Brigham and Houston
8 assert that optimal capital structure of a firm is determined by the trading
off between the tax advantage from employing debt and the cost of debt such as
agency cost, bankruptcy cost and as a result the firms’ value is maximized and
cost of capital is minimized. The graphs below explains tax shields and cost of
financial discomfort from the use of debt influence capital structure.

In the first graph, it could be seen that weighted average
cost of capital (WACC) decreases as a result of tax shield until it reaches its
minimum and then begin to increase due to the cost of too much debt. While in
the second graph, as debt increases, the market value of the firm also
increases until it reaches its maximum and then it begins to decline as debt
continues to increase, and this is also due to the cost of financial
discomfort. Firms need to the tradeoff point between tax shield and the cost of
financial discomfort where cost of capital is at its minimum and value of the
firm is at its maximum. At this point debt at its optimal level.


Variables of Study

As a measure of a firm’s performance almost all authors used
the profitability ratios ROA, ROE, and EPS (dependent variable) and leverage
ratios STDTA, LTDTA, DC, TDTA as capital structure indicators (independent

Return on Asset (ROA) is shows how efficient a firm is at
using its assets to generate income. It is calculated as net income before
taxes divided by average total assets. Return on equity (ROE) reveals how much
profit a firm generates with the fund shareholders invested thus how well a
firm generates earnings growth using investments. It is derived by net profit
divided by average shareholder equity. Earnings per share (EPS) which is
computed by dividing net profit minus preference share dividend by number of
outstanding shares helps measure the amount of net income earned per firm’s
outstanding shares. 

Leverage ratio helps measure the financial risk of a firm. It
helps determine the firm’s ability to meet its obligations. Short term debt to
total asset (STDTA) is short term debt divided by total assets of the firm.
Long term debt to total asset (LTDTA) is computed by dividing long term debt by
total assets of the firm. Debt to capital (DC) ratio is total debt (short term
and long term) divided by total capital (includes firm’s debt and shareholders’
equity). Total debt to total asset ratio (TDTA) is total debt divided by total
assets. The higher the ratios, implies high level of leverage hence high level
of financial risk.

The dependent variable is an important variable since the
financial risk faced by a firm is strongly affected by its profitability. The
likelihood of failure and bankruptcy of a firm is lower when profits are high.
Also high profit increases the ability of a firm to borrow thereby increasing
the use of tax savings. From another angle, high profit implies firms will be
able to finance itself through retained earnings hence a decrease in the
reliance on external funding. As a result of the fact that firms with high
profit have greater capacity to borrow hence increasing the use of tax savings,
there is a positive relationship between profitability and leverage ratio in a
capital structure of a firm based on Trade off theory. However, based on Peking
theory there is an inverse relationship between profitability and leverage
ratio in its capital structure since high profits implies companies will resort
to using internal financing rather than external financing.


Econometric model  

In order to examine the relationship between capital structure
and profitability, all the research papers utilized the multiple regression,
ordinary least squares estimator model. The only difference among the models is
the some of the models included firm specific variables such as liquidity (LQ),
firm size (SZ), growth opportunities of the firm (GOP) and some macro-economic
variables such as inflation (INF) and economic growth (GDP)). These additional
variables are to serve as control variables which seeks to single out the
impact of capital structure on firm’s performance. The performance of a firm is
usually influenced by its size, large firms turn to have greater capacity and
capabilities. By including firm specific variable in the model, differences in
the operating environment of the firm is controlled for. Also the inclusion of
macroeconomic variable controls for the effect of macroeconomic state of
affairs. The ability of firm to meets its short term liabilities when they
become due is inversely related to profitability since liquid assets yield low
return hence low profits. The effect of inflation on firm’s profitability has
no definite conclusion. In the short run, if it is a demand pull inflation with
rising economic growth as a result of increase in demand, prices of goods and
services will increase hence leading to increase in profits of firms. However
if it is a cost push inflation with competitive markets and high demand firms
will be forced to absorb the increasing cost and there profit will reduce. In
the long term low inflationary economy induces higher investments and growing
demand thereby increasing profitability 16. Trujillo-Ponce 17 confirmed
that inflation and ROA of banks are positively related while Sufian and
Habibullah 18 observed an inverse relation. Economic growth goes hand in with
profitability since in recession firms are unable to perform well and make
profits while the inverse is true in economic booms

Below is the regression model;

= ? +  +   +  +   +  +   +   +  +  + ?    


= ? +  +   +  +  + ?


 = firm’s performance
in terms of profitability ratios

, , , and = regression
coefficient for the independent variable

, , and= regression coefficient for the bank specific variables

 and  = regression
coefficient for the macroeconomic variables.


Empirical Evidence

Negative relationship

According to the study by Ramadan and Ramadan 9, there was
statistically significant inverse effect of capital structure, expressed by
long-term debt to capital ratio, total debt to capital ratio and total debt to
total assets ratio, on the performance of the Jordanian industrial companies
listed at ASE expressed by Return on asset ratio (ROA). Their research was
based 72 industrial companies in Jordan that were listed on Amman Stock
Exchange and the time frame of their data was from 2005 to 2013.

Nassar S 10 study aimed to investigate the impact of
capital structure on industrial companies listed under UXSIN index on the
Istanbul Stock Exchange (ISE). Data on 136 out 290 firms from the period of
2005-2012 was used. In this study firm’s performance was defined by EPS, ROA, and
ROE while capital structure was defined by total debt to total asset ratio. The
study concluded that there is a statistically significant negative relationship
between capital structure and profitability since using high level of debt
affects a firm’s ROA, EPS, and ROE negatively.

Using data of 22 banks for the period of 2005-2014, the study
by Siddik, Kabiraj and Joghee 11 on impacts of capital structure on
performance of banks in a developing economy, using evidence from Bangladesh
observed that empirically there are significant negative effects of capital
structure on Bangladeshi banks’ performance. In their pooled ordinary least
square regression model, banks performance was defined by ROA, ROE, and EPS
while capital structure was defined by STDTA, LTDTA, TDTA. They also included
firm specific variables and macroeconomic variables mentioned earlier for which
they observed that growth opportunities, size, and inflation have positive
relationship while GDP and liquidity has negative relationship with performance
of banks in developing economy, viz., Bangladesh.

Positive Relationship.

Contrary to the empirical results of negative impacts, many
studies have also observed positive impacts. In attempt to analyze the impact
of capital structure on banks’ performance in the Tehran Stock Exchange using
data over the time period 2008-2012, S.F. Nikoo study results showed that there
is a significant positive relationship between capital structure expressed by
debt to equity ratio and bank’s performance expressed by ROE, ROA, and EPS

In the study by Abor 13 where the author investigated the
effect of capital structure on the profitability of listed firms on the Ghana
Stock Exchange during a five year period, it was evident that STDTA and TDTA
had a positive relationship with ROE while LTDTA has a negative relationship.
In this study ROE was the only measure of a firm’s performance. The study
suggests that profitable firms has debt as their main source of finance.

No Significant Relationship

While it is evident in some studies that there is a
relationship either positive or negative between capital structure and the
performance of a firm, there are also other studies that points to the fact
that there are no relationship at all. Al-Taani in his study to identify the
association of capital structure with profitability using data from 2005-2009
on Jordanian listed companies concluded that STDTA,LTDTA and TDTA which are
capital structure indicators do not have any significant relationship or effect
on ROA and profit margin which are indicators of firms’ performance 14.

Based on data from 1997-2005 on non-financial Egyptian listed
firms with the aim of investigating the effect of capital structure choice on
the performance of firms in Egypt, the research conclusion of Ibrahim El?Sayed
Ebaid was there is weak-to-no impact of capital structure choice on  firm’s performance 15.


Comments on the empirical Evidence

The negative relationship results from these studies
mentioned above support the Peking order theory, which states that highly
profitable firms are less dependent on external source of finance and thus
there is an inverse relationship between profitability and borrowing hence
capital structure. While the positive relationship results from these studies
support the trade-off theory. Varying results from the various papers shows
that there is no conclusive or particular impact of capital structure on firm’s
performance. Other factors such as business risk, tax situation and asset
structure of the firm can affect how capital structure impact profitability.



Equity over Debt?

It is evident from various studies that debt financing does
not always lead to improved firms’ performance, so before employing debt
finance firms should have to a large extent exhausted shareholders’ funds. As a
result, risks associated with debt financing e.g. interest on debt exceeding
the return on assets financed by the debt will be minimized. In situations
where firms have exhausted equity financing and needs to finance the expansion
of its operation, reference should be made to the firm’s asset structure to
ensure that assets financed using debt financing earn higher returns than the
interest to be paid on the debt.

It could be said that capital structure is a vital key to the
profitability and survival of firm. Obtaining an optimal capital structure
which maximizes shareholders value and minimizes cost of capital and risk is
therefore important. In order to achieve this, management needs to first analyze
whether the firm is over or under levered or has the right mix. Based on the
result of the analysis, decision on whether to move gradually or immediately
towards the optimal has to be made.

For over levered firms with the threat of bankruptcy, debt
should be reduced by embarking on equity for debt swaps. While without
bankruptcy threat reduction of debt can be based on whether the firm has good
projects i.e. ROE and ROC is greater than cost of equity and cost of capital
respectively. In cases where they are greater, the projects are financed
through retained earnings or new equity whereas in the cases where they are not
greater debts are paid off using retained earnings or issuance new equity.

For under levered firms which are takeover targets, leverage
is increased through debt for equity swaps       or
borrow money to buy shares. In case the firm is not a takeover target, and the
firm has good projects i.e. ROC greater is than cost of capital, the projects
are financed using debt otherwise dividends are paid to shareholders or the
firm buys back stocks.


This essay provides evidence from various researches that
analyze the impact of capital structure on profitability of a firm. Although
there is no clear cut conclusion as to whether it is a positive or negative relationship
it is important to note that optimal capital structure is vital since wrong mix
of debt and equity may profoundly affect the performance and long term survival
of the firm.






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11.  Siddik, M.N.A.; Kabiraj, S.; Joghee,
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17.  Trujillo-Ponce, A. (2013) What
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18.  Sufian, F.; Habibullah, M.S. (2009)
Determinants of bank profitability in a developing economy: empirical evidence
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