The purpose of this paper is to point out the relationshipbetween capital structure and a firm’s performance and profitability. Firms canbe broadly classified into financial and non-financial. There is no significantdifference in the capital structure of the two types of firm mentioned eventhough due to the unique nature and financial risk of each firm’s business aswell as variations in intra-firm business there is a considerable interindustry differences in firms’ capital structure.
This essay will also attemptto answer two main questions; Does it matter if finance comes from stocks ordebt? and What determines choice between stocks and debt? (These questions weretaken from the lecture slides). Financing decisions basically has to do with how a firm utilizesdifferent sources of finance to maximize shareholders’ wealth with minimumrisks as well as improve its competitiveness. Debt and equity financing are thetwo primary sources of capital. By issuing debt instruments, a firm is able toobtain fund to finance its operation. The purchasers of these instruments arein return promised a stream of payment as well as a variety of other covenantsrelating to the firm’s behavior. Through the covenant, the purchaser has theright to repossess collateral presented by the issuer or force the issuer intobankruptcy in situations where the firms fails to fulfill its obligation by notmaking payments.
However, debt refinancing allows shareholders to retainownership and also the firm turns to enjoy the tax advantage that comes as aresult of interest being tax deductible. On the other hand, through the sale ofits shares or ownership interest a firm avoids the obligation of making regularpayments and the risk of being forced into bankruptcy even though it leads todilution of ownership. In regards to the question does it matter if financecomes from equity or debt, this decision is ultimately influenced by the typeof firm in question. However these sources of finance are not substitutes foreach other, they are different in nature and their impact of profitabilityvary.The concept of capital structure as described by Besley andBrigham 1 is blend oflong-term debt, preference shares and net worth used as a means of permanentfinancing by any firm.
Van Horne and Wachowicz 2 also described capitalstructure as a method of long term financing which is a mixture of long-termdebt, preference shares and equity. The concept of capital structure can besaid to be a mixture of debt and equity by a firm to finance its operation andgrowth.Optimal capital structure is the right mix of debt and equitythat maximizes a firm’s return on capital thereby minimizing cost of borrowingand maximizing profit and its value. One of the crucial decisions that affectthe profitability (the ability of a firm to yield profit or financial gain) ofa firm is capital structure choice. A wrong mix of debt and equity mayprofoundly affect the performance and long term survival of the firm. Thedecision of how a firm is financed is of vital importance to both the insidersand outsiders of the firm hence they devote a lot of attention to its structure.Capital Structure TheoriesDue to the importance of capital structure, many studies andscholars have tried to inspect and find evidence for the relationship betweencapital structure and the performance of a firm. Among these is Modigliani andMiller 3 (M&M), according to them in a world without taxes, bankruptcycosts, agency cost and under a perfectly competitive market conditions, thevalue of a firm is free from the influence of how that firm is financed butrather the value of a firm depends solely on its power of earnings.
Thereasoning behind the irrelevance capital structure principle is that, sincethere are no taxes and therefore no tax advantage for interest paid on debtthere is no special reason why a firm should go for debt financing so firmsbecome indifferent as to the sources of finance. Shortly after making thishypothesis, Modigliani and Miller 4 restated that if we move to a world wherethere are taxes with all other things being equal, due to tax advantage of debtthus interest on debt is tax deductible, the firm’s value is positively relatedto debt meaning a firm can increase its value by incorporating more debt intocapital structure. Based on the second hypothesis of M, optimal capitalstructure is one that has 100% of debt.
However, there are debates on the fact that the assumptionsmade Modigliani and Miller 3 by are unrealistic and unpractical in the realworld. In light of this, other researchers have come up with several theoriesto explain the relationship between capital structure and firm’s profitability.Peking order theory by Myers 5 believes that due to information asymmetrybetween firms and investors there is no optimal capital structure rather firmshave particular preference of financing. Information asymmetry is the situationin which management have more knowledge and information about the value of afirm than investors since they work in the firm. Firms prefer to use internalsource of funding i.
e. retained earnings to external financing and externalfinancing is only employed when the internal funds have been fully utilized.Debt is preferred as external finance to equity in such cases according toMuritala 6. Based on this theory, profitable firms will use less debt sincethey will have enough funds internally from retained earnings. However thisanalogy also affected by the dividend policy and the fact firms want to signalthe market of the good performance. If based on the dividend policy firms payout more dividend, even though they are profitable they might end up using moredebt.
According to Jensen and Meckling 7 who developed agencytheory, debt and equity should be mixed in a proportion that minimizes totalagency cost. Agency cost can be divided into agency cost of debt and agencycost of equity. Agency cost equity arises from the fact the goals of managermay differ from maximizing shareholder’s fund so in order to keep managers incheck shareholders engage monitoring and control activities which comes at acost. Debtholders in order to prevent management from favoring shareholders attheir expense also give rise to agency cost. Actions of management that mayfavor investors at the expense of shareholders could include embarking of riskyinvestments and project which yields high returns for which shareholders turnto enjoys majority of the gains when the investment succeeds but debtholdersuffer the consequences of the failure of such investments.
As a result of thedebates with respect to the assumptions by Modigliani and Miller 3, statictrade-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 interestpayments. Firms therefore seek to achieve optimal capital structure by takinginto consideration the pros and cons of debt financing. Citing from (Myers, 2002, P.
88) firmswill use debt until the marginal gain of tax advantage on additional debt isnullified by the increase in the present value of realizable costs of financialdiscomfort. Brigham and Houston8 assert that optimal capital structure of a firm is determined by the tradingoff between the tax advantage from employing debt and the cost of debt such asagency cost, bankruptcy cost and as a result the firms’ value is maximized andcost of capital is minimized. The graphs below explains tax shields and cost offinancial discomfort from the use of debt influence capital structure. In the first graph, it could be seen that weighted averagecost of capital (WACC) decreases as a result of tax shield until it reaches itsminimum and then begin to increase due to the cost of too much debt.
While inthe second graph, as debt increases, the market value of the firm alsoincreases until it reaches its maximum and then it begins to decline as debtcontinues to increase, and this is also due to the cost of financialdiscomfort. Firms need to the tradeoff point between tax shield and the cost offinancial discomfort where cost of capital is at its minimum and value of thefirm is at its maximum. At this point debt at its optimal level. Variables of StudyAs a measure of a firm’s performance almost all authors usedthe profitability ratios ROA, ROE, and EPS (dependent variable) and leverageratios STDTA, LTDTA, DC, TDTA as capital structure indicators (independentvariable). Return on Asset (ROA) is shows how efficient a firm is atusing its assets to generate income. It is calculated as net income beforetaxes divided by average total assets. Return on equity (ROE) reveals how muchprofit a firm generates with the fund shareholders invested thus how well afirm generates earnings growth using investments. It is derived by net profitdivided by average shareholder equity.
Earnings per share (EPS) which iscomputed by dividing net profit minus preference share dividend by number ofoutstanding shares helps measure the amount of net income earned per firm’soutstanding shares. Leverage ratio helps measure the financial risk of a firm. Ithelps determine the firm’s ability to meet its obligations.
Short term debt tototal 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 bytotal assets of the firm. Debt to capital (DC) ratio is total debt (short termand 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 totalassets. The higher the ratios, implies high level of leverage hence high levelof financial risk.The dependent variable is an important variable since thefinancial risk faced by a firm is strongly affected by its profitability.
Thelikelihood 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 increasingthe use of tax savings. From another angle, high profit implies firms will beable to finance itself through retained earnings hence a decrease in thereliance on external funding. As a result of the fact that firms with highprofit have greater capacity to borrow hence increasing the use of tax savings,there is a positive relationship between profitability and leverage ratio in acapital structure of a firm based on Trade off theory.
However, based on Pekingtheory there is an inverse relationship between profitability and leverageratio in its capital structure since high profits implies companies will resortto using internal financing rather than external financing. Econometric model In order to examine the relationship between capital structureand profitability, all the research papers utilized the multiple regression,ordinary least squares estimator model. The only difference among the models isthe some of the models included firm specific variables such as liquidity (LQ),firm size (SZ), growth opportunities of the firm (GOP) and some macro-economicvariables such as inflation (INF) and economic growth (GDP)). These additionalvariables are to serve as control variables which seeks to single out theimpact of capital structure on firm’s performance. The performance of a firm isusually influenced by its size, large firms turn to have greater capacity andcapabilities. By including firm specific variable in the model, differences inthe operating environment of the firm is controlled for. Also the inclusion ofmacroeconomic variable controls for the effect of macroeconomic state ofaffairs.
The ability of firm to meets its short term liabilities when theybecome due is inversely related to profitability since liquid assets yield lowreturn hence low profits. The effect of inflation on firm’s profitability hasno definite conclusion. In the short run, if it is a demand pull inflation withrising economic growth as a result of increase in demand, prices of goods andservices will increase hence leading to increase in profits of firms. Howeverif it is a cost push inflation with competitive markets and high demand firmswill be forced to absorb the increasing cost and there profit will reduce. Inthe long term low inflationary economy induces higher investments and growingdemand thereby increasing profitability 16. Trujillo-Ponce 17 confirmedthat inflation and ROA of banks are positively related while Sufian andHabibullah 18 observed an inverse relation.
Economic growth goes hand in withprofitability since in recession firms are unable to perform well and makeprofits while the inverse is true in economic boomsBelow is the regression model;= ? + + + + + + + + + + ? or = ? + + + + + ? Where = firm’s performancein terms of profitability ratios , , , and = regressioncoefficient for the independent variable, , and= regression coefficient for the bank specific variables and = regressioncoefficient for the macroeconomic variables. Empirical EvidenceNegative relationshipAccording to the study by Ramadan and Ramadan 9, there wasstatistically significant inverse effect of capital structure, expressed bylong-term debt to capital ratio, total debt to capital ratio and total debt tototal assets ratio, on the performance of the Jordanian industrial companieslisted at ASE expressed by Return on asset ratio (ROA). Their research wasbased 72 industrial companies in Jordan that were listed on Amman StockExchange and the time frame of their data was from 2005 to 2013. Nassar S 10 study aimed to investigate the impact ofcapital structure on industrial companies listed under UXSIN index on theIstanbul Stock Exchange (ISE).
Data on 136 out 290 firms from the period of2005-2012 was used. In this study firm’s performance was defined by EPS, ROA, andROE while capital structure was defined by total debt to total asset ratio. Thestudy concluded that there is a statistically significant negative relationshipbetween capital structure and profitability since using high level of debtaffects a firm’s ROA, EPS, and ROE negatively.Using data of 22 banks for the period of 2005-2014, the studyby Siddik, Kabiraj and Joghee 11 on impacts of capital structure onperformance of banks in a developing economy, using evidence from Bangladeshobserved that empirically there are significant negative effects of capitalstructure on Bangladeshi banks’ performance. In their pooled ordinary leastsquare regression model, banks performance was defined by ROA, ROE, and EPSwhile capital structure was defined by STDTA, LTDTA, TDTA.
They also includedfirm specific variables and macroeconomic variables mentioned earlier for whichthey observed that growth opportunities, size, and inflation have positiverelationship while GDP and liquidity has negative relationship with performanceof banks in developing economy, viz., Bangladesh.Positive Relationship.Contrary to the empirical results of negative impacts, manystudies have also observed positive impacts. In attempt to analyze the impactof capital structure on banks’ performance in the Tehran Stock Exchange usingdata over the time period 2008-2012, S.F.
Nikoo study results showed that thereis a significant positive relationship between capital structure expressed bydebt to equity ratio and bank’s performance expressed by ROE, ROA, and EPS12.In the study by Abor 13 where the author investigated theeffect of capital structure on the profitability of listed firms on the GhanaStock Exchange during a five year period, it was evident that STDTA and TDTAhad 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 studysuggests that profitable firms has debt as their main source of finance. No Significant RelationshipWhile it is evident in some studies that there is arelationship either positive or negative between capital structure and theperformance of a firm, there are also other studies that points to the factthat there are no relationship at all. Al-Taani in his study to identify theassociation of capital structure with profitability using data from 2005-2009on Jordanian listed companies concluded that STDTA,LTDTA and TDTA which arecapital structure indicators do not have any significant relationship or effecton ROA and profit margin which are indicators of firms’ performance 14.Based on data from 1997-2005 on non-financial Egyptian listedfirms with the aim of investigating the effect of capital structure choice onthe performance of firms in Egypt, the research conclusion of Ibrahim El?SayedEbaid was there is weak-to-no impact of capital structure choice on firm’s performance 15.
Comments on the empirical EvidenceThe negative relationship results from these studiesmentioned above support the Peking order theory, which states that highlyprofitable firms are less dependent on external source of finance and thusthere is an inverse relationship between profitability and borrowing hencecapital structure. While the positive relationship results from these studiessupport the trade-off theory. Varying results from the various papers showsthat there is no conclusive or particular impact of capital structure on firm’sperformance. Other factors such as business risk, tax situation and assetstructure of the firm can affect how capital structure impact profitability.
Equity over Debt?It is evident from various studies that debt financing doesnot always lead to improved firms’ performance, so before employing debtfinance firms should have to a large extent exhausted shareholders’ funds. As aresult, risks associated with debt financing e.g. interest on debt exceedingthe return on assets financed by the debt will be minimized. In situationswhere firms have exhausted equity financing and needs to finance the expansionof its operation, reference should be made to the firm’s asset structure toensure that assets financed using debt financing earn higher returns than theinterest to be paid on the debt.It could be said that capital structure is a vital key to theprofitability and survival of firm. Obtaining an optimal capital structurewhich maximizes shareholders value and minimizes cost of capital and risk istherefore important. In order to achieve this, management needs to first analyzewhether the firm is over or under levered or has the right mix.
Based on theresult of the analysis, decision on whether to move gradually or immediatelytowards the optimal has to be made. For over levered firms with the threat of bankruptcy, debtshould be reduced by embarking on equity for debt swaps. While withoutbankruptcy threat reduction of debt can be based on whether the firm has goodprojects i.e. ROE and ROC is greater than cost of equity and cost of capitalrespectively. In cases where they are greater, the projects are financedthrough retained earnings or new equity whereas in the cases where they are notgreater debts are paid off using retained earnings or issuance new equity.For under levered firms which are takeover targets, leverageis increased through debt for equity swaps orborrow money to buy shares.
In case the firm is not a takeover target, and thefirm has good projects i.e. ROC greater is than cost of capital, the projectsare financed using debt otherwise dividends are paid to shareholders or thefirm buys back stocks.ConclusionThis essay provides evidence from various researches thatanalyze the impact of capital structure on profitability of a firm. Althoughthere is no clear cut conclusion as to whether it is a positive or negative relationshipit is important to note that optimal capital structure is vital since wrong mixof debt and equity may profoundly affect the performance and long term survivalof the firm.
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