Aveneu Park, Starling, Australia

Introduction. and profitability. Firms can be broadly

Introduction. The purpose of this paper is to point out the connection of capital structure with a firm’s performance and profitability. Firms can be broadly classified into financial and non-financial. According to Buser (1981), there is no significant difference in the capital structure of the two types of firm mentioned even though due to the unique nature and financial risk of each firm’s business aswell as variations in intra-firm business there is a considerable inter industry differences in firms’ capital structure. This essay will also attempt to answer two main questions; Does it matter if finance comes from stocks or debt? and What determines choice between stocks and debt? (These questions were taken from the lecture slides). Financing decisions basically has to do with how a firm utilizes different sources of finance to maximize shareholders’ wealth with minimum risks as well as improve its competitiveness. Debt and equity financing are the two primary sources of capital. By issuing debt instruments, a firm is able to obtain fund to finance its operation. The purchasers of these instruments are in return promised a stream of payment as well as a variety of other covenants relating to corporate behavior e.g. the value and risk of a firm’s assets. Through the covenant, the purchaser has the right to repossess collateral presented by the issuer or force the issuer into bankruptcy in situations where the firms fails to fulfill its obligation by not making payments. However, debt refinancing allows shareholders to retain ownership and also the firm turns to enjoy the tax advantage that comes as a result of interest being tax deductible. On the other hand, the firm avoids the obligation of making regular payments and the risk of being forced into bankruptcy when it uses equity financing 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. However these sources of finance are not substitutes for each other, they are different in nature and their impact of profitability vary. The concept of capital structure as described by Besley and Brigham is blend of long-term debt, preference shares and net worth used as a means of permanent financing by any firm. Van Horne and Wachowicz also described capital structure as a method of long term financing which is a mixture of long-term debt, preference shares and equity. Capital structure can be said to be a mix of debt and equity by a firm to finance its operation and growth. Optimal capital structure is the right mix of debt and equity that maximizes a firm’s return on capital thereby minimizing cost of borrowing and maximizing profit and its value. One of crucial decisions that affect the profitability of a firm is capital structure decision. A wrong mix of debt and equity may profoundly affect the performance and long term survivability of the firm. The decision of how a firm is financed is of vital importance to both the insiders and 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 have tried to inspect and find evidence for the relationship between capital structure and the performance of a firm. Among these is Modigliani and Miller (M&M). According to them in a world without taxes, bankruptcy costs, agency cost and under a perfectly competitive market conditions, the value of a firm is free from the influence of how that firm is financed but rather the value of a firm depends solely on its power. Shortly after, M&M restated that if we move to a world where there are taxes with all thingsbeing equal, due to tax advantage of debt thus interest on debt is tax deductible, the firm’s value is positively related to debt meaning a firm can increase its value by incorporating more debt into capital structure. Based on the second hypothesis of M, optimal capital structure is one that comprise of 100% debt. However, there is debate on the fact that the assumptions made by M unrealistic and unpractical in the real world. In light of this, other scholars have come up with several theories to explain the relationship between capital structure and firm’s profitability. Peking order theory by Myers due to information asymmetry between firms and investors believes that there is no optimal capital structure rather firms prefer to use internal financing i.e. retained earnings to external financing. External financing 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 agency cost. In agency cost theory, debt is considered a necessary factor for the conflict in the goals of shareholders and managers. Agency cost can be divided into agency cost of debt and agency cost of equity. Agency cost equity arises from the fact the goals of manager may differ from maximizing shareholder’s fund so in order to keep managers in check shareholders engage monitoring and control activities which comes at a cost. Debtholders in order to prevent management from favoring shareholders at their expense also give rise to agency cost As a result of the debates with respect to the assumptions by M, static trade-off theory was developed.   According to this theory by including tax in M, earnings can be protected taking advantage of tax benefits from interest payments. Brigham and Houston assert that optimal capital structure of a firm is determined by the trading off between the tax advantage 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 of capital is minimized.  Definition of Key Terms Equity: Equity is used in reference to the value of an ownership interest in a firm including shareholders’ equity. It is a firm’s total assets less its total liabilities. Debt: It is the amount owed by one party to the other. Large purchases 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 a later date with interest. Equityfinancing: is when capital of firm is raised through the sale of its shares or ownership interest. Debt financing: It is a means by which firms raise capital by selling debt instruments such bonds, bills, and notes to investors. Profitability: It is the ability of a firm to yield profit or financial gain. Cost of Capital: It is a firms cost of funding i.e. both cost of debt and cost of equity. Cost of equity is the required rate return shareholders expect on their investment while cost of debt is the effective rate a firm pays on all its debts. Agency Problem: It is the conflict of interest between management of a firm and its shareholders. Variables of Study As a measure of a firm’s performance almost all authors used the profitability ratios ROA, ROE, and EPS (dependent variable) and leverage ratios STDTA,LTDTA, DC, TDTA as capital structure variables (independent variable). Return on Asset (ROA) is shows how efficient a firm is at using its assets to generate income. It is calculated as net income before taxes divided by average total assets. Return on equity (ROE) reveals how much profit a firm generates with the fund shareholders invested thus how well a firm generates earnings growth using investments. It is derived by net profit divided by average shareholder equity. Earnings per share (EPS) which is computed by dividing net profit minus preference share dividend by number of outstanding shares helps measure the amount of net income earned per firm’s outstanding shares.  The dependent variable is an important variable since the financial risk faced by a firm is strongly affected by its profitability. The likelihood of failure is lower when profits are high. Also high profit increases the ability of a firm to borrow thereby increasing the use of tax savings. From another angle, high profit implies firms will be able to finance itself through retained earnings hence a decrease in the reliance on external funding. As a result of the fact that firms with high profit have greater capacity to borrow hence increasing the use of tax savings, there is a positive relationship between profitability and leverage ratio in a capital structure of a firm based on Trade off theory. However, based on Peking theory there is an inverse relationship between profitability and leverage ratio in its capital structure since high profits implies companies will resort to using internal financing rather than external financing. Leverage ratio helps measure the financial risk of a firm. It helps determine the firm’s ability to meet its obligations. Short term debt to total 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 by total assets of the firm. Debt to capital (DC) ratio is total debt (short term and 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 total assets. The higher the ratios, implies high level of leverage hence high level of financial risk.   Econometric model   In order toexamine the relationship between capital structure and profitability, almost all the research papers utilized the multiple regression, ordinary least squares estimator framework. The only difference among the models used is the inclusion control variables such as firm specific variables (firm size(SZ), growth opportunities of the firm (GOP) which is calculated by assets of current period less assets of previous period divided by assets of previous period), and some macro-economic variables (inflation(INF) and economic growth (GDP)). The control variables seeks to single out the impact of capital structure on firm’s performance. The performance of a firm isusually influenced by its size, large firms turn to have greater capacity and capabilities. By including firm specific variable in themodel, differences in the operating environment of the firm is controlled for. Also the inclusion of macroeconomic variable controls forthe effect of macroeconomic state of affairs. Below is the regression model; = ? +  +   +  +   +  +   +  +  + ?     or = ? +  +   +  +  + ?  depending on whether firm specific and macroeconomic variables are controlled for.   represents the firm’s performance 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 independent variables,, , and, represents the regression coefficient for the bank specific variables, and  and  represents the regression coefficient for the macroeconomic variables. All these coefficients are to be estimated using data.    Empirical Evidence Using data from the period of 2005 to 2013 on 72 industrial Jordanian 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 structure represented by long-term debt to capital ratio, total debt to capital ratio and total debt to total assets ratio has a significant inverse impact on the performance represented by ROA of the Jordanian industrial companies listed on ASE. Nassar S (2016) study aimed to investigate the impact of capital structure on industrial companies listed under UXSIN index on the Istanbul Stock Exchange (ISE). Data on 136 out 290 firms from the period of 2005-2012 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 negative relationship between capital structureand profitability since using high level of debt affects a firm’s ROA, EPS, and ROE negatively. Using data from the period of 2005-2014 on 22 banks in Bangledesh, the study by Siddik, Kabiraj and Joghee on impacts of capital structure on performance of banks showed there are significant negative relationship between capital structure and Bangladeshi banks’ performance. In their pooled ordinary least square regression model, banks performance was defined by ROA, ROE, and EPS while capital structure was defined by STDTA,LTDTA, TDTA. They also included firm specific variables and macroeconomic variables mentioned earlier for which they observed that growth opportunities, size, and inflation have positive relationship while GDP has negative relationship with performance of banks in developing economy, viz., Bangladesh. The results from these studies mentioned above support the Peking order theory, which statesthat highly profitable firms are less dependent on external source of finance and thus there is an inverse relationship between profitability and borrowing hence capital structure. In contrast to the above empirical results of negative impacts, other studies have also concluded on positive relationships between capital structure and profitability. In attempt to analyze the impact of capital structure on banks’ performance in the Tehran Stock Exchange using data over the time period 2008-2012, S.F. Nikoo (2015) study results showed that there is a significant positive relationship between capital structure expressed 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 effect of capital structure on the profitability of listed firms on the Ghana Stock Exchange during a five year period, it was evident that STDTA and TDTA had a positive relationship with ROE while LTDTA has a negative relationship. In this study ROE was the only measure of a firm’sperformance. The study suggests that profitable firms has debt as their main source of finance. The results from these studies support the trade-off theory. Some studies have also found out that there are no significant relationship between capital structure and profitability of a firm. Al-Taani (2013) in his study to identify the association of capital structure with profitability using data from 2005-2009 on Jordanian listed companies concluded that STDTA,LTDTA and TDTA which are capital structure indicators do not haveany significant relationship or effect on ROA and profit margin which are indicators of firms’ performance. Based on data from 1997-2005 on non-financial Egyptian listed firms with the aim of investigating the effect of capital structure choice on the performance of firms in Egypt, the research conclusion of Ibrahim El?Sayed Ebaid (2009) was there is weak-to-no impact of capital structure choice on  firm’s performance. The results from these studies support M&M capital structure irrelevance theorem. Equity over Debt? Since it is empirically evident that debt financing does not always lead to improved firms’ performance, before employing debt finance firms should have exhausted shareholders’ funds as much as possible. As a result risks associated with debt financing e.g. interest on debt exceeding the return on assets financed by the debt will be minimized. In situations where firms have exhausted equity financing and needs to finance the expansion of its operation, reference should be made to the firm’s asset structure to ensure that assets financed using debt financing earn higher returns than the interest to be paid on the debt. It could be said that capital structure is a vital key to the profitability and survivability of firm. Obtaining an optimal capital structure which maximizes shareholders value and minimizes cost of capital and risk is therefore important. In order to achieve this, management needs to first analyze whether the firm is over or under levered or has the right mix. Based on the result of the analysis, decision on whether to move gradually or immediately towardsthe optimal has to be made. For over levered firms with the threat of bankruptcy, debt should be reduced by embarking on equity for debt swaps. While without bankruptcy threat reduction of debt can be based on whether the firm has good projects i.e. ROE and ROC is greater than cost of equity and cost of capital respectively. In cases where they are greater, the projects are financed through retained earnings or new equity whereas in the cases where they are not greater debts are paid off using retained earnings or issuance new equity. For under levered firms which are takeover targets, leverage is increased through debt for equity swaps       or borrow money to buy shares. In case the firm is not a takeover target, and the firm has good projects i.e. ROC greater is than cost ofcapital, the projects are financed using debt otherwise dividends are paid to shareholders or the firm buys back stocks.   Conclusion This essay provides evidence from various researches that analyze the impact of capital structure on profitability of a firm. Although there is no clear cut conclusion as to whether it is a positive or negative relationship it is important to note that optimal capital structure is vital since wrong mix of debt and equity may profoundly affect the performance and long term survivability of the firm.undefined undefined undefined undefined undefined undefined undefined undefined undefined undefined undefined undefinedundefined undefined undefined undefined undefined undefined undefined undefined undefined undefined undefined undefinedundefined undefined undefined undefined undefined undefined undefined undefined undefined undefined undefined undefinedundefined undefined undefined undefined undefined undefined


I'm Simon!

Would you like to get a custom essay? How about receiving a customized one?

Check it out