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Financial Management - Assignment 1

Name: Pratap Kulhari

Roll number: 50

Course: EPGDIB VSAT Batch 7

Topic: Capital structure and its effect on corporate performance

Reference Articles:

1. The impact of capital structure on profitability with special reference to it industry inIndia

2. Impact of debt structure on profitability in textile industry of Pakistan3. The effect of financial leverage on corporate performance of some selected companies

in Nigeria

Abstract of Findings:

The general findings are that while financial leverage offers tax advantages and cheaper source

of finance, the profitability has a significant negative relationship with debt ratio.


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1. The impact of capital structure on profitability with special reference to it industry in India

The journal article is aimed to find out The impact of capital structure on profitability with

special reference to it industry in India. In their study, the authors have used the data from

102 IT sector companies listed on the stock exchange. The data were collected from CMIE

(Centre for Monitoring Indian Economy) Prowess Package. 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 CS (Capital

Structure) variables and Profitability variables, Return on Assets (ROA) and Return on Capital

Employed (ROCE) and the CS has significant influence on Profitability, and increase in use of

debt fund in CS tends to minimize the net profit of the it firms listed in Bombay Stock Exchange

in India.

The article refers to various prior studies on the topic. One of the interesting facts covered inthe study is the possible bankruptcy risk while using extra debt. The higher the debt ratio, the

greater the risk, and thus higher the interest rate will be. At the same time, rising interest rates

overwhelm the tax advantages of debt. If the firm falls on hard times and if its operating

income is insufficient to cover interest charges, then stockholders will have to make up the

short fall, and if they cant, the firm may be forced into bankruptcy. Good times may be just

around the corner. But too much debt can keep the company wipeout shareholders in the

process.

In terms of preferred order of financing, 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 study has divided the sample data based on two parameters i.e. Income Groups (Low,

Medium and High) and Size of Total Assets (Small, Medium and Large). The study results show

that there is no significant relationship between selected CS variables and ROA of low income IT

firms, while there is an inverse relationship between these variables for the medium and high

income group firms. Also, there is a clear inverse relationship between CS and ROA variables for

all the three groups of firms under Asset size category i.e. small, medium and large firms.

The study concludes that overall there has been a strong one-to-one relationship between CSvariables and Profitability variables (ROA and ROCE), and the CS has a significant influence on

Profitability, and increase in the use of debt fund in CS tends to reduce the net profit of the it

firms listed in Bombay Stock Exchange in India.


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2. Impact of debt structure on profitability in textile industry of Pakistan

The journal article is aimed to find out Impact of debt structure on profitability in textile

industry of Pakistan. In order to do so, the authors have used the data from 17 companies

from the industry.

The article refers to Modigliani and Miller (1958) which states that any firms market value and

its cost of capital were free of its capital structure in the perfect market conditions. However,

according to the authors, the basic assumptions behind this study never hold true in the real

markets.

Through references to various studies, the article points out to some of the important findings

related to the subject. One such finding indicates that an increase in the long-term debt

position is linked with a decrease in profitability. As per the pecking order theory, any

organization and industry would first prefer using internal available funds, then debt and finallyexternal equity.

The authors of the study have also defined the key variables used in their study. According to

them, profitability is calculated by frequently used ratio by many researchers i.e. return on

equity (ROE). It is calculated by dividing the net profit before interest and taxes by the

shareholders equity, stating the result in percentage (however, usually the net income i.e. net

profit after interest and tax is used for ROE calculation). Return on equity reveals the

percentage earnings of the funds of a shareholder.

From the their research, it can be seen from the results that the debt levels affect theprofitability of the firm only when the sales are high (i.e. in Billions of rupees in their sample)

and has no impact on the companies which have low sales (i.e. in Millions of rupees in their

sample). Further it is also suggested that the companies with huge sales should not go for the

short term debts, as short term debts have less potential for profit for them. However, the

companies having small sales should go for the short term debts viz-a-viz long term debts. As

the latter have negative relationship with the profitability.


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3. The effect of financial leverage on corporate performance of some selected companies inNigeria

The journal article is aimed to find out What is the effect of introduction of fixed- interest-

bearing funds (debts) on the return to the firms shareholders. It is done by examining the

impact of leverage on the earnings per share and net assets per share of corporate firms in

Nigeria.

Few of the prior studies referred in the article state that debt magnifies the earnings available

to shareholders. However, this assertion will only be valid if the return on assets (ROA) is higher

than the cost of debt. In this case the more the debt, the higher the return on equity (ROE). The

implication of this is that Earnings per Share and of course, Net Assets per Share will fall if the

company obtains debt at a cost higher than the rate of return on the companys assets.

The article also explains the concept of financial leverage and its various effects on thecompanys performance. The degree of financial leverage is defined as the change in a

companys profit after tax due to changes in its EBIT. Financial leverage increases the potential

reward to shareholders, but it also increases the potential for financial distress and business

failures. It is therefore enough to note that financial leverage increases the firms (financial) risk

and hence, the equity beta of the firm.

The article concludes that leverage changes (debt/ equity ratio) have substantial effect on

corporate performance especially when the net assets per share (NAPS) is used as an

indicator of corporate performance in Nigeria over the period covered by the study. Earnings

per share depend on indirect effects of leverage changes and less on direct effects. Also, thefinding revealed that the leverage effect on earnings per share indirectly affect the net assets

per share of firms as the bulk of the effects on the net assets per share was received from

earnings per share of the firms.


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REFERENCES:

The impact of capital structure on profitability with special reference to it industry in India

By: Ramachandran Azhagaiah, Candasamy GavouryVolume 9 Number 4 Winter 2011 - Managing Global Transitions

http://www.fm-kp.si/zalozba/ISSN/1581-6311/9_371-392.pdf

Impact of debt structure on profitability in textile industry of Pakistan

By: Wali ur Rehman, Goher Fatima, Dr. Mehboob Ahmad

International Journal of Economics and Research, 2012, v3i2, 61-70

http://www.ijeronline.com/documents/volumes/Vol%203%20issue%202/ijer20120301MA(5).p

df

The effect of financial leverage on corporate performance of some selected companies in

Nigeria

By: Akinmulegun Sunday Ojo

Canadian Social Science, vol. 8, no. 1, 2012, pp. 85-91

http://cscanada.net/index.php/css/article/view/j.css.1923669720120801.700

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