Introduction. in firms’ capital structure. This essay will

Topic: FinanceBank
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Last updated: May 2, 2019

Introduction.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. According to Buser(1981), there is no significant difference in the capital structure of the twotypes of firm mentioned even though due to the unique nature and financial riskof each firm’s business as well as variations in intra-firm business there is aconsiderable inter industry differences in firms’ capital structure. This essaywill also attempt to answer two main questions; Does it matter if finance comesfrom stocks or debt? and What determines choice between stocks and debt? (Thesequestions were taken 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 corporate behavior e.g. the value and risk of a firm’s assets.

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Through the covenant, the purchaser has the right to repossess collateralpresented by the issuer or force the issuer into bankruptcy in situations wherethe firms fails to fulfill its obligation by not making payments. However, debtrefinancing allows shareholders to retain ownership and also the firm turns toenjoy the tax advantage that comes as a result of interest being taxdeductible. On the other hand, the firm avoids the obligation of making regularpayments and the risk of being forced into bankruptcy when it uses equityfinancing even though it leads to dilution of ownership.

In regards to thequestion does it matter if finance comes from equity or debt, this decision isultimately influenced by the type of firm in question. However these sources offinance are not substitutes for each other, they are different in nature andtheir impact of profitability vary.The concept of capital structure as described by Besley andBrigham is blend oflong-term debt, preference shares and net worth used as a means of permanentfinancing by any firm. Van Horne and Wachowicz also described capital structureas 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 tobe a mixture of debt and equity by a firm to finance its operation and growth.

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 of a firm is capital structure choice. A wrong mix of debtand equity may profoundly affect the performance and long term survival of thefirm. The decision of how a firm is financed is of vital importance to both theinsiders and outsiders of the firm hence they devote a lot of attention to itsstructure.

Due 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 (M&M). According to them in a world without taxes, bankruptcy costs,agency cost and under a perfectly competitive market conditions, the value of afirm is free from the influence of how that firm is financed but rather thevalue of a firm depends solely on its power of earnings. Shortly after makingthis hypothesis, M&M restated that if we move to a world where there aretaxes with all other things being equal, due to tax advantage of debt thusinterest on debt is tax deductible, the firm’s value is positively related todebt 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 comprise of 100% debt.

However, there are debates on the fact that the assumptionsmade by M are unrealistic and unpractical in the real world. In light ofthis, other researchers have come up with several theories to explain therelationship between capital structure and firm’s profitability.Peking order theory by Myers believes that due to informationasymmetry between firms and investors there is no optimal capital structurerather firms have particular preference of financing.

Firms prefer to useinternal financing 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 to Muritala.According to Jensen and Meckling who developed agency theory,debt and equity should be mixed in a proportion that minimizes total agencycost. Agency cost can be divided into agency cost of debt and agency cost ofequity.

Agency cost equity arises from the fact the goals of manager may differfrom maximizing shareholder’s fund so in order to keep managers in checkshareholders engage monitoring and control activities which comes at a cost. Debtholdersin order to prevent management from favoring shareholders at their expense alsogive rise to agency costAs a result of the debates with respect to the assumptions byM, static trade-off theory was developed.   According to this theory by including tax inM, earnings can be protected taking advantage of tax benefits frominterest payments. Brigham and Houston assert that optimal capital structure ofa firm is determined by the trading off between the tax advantage fromemploying debt and the cost of debt such as agency cost, bankruptcy cost and asa result the firms’ value is maximized and cost of capital is minimized.  Definition of Key TermsEquity: Equity is used in reference to the value of anownership interest in a firm including shareholders’ equity. It is a firm’stotal assets less its total liabilities.

Debt: It is the amount owed by one party to the other. Largepurchases which firms could not have been able to make are made using debt.Debt Arrangement permits the borrower to borrow money that is to be paid at alater date with interest.Equity financing: is when capital of firm is raised throughthe sale of its shares or ownership interest.Debt financing: It is a means by which firms raise capital byselling debt instruments such as bonds, bills, and notes to investors.

Profitability: It is the ability of a firm to yield profit orfinancial gain.Cost of Capital: It is a firms cost of funding i.e.

both costof debt and cost of equity. Cost of equity is the required rate returnshareholders expect on their investment while cost of debt is the effectiverate a firm pays on all its debts.Agency Problem: It is the conflict of interest betweenmanagement of a firm and its shareholders.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.

  The dependent variable is an important variable since thefinancial risk faced by a firm is strongly affected by its profitability. Thelikelihood of failure is lower when profits are high. Also high profitincreases the ability of a firm to borrow thereby increasing the use of taxsavings.

From another angle, high profit implies firms will be able to financeitself through retained earnings hence a decrease in the reliance on externalfunding. As a result of the fact that firms with high profit have greatercapacity to borrow hence increasing the use of tax savings, there is a positiverelationship between profitability and leverage ratio in a capital structure ofa firm based on Trade off theory. However, based on Peking theory there is aninverse relationship between profitability and leverage ratio in its capitalstructure since high profits implies companies will resort to using internalfinancing rather than external financing.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. Econometric model   In order to examine the relationship between capitalstructure and profitability, almost all the research papers utilized themultiple regression, ordinary least squares estimator framework.

The onlydifference among the models used is the inclusion control variables such asfirm specific variables (firm size(SZ), growth opportunities of the firm (GOP)which is calculated by assets of current period less assets of previous perioddivided by assets of previous period), and some macro-economic variables(inflation(INF) and economic growth (GDP)). The control variables seeks to singleout the impact of capital structure on firm’s performance. The performance of afirm is usually influenced by its size, large firms turn to have greatercapacity and capabilities. By including firm specific variable in the model,differences in the operating environment of the firm is controlled for. Alsothe inclusion of macroeconomic variable controls for the effect of macroeconomicstate of affairs.

Below is the regression model;= ? +  +   +  +   +  +   +  +  + ?     or = ? +  +   +  +  + ? depending on whetherfirm specific and macroeconomic variables are controlled for.   represents the firm’sperformance in terms of profitability ratios mentioned earlier for firm i(1,2,3…) in period t (1,2,3…). , , , and represents the regression coefficient for the independentvariables,, , and, represents the regression coefficient for the bank specificvariables, and  and  represents theregression coefficient for the macroeconomic variables. All these coefficientsare to be estimated using data.  Empirical EvidenceUsing data from the period of 2005 to 2013 on 72 industrialJordanian companies listed on the Amman Stock Exchange, Ramadan and Ramadan(2015) applied unbalanced cross sectional pooled Ordinary Least Square (OLS)regression model to identify the effect of capital structure on firms’performance. Results from the study concluded that capital structurerepresented by long-term debt to capital ratio, total debt to capital ratio andtotal debt to total assets ratio has a significant inverse impact on the performancerepresented by ROA of the Jordanian industrial companies listed on ASE. Nassar S (2016) 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,and ROE while capital structure was defined by total debt to total asset ratio.The study concluded that there is a statistically significant negativerelationship between capital structure and profitability since using high levelof debt affects a firm’s ROA, EPS, and ROE negatively.Using data from the period of 2005-2014 on 22 banks inBangledesh, the study by Siddik, Kabiraj and Joghee on impacts of capitalstructure on performance of banks showed there are significant negative relationshipbetween capital structure and Bangladeshi banks’ performance. In their pooledordinary least square regression model, banks performance was defined by ROA,ROE, and EPS while capital structure was defined by STDTA, LTDTA, TDTA. Theyalso included firm specific variables and macroeconomic variables mentionedearlier for which they observed that growth opportunities, size, and inflationhave positive relationship while GDP has negative relationship with performanceof banks in developing economy, viz., Bangladesh.

The results from these studies mentioned above support thePeking order theory, which states that highly profitable firms are lessdependent on external source of finance and thus there is an inverserelationship between profitability and borrowing hence capital structure.In contrast to the above empirical results of negativeimpacts, other studies have also concluded on positive relationships betweencapital structure and profitability. In attempt to analyze the impact ofcapital structure on banks’ performance in the Tehran Stock Exchange using dataover the time period 2008-2012, S.F.

Nikoo (2015) study results showed thatthere is a significant positive relationship between capital structureexpressed by debt to equity ratio and bank’s performance expressed by ROE, ROA,and EPS. In the study by Abor (2005) where the author investigated the effectof capital structure on the profitability of listed firms on the Ghana StockExchange during a five year period, it was evident that STDTA and TDTA had apositive relationship with ROE while LTDTA has a negative relationship. In thisstudy ROE was the only measure of a firm’s performance. The study suggests thatprofitable firms has debt as their main source of finance. The results fromthese studies support the trade-off theory. Some studies have also found out that there are nosignificant relationship between capital structure and profitability of a firm.Al-Taani (2013) in his study to identify the association of capital structurewith profitability using data from 2005-2009 on Jordanian listed companiesconcluded that STDTA,LTDTA and TDTA which are capital structure indicators donot have any significant relationship or effect on ROA and profit margin whichare indicators of firms’ performance. Based on data from 1997-2005 onnon-financial Egyptian listed firms with the aim of investigating the effect ofcapital structure choice on the performance of firms in Egypt, the researchconclusion of Ibrahim El?Sayed Ebaid (2009) was there is weak-to-no impact ofcapital structure choice on  firm’sperformance.

The results from these studies support M&M capital structureirrelevance theorem. Equity over Debt?Since it is empirically evident that debt financing does notalways lead to improved firms’ performance, before employing debt finance firmsshould have exhausted shareholders’ funds as much as possible. As a resultrisks associated with debt financing e.g. interest on debt exceeding the returnon assets financed by the debt will be minimized.

In situations where firmshave exhausted equity financing and needs to finance the expansion of itsoperation, reference should be made to the firm’s asset structure to ensurethat assets financed using debt financing earn higher returns than the interestto 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 negativerelationship it is important to note that optimal capital structure is vitalsince wrong mix of debt and equity may profoundly affect the performance andlong term survival of the firm. 

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