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.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.
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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, through the sale of its shares or ownershipinterest a firm avoids the obligation of making regular payments and the riskof 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. Howeverthese sources of finance are not substitutes for each other, they are differentin nature and their 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 (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.
Due to the importance of capital structure, many studies and scholars havetried to inspect and find evidence for the relationship between capitalstructure and the performance of a firm. Among these is Modigliani and Miller(M&M). According to them in a world without taxes, bankruptcy costs, agencycost and under a perfectly competitive market conditions, the value of a firmis free from the influence of how that firm is financed but rather the value ofa firm depends solely on its power of earnings. Shortly after making thishypothesis, M&M restated that if we move to a world where there are taxeswith all other things being equal, due to tax advantage of debt thus intereston debt is tax deductible, the firm’s value is positively related to debtmeaning a firm can increase its value by incorporating more debt into capitalstructure. Based on the second hypothesis of M, optimal capital structureis 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 ordertheory by Myers believes that due to information asymmetry between firms andinvestors there is no optimal capital structure rather firms have particularpreference of financing.
Information asymmetry is the situation in whichmanagement have more knowledge and information about the value of a firm thaninvestors since they work in the firm. Firms prefer to use internal financingi.e. retained earnings to external financing and external financing is onlyemployed when the internal funds have been fully utilized. Debt is preferred asexternal finance to equity in such cases according to Muritala.
Based on thistheory, profitable firms will use less debt since they will have enoughinternal funds from retained earnings. However this is also affected by thedividend policy and the fact firms want to signal the market of the goodperformance. If based on the dividend policy firms pay out more dividend, eventhough they are profitable they might end up using more debt.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 cost. As a result of thedebates with respect to the assumptions by M, static trade-off theory wasdeveloped.
According to this theory byincluding tax in M, earnings can be protected by taking advantage of taxbenefits from interest payments. Firms therefore seek to achieve optimalcapital structure by taking into consideration the pros and cons of debtfinancing. Citing from (Myers,2002, P.88) firms will use debt until the marginal gain of tax advantage onadditional debt is nullified by the increase in the present value of realizablecosts of financial discomfort. Brigham and Houston assert that optimalcapital structure of a firm is determined by the trading off between the taxadvantage 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 ofcapital 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 WACC decreases as aresult of tax shield until it reaches its minimum and then begin to increasedue 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 andthen it begins to decline as debt continues to increase, and this is also dueto the cost of financial discomfort.
Firms need to the tradeoff point betweentax shield and the cost of financial discomfort where cost of capital is at itsminimum and value of the firm is at its maximum. At this point debt at itsoptimal 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.
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 EvidenceAccording to the study by Ramadan and Ramandan (2015),capital structure is inversely related to profitability of a frim. Theirresearch was based 72 industrial companies in Jordan that were listed on AmmanStock Exchange.
The time frame of their data was from 2005 to 2013. In theirregression model, they used long-term debt to capital ratio, total debt tocapital ratio and total debt to total assets ratio as their capital structurevariable and ROA as their performance variable.The result of Ramadan and Ramadan (2015) was consistent withthat of Nassar S (2016) and Siddik et al(2017) even though their research data were different. Nassar S used data on136 listed companies on Istanbul Stock Exchange from 2005-2013. The capitalstructure indicator of his research was total debt to total asset ratio andperformance indicators were ROA, EPS, and ROE. Saddik et al also used data on22 banks in Bangladesh from 2005 to 2014.
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 in their regression model for which they observed that growthopportunities, size, and inflation have positive relationship while GDP hasnegative relationship with performance of banksThe 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.The study results of S.F. Nikoo (2015), and Abor (2005) werehowever in contrast with the above results. They found out that capitalstructure and profitability are positively related which supports the tradeofftheory. Nikoo’s research analyzed data on banks listed Tehran Stock Exchangefrom 2008-2012.
In his paper, capital structure was expressed by debt to equityratio and bank’s performance was expressed by ROE, ROA, and EPS. Abor on theother hand focused on listed firms on the Ghana stock exchange and the data wasfor a 5 year period. It is worth noting that in Abor’s results if STDTA isexcluded from the capital structure, then there will be an inverse relationshipbetween capital structure and profitability since he found that STDTA and TDTAhad a positive relationship with ROE while LTDTA has a negative relationship.
Just as the researchers mentioned above found a relationshipbetween capital structure and profitability be it negative or positive, Al-Taani(2013) and Ibrahim El?Sayed Ebaid (2009) papers showed evidence that there issignificantly weak to no relationship between capital structure decision andprofitability of a firm. Their results supports the capital structureirrelevance theorem by M&M. Al-Taani studies was also on listed companiesin Jordan from a period of 2005-2009. He used profit margin and ROA asprofitability measure and STDTA, LTDTA and TDTA as capital variable. Theanalysis of El?Sayed Ebaid was based on non-financial Egyptian listed firms andthe data was from a period of 1997-2005.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 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.