Introduction. out the relationship between capital structure and a

Introduction.

The purpose of this paper is to point out the relationship
between capital structure and 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 as well 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).

We Will Write a Custom Essay Specifically
For You For Only $13.90/page!


order now

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, through the sale of its shares or ownership
interest a firm avoids the obligation of making regular payments and the risk
of 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. 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. The concept of capital structure can be said to
be 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 equity
that maximizes a firm’s return on capital thereby minimizing cost of borrowing
and maximizing profit and its value. One of the crucial decisions that affect
the profitability (the ability of a firm to yield profit or financial gain) of
a firm is capital structure choice. A wrong mix of debt and equity may
profoundly affect the performance and long term survival 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 of earnings. Shortly after making this
hypothesis, M&M restated that if we move to a world where there are taxes
with all other things being 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 are debates on the fact that the assumptions
made by M are unrealistic and unpractical in the real world. In light of
this, other researchers have come up with several theories to explain the
relationship between capital structure and firm’s profitability. Peking order
theory by Myers believes that due to information asymmetry between firms and
investors there is no optimal capital structure rather firms have particular
preference of financing. Information asymmetry is the situation in which
management have more knowledge and information about the value of a firm than
investors since they work in the firm. Firms prefer to use internal financing
i.e. retained earnings to external financing and 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. Based on this
theory, profitable firms will use less debt since they will have enough
internal funds from retained earnings. However this is also affected by the
dividend policy and the fact firms want to signal the market of the good
performance. If based on the dividend policy firms pay out more dividend, even
though 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 agency
cost. 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 by taking advantage of tax
benefits from interest payments. Firms therefore seek to achieve optimal
capital structure by taking into consideration the pros and cons of debt
financing.  Citing from (Myers,
2002, P.88) firms will use debt until the marginal gain of tax advantage on
additional debt is nullified by the increase in the present value of realizable
costs of financial discomfort.   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. The graphs below explains tax shields and cost of
financial discomfort from the use of debt influence capital structure.

In the first graph, it could be seen that WACC decreases as a
result of tax shield until it reaches its minimum and then begin to increase
due 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 and
then it begins to decline as debt continues to increase, and this is also due
to the cost of financial discomfort. Firms need to the tradeoff point between
tax shield and the cost of financial discomfort where cost of capital is at its
minimum and value of the firm is at its maximum. At this point debt at its
optimal level.

 

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 indicators (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 to examine 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 is usually influenced by its size, large firms turn to have greater
capacity and capabilities. By including firm specific variable in the model,
differences in the operating environment of the firm is controlled for. Also
the inclusion of macroeconomic variable controls for the 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

According to the study by Ramadan and Ramandan (2015),
capital structure is inversely related to profitability of a frim. Their
research was based 72 industrial companies in Jordan that were listed on Amman
Stock Exchange. The time frame of their data was from 2005 to 2013. In their
regression model, they used long-term debt to capital ratio, total debt to
capital ratio and total debt to total assets ratio as their capital structure
variable and ROA as their performance variable.

The result of Ramadan and Ramadan (2015) was consistent with
that of  Nassar S (2016) and Siddik et al
(2017) even though their research data were different. Nassar S used data on
136 listed companies on Istanbul Stock Exchange from 2005-2013. The capital
structure indicator of his research was total debt to total asset ratio and
performance indicators were ROA, EPS, and ROE. Saddik et al also used data on
22 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. They
also included firm specific variables and macroeconomic variables mentioned
earlier in their regression model for which they observed that growth
opportunities, size, and inflation have positive relationship while GDP has
negative relationship with performance of banks

The results from these studies mentioned above support the
Peking order theory, which states that 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.

The study results of S.F. Nikoo (2015), and Abor (2005) were
however in contrast with the above results. They found out that capital
structure and profitability are positively related which supports the tradeoff
theory. Nikoo’s research analyzed data on banks listed Tehran Stock Exchange
from 2008-2012. In his paper, capital structure was expressed by debt to equity
ratio and bank’s performance was expressed by ROE, ROA, and EPS. Abor on the
other hand focused on listed firms on the Ghana stock exchange and the data was
for a 5 year period. It is worth noting that in Abor’s results if STDTA is
excluded from the capital structure, then there will be an inverse relationship
between capital structure and profitability since he found that STDTA and TDTA
had a positive relationship with ROE while LTDTA has a negative relationship.

Just as the researchers mentioned above found a relationship
between capital structure and profitability be it negative or positive, Al-Taani
(2013) and Ibrahim El?Sayed Ebaid (2009) papers showed evidence that there is
significantly weak to no relationship between capital structure decision and
profitability of a firm. Their results supports the capital structure
irrelevance theorem by M&M. Al-Taani studies was also on listed companies
in Jordan from a period of 2005-2009. He used profit margin and ROA as
profitability measure and STDTA, LTDTA and TDTA as capital variable. The
analysis of El?Sayed Ebaid was based on non-financial Egyptian listed firms and
the data was from a period of 1997-2005.

Equity over Debt?

It is evident from various studies that debt financing does
not always lead to improved firms’ performance, so before employing debt
finance firms should have to a large extent exhausted shareholders’ funds. 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 survival 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
towards the 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 of capital, 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 survival of the firm.