Impact of Capital Structure on Firms Profitability

Impact of Capital Structure on Firms ProfitabilityAn empirical study to find out relationship between capital structure and profitability of firms listed on Karachi Stock Exchange

Name: Muhammad Junaid IqbalMuhammad Bilawal AliZubair Rafique

Class: MBAE

Semester: [2011]

Submitted toAbid AwanDepartment of Management ScienceSZABIST, Islamabad

Impact of Capital Structure on Firms ProfitabilityAn empirical study to find out relationship between capital structure and profitability of Firms listed on Karachi Stock Exchange

Contents1. INTRODUCTION41.1. General Information41.2. Background to the Study41.3. Statement of the Research Problem51.4. Research Objective51.4.1. Specific Objective51.4.2. Research Questions51.5. Significance of the Study51.6. Scope of the Study61.7. Definition of Terms62. LITERATURE REVIEW62.1. Literature Review62.1.1. Capital Structure Irrelevance Theory62.1.2. The Asymmetry of Information Theory72.1.3. The Pecking Order Theory72.2. Empirical framework72.3. Theoretical Framework82.4. Hypotheses83. RESEARCH METHODOLOGY93.1. Research Paradigm93.2. Population93.3. Sample Size and Sampling Frame93.4. Data Collection Tools93.5. Operationalization of Concepts93.5.1. Profitability - Dependent Variable93.5.2. Debt ratios - Independent Variable93.5.3. Control variable.10REFERENCES11

CHAPTER ONE1. INTRODUCTION1.1. General InformationThe capital structure decision is crucial for any business organization. The decision is important because of the need to maximize returns to various organizational constituencies, and also because of the impact such a decision has on a firms ability to deal with its competitive environment. The capital structure of a firm is actually a mix of different securities issued by a firm. In general, a firm can choose among many alternative capital structures. It can issue a large amount of debt or very little debt. It can arrange lease financing, use warrants, issue convertible bonds, sign forward contracts or trade bond swaps. It can issue dozens of distinct securities in countless combinations; however, it attempts to find the particular combination that maximizes its overall market value. A number of theories have been advanced in explaining the capital structure of firms. Despite the theoretical appeal of capital structure, researchers in financial management have not found the optimal capital structure. The best that academics and practitioners have been able to achieve are prescriptions that satisfy short-term goals. For example, the lack of a consensus about what would qualify as optimal capital structure has necessitated the need for this research. A better understanding of the issues at hand requires a look at the concept of capital structure and its effect on firm profitability. This study will examine the relationship between capital structure and profitability of companies listed on the Karachi Stock Exchange.1.2. Background to the StudyThe theory of capital structure and its relationship with a firms value and performance has been a puzzling issue in corporate finance and accounting literature since the seminal work of (Modigliani & Miller, 1963) (MM-1958). MM-1958 argue that under very restrictive assumptions of perfect capital markets, investors homogenous expectations, tax-free economy, and no transactions costs, capital structure is irrelevant in determining firm value. According to this proposition, a firms value is determined by its real assets, not by the mix of securities it issues. If this proposition does not hold then arbitrage mechanisms will take place, investor will buy the shares of the undervalued firm and sell the shares of the overvalued firm in such a way that identical income streams are obtained. As investors exploit these arbitrage opportunities, the price of overvalued shares will fall and that of the undervalued shares will rise, until both prices are equal. However, these restrictive assumptions do not hold in the real world, which led many researchers to introduce additional rationalization for this proposition and its underlying assumptions showing that capital structure affects firms value and performance, especially after the seminal paper of Jensen and Meckling (1976) which demonstrate that the amount of leverage in a firms capital structure affects the agency conflicts between managers and shareholders by constraining or encouraging managers to act more in the interest of shareholders and, thus, can alter managers behaviors and operating decisions, which means that the amount of leverage in capital structure affects firm performance. 1.3. Statement of the Research ProblemSince, Jensen and Meckling (1976) argument regarding the possibility of capital structure influence on firm performance, several researchers have followed this extension and conducted numerous studies that aim to examine the relationship between financial leverage and firm performance over the last decades. However, empirical evidence regarding this relationship is contradictory and mixed. While a positive relationship between leverage level and firm performance had been documented in some of these studies (Taub, 1975; Roden and Lewellen, 1995; Champion, 1999; Hadlock and James, 2002). Other studies document a negative relationship between leverage level and firm performance (Fama and French, 1998; Gleason et al., 2000; Simerly and Li, 2000). While the literature examining the performance implications of capital structure choices is immense in developed markets (e.g. USA and Europe), little is empirically known about such implications in emerging or transition economies such as Pakistan. In such a country capital market is less efficient and incomplete and suffers from higher level of information asymmetry than capital markets in developed countries. This environment of the market may cause financing decisions to be incomplete and subject to a considerable degree of irregularity. It is, therefore, necessary to examine the validity of corporate leverage levels impact on a firms performance in Pakistan as an example of emerging economies. 1.4. Research ObjectiveThe main aim of this study is to examine the relationship between financial leverage and profitability of non financial companies listed on Karachi stock exchange.1.4.1. Specific Objective To examine the relationship between Short term Debt to Capital ratio and firm Profitability. To examine the relationship between Long term Debt to Capital ratio and firm Profitability. To examine the relationship between Total Debt to Capital ratio and firm Profitability.1.4.2. Research Questions Does level of Short term Debt has effect on firm Profitability? Does level of Long term Debt has effect on firm Profitability? Does level of Total Dept has effect on firm Profitability?1.5. Significance of the StudyThe capital structure decision is crucial for any business organization. The decision is important because of the need to maximize returns to various organizational constituencies, and also because of the impact such a decision has on a firms ability to deal with its competitive environment. Thus the findings of this study will assist financial managers in deciding the optimal mix of capital structure. This study will produce information which will be useful to them when choosing financing sources (for this case debt) and in deciding the level of debt to acquire.1.6. Scope of the StudyThis study will focus on non financial firms listed on the Karachi Stock Exchange (KSE 100 Index) basing on their accessibility and availability of data and industry participation.1.7. Definition of TermsFinancial Leverage is the proportion of debt in the capital structure. There two ways of putting into perspective the levels of debt that a firm carries i.e. Capital leverage focuses on the extent to which a firms total capital is in the form of debt and Income leverage is concerned with proportion of the annual income stream which is devoted to the prior claims of debt holders.

CHAPTER TWO2. LITERATURE REVIEW2.1. Literature ReviewThe linkage between capital structure and firm value has engaged the attention of both academics and practitioners. Throughout the literature, debate has centered on whether there is an optimal capital structure for an individual firm or whether the proportion of debt usage is irrelevant to the individual firms value. The capital structure of a firm concerns the mix of debt and equity the firm uses in its operation. Brealey and Myers (2003) contend that the choice of capital structure is fundamentally a marketing problem. They state that the firm can issue dozens of distinct securities in countless combinations, but it attempts to find the particular combination that maximizes market value. According to Weston and Brigham (1992), the optimal capital structure is the one that maximizes the market value of the firms outstanding shares.2.1.1. Capital Structure Irrelevance TheoryThe seminal work by Modigliani and Miller (1958) in capital structure provided a substantial boost in the development of the theoretical framework within which various theories were about to emerge in the future. Modigliani and Miller (1958) concluded to the broadly known theory of capital structure irrelevance where financial leverage does not affect the firms market value. However their theory was based on very restrictive assumptions that do not hold in the real world. These assumptions include perfect capital markets, homogenous expectations, no taxes, and no transaction costs. The presence of bankruptcy costs and favorable tax treatment of interest payments lead to the notion of an optimal capital structure which maximizes the value of the firm, or respectively minimizes its total cost of capital. (Modigliani & Miller, 1963) reviewed their earlier position by incorporating tax benefits as determinants of the capital structure of firms. The key feature of taxation is that interest is a tax-deductible expense. A firm that pays taxes receives a partially offsetting interest tax-shield in the form of lower taxes paid. Therefore, as Modigliani and Miller (1963) propose, firms should use as much debt capital as possible in order to maximize their value. Along with corporate taxation, researchers were also interested in analyzing the case of personal taxes imposed on individuals. (Miller, 1977) based on the tax legislation of the USA, discerns three tax rates that determine the total value of the firm. These are:(1) The corporate tax rate;(2) The tax rate imposed on the income of the dividends; and(3) The tax rate imposed on the income of interest inflows.According to Miller (1977), the value of the firm depends on the relative level of each tax rate, compared with the other two.2.1.2. The Asymmetry of Information TheoryThe concept of optimal capital structure is also expressed by (Myers S. C., The Capital Structure Puzzle, 1984) and Myers and Majluf (1984), based on the notion of asymmetric information. The existence of information asymmetries between the firm and likely finance providers causes the relative costs of finance to vary between the different sources of finance. For instance, an internal source of finance where the funds provider is the firm will have more information about the firm than new equity holders; thus, these new equity holders will expect a higher rate of return on their investments. This means that it will cost the firm more to issue fresh equity shares than using internal funds. Similarly, this argument could be provided between internal finance and new debt holders. The conclusion drawn from the asymmetric information theories is that there is a hierarchy of firm preferences with respect to the financing of their investments (Myers & Majluf, Corporate Finance and Investment decisions when firms has information that investors do not have, 1984)2.1.3. The Pecking Order TheoryThis pecking order theory suggests that firms will initially rely on internally generated funds, i.e. undistributed earnings, where there is no existence of information asymmetry, and then they will turn to debt if additional funds are needed and finally they will issue equity to cover any remaining capital requirements. The order of preferences reflects the relative costs of various financing options. The pecking order hypothesis suggests that firms are willing to sell equity when the market overvalues it.2.2. Empirical frameworkMost of the research concerning the relationship between capital structure and firms performance was conducted in developed countries and markets. A few studies empirically examined this relationship in emerging (transition) economies. For instance, Majumdar and Chhibber (1999) examine the relationship between capital structure and performance of Indian firms showing that debt level is negatively related with performance (i.e. return on net worth). Chiang et al. (2002) examine the relationship between capital structure and performance of firms in property and construction sector in Hong Kong showing that high gearing is negativity related with performance (i.e. profit margin). Kyereboah-Coleman (2007) examines the relationship between capital structure and performance of microfinance institutions in sub-Saharan Africa showing that high leverage is positively related with performance (i.e. ROA and ROE). Finally, Abor (2007) examines the relationship between debt policy (capital structure) and performance of small and medium-sized enterprises in Ghana and South Africa showing that capital structure, especially long-term and total debt level, is negatively related with performance (both the accounting and market measures). In summary, empirical studies regarding the relationship between capital structure and firms performance in developed countries provided fixed and contradictory evidence, on the other hand there is a few studies empirically examine this relationship in emerging (transition) economies. The present study extends the literature on the impact of capital structure on firms performance by empirically examining the relationship between capital structure and firms performance in Pakistan. In fact, Pakistan is a unique case because; capital market in Pakistan is less efficient and incomplete and suffers from higher level of information asymmetry than capital markets in developed countries. This environment of the market may cause financing decisions to be incomplete and subject to a considerable degree of irregularity. It is important, therefore, to explore the validity of debt financing firms performance relationship under this unique economic setting.2.3. Theoretical Framework

Short term debt/ Capital

Long term debt/ Capital

Profitability

Total debt/ Capital

Firms Size (Log of sales)(Note: The size of firm is taken as control variable (Joshua Abor, 2007)2.4. HypothesesThe study will be tested by the following hypotheses The level of short term debt has positive effect on firm profitability. The level of long term debt has positive effect on firm profitability. The level of total debt has positive effect on firm profitability. Debt to equity ratio has positive effect on profitability.CHAPTER THREE

3. RESEARCH METHODOLOGY3.1. Research ParadigmQuantitative research approach will be used to examine the impact of capital structure on firms profitability.3.2. PopulationThe population for this study will be all non financial publicly traded firms on KSE 100 Index. 3.3. Sample Size and Sampling FrameThe sampling frame of this study will be the list of all the listed non financial firms on KSE 100 Index. The listed firms will then be screened against several factors; financial services institutions (banks) will be deleted from list, and remaining firms will then be purposely selected due to availability of financial data and industry participation as per the expert opinion.3.4. Data Collection ToolsThe data will be collected via firms website and annual financial reports of the firms. 3.5. Operationalization of Concepts3.5.1. Profitability - Dependent VariableLiterature uses a number of different measures of firms profitability; but for the purpose of this study the common accounting-based profitability measure (i.e. ROE, ROA and Net profit margin) will be used. This measure will be calculated from the firms financial statements. ROE is computed as the ratio of net profit to average total equity, ROA is measured as the ratio of Net profit to total assets and Net Profit margin is computed as a ratio of Net Profit to Net Sales. 3.5.2. Debt ratios - Independent VariableDebt ratios will be measured in the study by three accounting ratios (Joshua Abor, 2007 and Chiang Yat Hung, Chan Ping Chuen Albert and Hui Chi Man Eddie, 2002): Short-term debt to the total capital; Long-term debt to total capital; and Total debt to total capital3.5.3. Control variable.Prior researches suggest that firms size may influence its performance hence larger firms have a greater variety of capabilities and can enjoy economies of scale, which may influence the results and the inferences. Therefore, this study will control the differences in firms operating environment by including the size variable in the model. Size is measured by the log of total sales of the firm (Joshua Abor, 2007) and included in the model to control for effects of firm size on dependent variable (i.e. profitability). Short-term debt to the total capital; Long-term debt to total capital; and Total debt to total capital.

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Myers, S. C. (1984). The Capital Structure Puzzle. Journal of Finance , 39, 575-592.

Myers, S. C., & Majluf, N. S. (1984). Corporate Finance and Ivestment decisions when firms has information that investors do not have. Journal of Financial Economics , 12, 187-221.

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