Introduction.Capital is a fundamental element throughout the life cycle ofany firm. The manner, in which a firm structures its capital can eitherpositively or adversely influence its overall financial performance andprofitability. This paper seeks to establishthe relationship between capital structure and the financial performance and profitabilityof firms.
This essay will also attempt to answer two main questions; does itmatter if finance comes from stocks or debt? and What determines choice betweenstocks and debt? (These questions were taken from the lecture slides). Financing options involve how a firm utilizes differentsources of finance to maximize shareholders’ wealth with minimum risks as wellas improve its competitiveness. Debt and equity financing are the two primarysources of capital.
By issuing debt instruments, a firm is able to obtain fundingto finance its operations. The purchasers of these instruments are in return,promised a stream of payment as well as a variety of other covenants relatingto the firm’s behavior. Through the covenant, the purchaser has the right torepossess collateral presented by the issuer or force the issuer intobankruptcy in situations where the issuer fails to fulfill its obligation bynot making scheduled payments. However, debt financing allows shareholders toretain ownership and also tax advantages since the interest is tax deductible. On the other hand, through the sale of a firm’s shares orownership interest, the firm avoids the obligation of making regular paymentsand the risk of being forced into bankruptcy. On the downside, this optionresults in the dilution of firm’s ownership. With regards to the option of equityas opposed to debt, this decision is ultimately influenced by the type of firmin question.
It is worth noting that these sources of financing are not strict substitutesfor each other firms adopt both but try to find the right balance for each.The concept of capital structure as described by Besley andBrigham 1 is a blendof long-term debt, preference shares and net worth used as a means of permanentfinancing by any firm. Van Horne and Wachowicz 2 also described capitalstructure as a method of long term financing which is a mixture of long-termdebt, preference shares and equity. The concept of capital structure can besaid to be a mixture of debt and equity by a firm to finance its operation andgrowth.
An optimal capital structure is realized where there is theright balance of debt and equity financing; that maximizes a firm’s return oncapital thereby minimizing cost of borrowing and maximizing profit. A wrong mixof debt and equity may adversely affect the profitability and long termsurvival of the firm, hence internal and external stakeholders devote a lot ofattention to it. Capital StructureTheoriesMany studies by scholars have been conducted to inspect andfind evidence for the relationship between capital structure and theperformance of a firm. Among these is Modigliani and Miller 3 (M), accordingto them, in a world without taxes, bankruptcy costs, agency cost and under perfectlycompetitive market conditions, the value of a firm is free from the influenceof how that firm is financed but rather the value of a firm depends solely onits power of earnings.
The reason for the irrelevance of capital structure isthat, where there are no taxes, there will be no tax advantage for interestpaid on debt. This will provide no incentive for a firm to opt specifically fordebt financing; making them indifferent as to the choice of financing. Shortlyafter making this hypothesis, Modigliani and Miller 4 restated that if wemove to a world where there are taxes with all other things being equal, due totax advantage of debt, the firm’s value can be increased by incorporating moredebt into capital structure. Based on this hypothesis, one could say thatoptimal capital structure is one that has 100% of debt. However, there are debates on the fact that the assumptionsmade by Modigliani and Miller 3 are unrealistic and unpractical in the realworld.
In light of this, other researchers have come up with several theoriesto explain the relationship between a firm’s capital structure and its profitability.Peking order theory by Myers 5 believes that due to information asymmetrybetween firms and investors there is no optimal capital structure rather firmshave particular preference of financing. Information asymmetry is the situationin which management have more knowledge and information about the value of a firmthan investors since they work in the firm. Firms prefer to use internal sourcesof funding i.e.
retained earnings as opposed to external financing; which isonly employed when the internal funds have been fully utilized. Debt, as anexternal source of financing, is preferred over equity in such cases accordingto Muritala 6. Based on this theory, profitable firms will use less debtsince they will have enough funds internally from retained earnings. However,this analogy is also affected by the dividend policy and the fact that firmswant to signal market of their good performance. If firms have a dividendpolicy that makes pay out more dividend, even though they are profitable theymight end up using more debt. According to Jensen and Meckling 7 who developed agencytheory, debt and equity should be mixed in a proportion that minimizes totalagency cost. Agency cost can be divided into agency cost of debt and agencycost of equity.
Agency cost equity arises from the fact the goals of managersmay differ from maximizing shareholder’s fund so in order to keep managers incheck shareholders engage monitoring and control activities which comes at acost. Debtholders in order to prevent management from favoring shareholders attheir expense also give rise to agency cost. Actions of management that mayfavor investors at the expense of shareholders could include engaging in riskyinvestments and projects, which yield high returns for which shareholders turnto enjoy majority of the gains when the investment succeeds but debtholderssuffer the consequences of the failure of such investments. As a result of thedebates with respect to the assumptions by Modigliani and Miller 3, statictrade-off theory was developed. According to this theory, by including tax in Modigliani and Miller’s3 argument, earnings can be protected by taking advantage of tax benefitsfrom interest payments. Firms therefore seek to achieve optimal capitalstructure by taking into consideration the pros and cons of debt financing. Citing from (Myers, 2002, P.88) firms willuse debt until the marginal gain of tax advantage on additional debt isnullified by the increase in the present value of realizable costs of financialdiscomfort.
Brigham and Houston 8 assert that optimalcapital structure of a firm is determined by the trade-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 weighted averagecost of capital (WACC) decreases as a result of tax shield until it reaches itsminimum and then begins to increase due to the cost of excessive debt. While inthe second graph, as debt increases, the market value of the firm alsoincreases until it reaches its maximum and then it begins to decline as debtcontinues to increase, due to the cost of financial discomfort.
Firms need tofind the tradeoff point between tax shield and the cost of financial discomfortwhere cost of capital is at its minimum and the value of the firm is at itsmaximum. At this point debt is at its optimal level. Variables of StudyIn the table below is a summary of the variables used by theauthors of the papers referenced later. The dependent variables were themeasure of profitability while the independent variables were the measure forcapital structure choice.
Variable Legend Measurement Dependent Variables: Return on Assets ROA Net profit(Before taxes)/Total assets Return on Equity ROE Net profit/Shareholders Equity Earnings per share EPS Net income / number of shares outstanding Independent Variables: Short Term Debts to Total Assets STDTA Short-term debt / Total asset Long Term Debts to Total Assets LTDTA Long-term debt / Total asset Total Debts to Total Assets TDTA Total debt / Total asset The dependent variable is an important variable since thefinancial risk faced by a firm is strongly affected by its profitability. Thelikelihood of failure and bankruptcy of a firm is lower when profits are high.Also high profit increases the ability of a firm to borrow thereby increasingthe use of tax savings.
From another angle, high profit implies firms will beable to finance itself through retained earnings hence a decrease in thereliance on external funding. As a result of the fact that firms with highprofit have greater capacity to borrow hence increasing the use of tax savings,there is a positive relationship between profitability and leverage ratio in acapital structure of a firm based on Trade off theory. However, based on Pekingtheory there is an inverse relationship between profitability and leverageratio in its capital structure since high profits implies companies will resortto using internal financing rather than external financing. Econometric model In order to examine the relationship between capital structureand profitability, all the research papers referenced later utilized themultiple regression, ordinary least squares estimator model. The only differenceamong the models is the some of the models included firm specific variablessuch as liquidity (LQ), firm size (SZ), growth opportunities of the firm (GOP)and some macro-economic variables such as inflation (INF) and economic growth(GDP)).
These additional variables are to serve as control variables, which seekto single out the impact of capital structure on a firm’s performance. Theperformance of a firm is usually influenced by its size. Large firms turn tohave greater capacity and capabilities. By including firm specific variables inthe model, differences in the operating environment of the firm is controlledfor. Also the inclusion of macroeconomic variable controls for the effect ofmacroeconomic state of affairs. The ability of a firm to meets its short-termliabilities when they become due is inversely related to profitability sinceliquid assets yield low returns; hence low profits. The effect of inflation on afirm’s profitability has no definite conclusion. In the short run, if there isa demand pull inflation with rising economic growth as a result of increase indemand, prices of goods and services will increase hence leading to increase inprofits of firms.
However, if there is a cost-push inflation with competitivemarkets and high demand, firms will be forced to absorb the increasing; therebyreducing profits. In the long term, low inflationary economy induces higherinvestments and growing demand thereby increasing profitability 16.Trujillo-Ponce 17 confirmed that inflation and ROA of banks are positivelyrelated while Sufian and Habibullah 18 observed an inverse relation.
Economicgrowth goes hand in with profitability since in times of recession, firms areunable to perform well and make profits while the inverse is true in economicboomsBelow is the regression model;= ? + + + + + + + + + + ? or = ? + + + + + ? Where = firm’s performancein terms of profitability ratios , , , and = regressioncoefficient for the independent variable, , and= regression coefficient for the bank specific variables and = regressioncoefficient for the macroeconomic variables. Empirical EvidenceNegative relationshipAccording to the study by Ramadan and Ramadan 9, there wasstatistically significant inverse effect of capital structure, expressed bylong-term debt to capital ratio, total debt to capital ratio and total debt tototal assets ratio, on the performance of the Jordanian industrial companieslisted at ASE expressed by Return on asset ratio (ROA). Their research wasbased on 72 industrial companies in Jordan that were listed on Amman StockExchange and the time frame of their data was from 2005 to 2013.
Nassar’s 10 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 over the period,2005-2012 was used. In this study, a firm’s performance was defined by EPS,ROA, and ROE while capital structure was defined by total debt to total assetratio. 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 of 22 banks over the period; 2005-2014, the studyby Siddik, Kabiraj and Joghee 11 on impacts of capital structure onperformance of banks in a developing economy, using evidence from Bangladesh,observed that empirically there are significant negative effects of capitalstructure choice on Bangladeshi banks’ performance. In their pooled ordinaryleast square regression model, banks’ performance was defined by ROA, ROE, andEPS, while capital structure was defined by STDTA, LTDTA and TDTA. They alsoincluded firm specific variables and macroeconomic variables mentioned earlierfor which they observed that growth opportunities, size, and inflation havepositive relationship while GDP and liquidity have negative relationship withperformance of banks in developing economy, viz.
, Bangladesh. Positive Relationship.Contrary to the empirical results of negative impacts, manystudies have also observed positive impacts.
In attempt to analyze the impactof capital structure on banks’ performance in the Tehran Stock Exchange usingdata over the time period 2008-2012, S.F. Nikoo study results showed that thereis a significant positive relationship between capital structure expressed bydebt to equity ratio and bank’s performance expressed by ROE, ROA, and EPS12.
In the study by Abor 13 where the author investigated theeffect of capital structure on the profitability of listed firms on the GhanaStock Exchange during a five year period, it was evident that STDTA and TDTAhad a positive relationship with ROE; while LTDTA has a negative relationship. Inhis study, ROE was the only measure of a firm’s performance. The study suggeststhat profitable firms have debt as their main source of finance. No SignificantRelationshipWhile it is evident in some studies that there is arelationship either positive or negative between capital structure and the performanceof a firm, there are also other studies that points to the fact that there isno relationship at all. Al-Taani in his study to identify the association ofcapital structure with profitability using data from 2005-2009 on Jordanianlisted companies concluded that STDTA,LTDTA and TDTA which are capitalstructure indicators do not have any significant relationship or effect on ROAand profit margin which are indicators of firms’ performance 14.Based on data over the period; 1997-2005 on non-financialEgyptian listed firms with the aim of investigating the effect of capitalstructure choice on the performance of firms in Egypt, the research conclusionof Ibrahim El?Sayed Ebaid was: there is weak-to-no impact of capital structurechoice on a firm’s performance 15. Comments on theempirical EvidenceThe negative relationship results from these studiesmentioned above support the Peking order theory, which states that highlyprofitable firms are less dependent on external source of finance and thusthere is an inverse relationship between profitability and borrowing hencecapital structure.
While the positive relationship results from these studiessupport the trade-off theory. Varying results from the various papers showsthat there is no conclusive or particular impact of capital structure on firm’sperformance. Other factors such as business risk, tax laws and asset structureof the firm can affect how capital structure impact profitability.
Equity over Debt?In order to achieve optimal structure which leads toprofitability, analyzing whether the firm is over or under levered or has theright mix is important. For over-levered firms with the threat of bankruptcy,adopting equity for debt swaps will reduce. While without the threat of bankruptcy,a reduction of debt can be based on whether the firm has good projects i.e.
ROEand ROC is greater than cost of equity and cost of capital respectively. Incases where they are greater, the projects are financed through retainedearnings or new equity whereas in the cases where they are not greater debtsare paid off using retained earnings or issuance of new equity. For such firmsmore equity is preferred to debt.
For under-levered firms; which are takeover targets, leverageis increased through debt for equity swaps or borrowing money to buy shares. Inthe case where the firm is not a takeover target, and the firm has goodprojects i.e. ROC greater is than cost of capital, the projects are financedusing debt otherwise dividends are paid to shareholders or the firm buys backstocks. For these firms more debt is preferable to equity. 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 evident from the various studies mentioned earlier that debtfinancing does not always lead to improved firms’ performance.
Before employingdebt finance firms should to large extent exhaust shareholders’ funds the risksassociated with debt financing e.g. interest on debt exceeding the return onassets financed by the debt will be minimized. In situations where firms have exhaustedequity financing and needs to finance the expansion of its operation, referenceshould be made to the firm’s asset structure to ensure that assets financedusing debt financing earn higher returns than the interest to be paid on thedebt. This capital structure choice would have a positive impact onprofitability. References1.
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