Research its operation. The capital structure of a

Research Project

 

Topic: Capital
Structure and Firm’s Profitability

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Objectives of the study:

1.      To
identify and analyze the capital structure of the selected companies.

2.      To
identify and analyze the profitability of the selected companies.

3.      To
analyze the relationship between the capital structure and profitability.

 

Scope of Research:

We cannot ignore the relationship between
profitability and capital structure. The long-term survivability of the firm
depends upon the improvement in the profitability. Interest payment on debt is
tax deductible; hence, the addition of debt in the capital structure will
improve the profitability of the firm. So, it becomes important to find out the
relationship between capital structure and the profitability of the firm in
order to make appropriate capital structure decisions.

The lack of a consensus about what would qualify as
optimal capital structure in the food processing industries in India has
motivated me to conduct this research. This study requires knowledge about the
capital structure and the profitability indicators of the firm.

 

Hypothesis:

H0: There is no significant relationship between the
capital structure and profitability of selected firms.

H1: There is significant relationship between the
capital structure and profitability of selected firms.

 

 

 

 

 

Introduction

 

The
capital structure is defined as the mix of debt and equity that the firm uses
in its operation. The capital structure of a firm is a mixture of different
securities. In general, firms can choose among many alternative capital
structures. For example, firms can arrange lease financing, use warrants, issue
convertible bonds, sign forward contracts or trade bond swaps. Firms can also
issue various distinct securities in different combinations to maximize overall
market value.

 

The present era is the era of intense
competition and survival of the fittest is the slogan of the corporate world.
In such a scenario decision making has emerged as one of the toughest tasks as
it decides the fate of every firm. Therefore, managers have to take into
consideration the cause effect relationship while making a particular decision.
The managers of present corporate world have to follow systems approach in
their decision making because a decision taken in isolation can bring a firm to
the verge of a disaster.

 

In today’s competitive and dynamic
business world, financial decision plays a fundamental role in the firm’s day
to day performance and operations. Firm’s financial decision affects almost all
activities within the company. In the field of corporate finance, capital
structure decision is the most debatable issue for academicians and
practitioners of corporate finance starting from a seminar work of Modigliani
and Miller in 1958. Modigliani and Miller (1958) stated that the firm’s value is
independent from their capital structure decision, by assuming unrealistic
assumptions on the real world; such as no corporate taxes, no transaction cost,
and perfect capital market. However, Modigliani and Miller (1963) incorporated
corporate taxes into their earlier assumption and they stated that optimal
capital structure can be attained from 100 per cent debt financing through
getting tax saving advantage of using debt. However, the second proposition
also not considered the disadvantages of using more debts, such as bankruptcy
cost and default risk.

 

After the work of Modigliani and Miller
(1958 & 1963) a number of theories have been developed to explain optimal
capital structure of the firms. Agency cost theory, static trade-off theory,
and pecking order theory are the most popular theories of capital structure.
However, both debt and equity finance have their own merits and demerits. The
merits of debt financing are tax-shield, disciplinary tool and cheapest sources
of finance, while bankruptcy cost and default risks are its disadvantage. In
the case of equity share, its advantage is there is a low probability of
bankruptcy cost, while no tax advantage, costly and difficulty of controlling
free cash flow are its disadvantages.

 

 

Of all the aspects of capital investment
decision, capital structure decision is the vital one, since the profitability
of an enterprise is directly affected by such decision. Hence, proper care and
attention need to be given while making the capital structure decision. There could
be hundreds of options but to decide which option is best in firm’s interest in
a particular scenario needs to have deep insight in the field of finance as use
of more proportion of Debt in capital structure can be effective as it is less
costly than equity but it also has some limitations because after a certain
limit it affects company’s leverage. Therefore, a balance needs to be
maintained.

 

There are two main benefits of debt for
a company. The first one is the tax shield: interest payments usually are not
taxable; hence the debt can increase the value of the firm. Another benefit is
that debt disciplines managers. Managers use free cash flows of the company to
invest in projects, to pay dividends, or to hold on cash balance. But if the
firm is not dedicated to some permanent payments such as interest expenses,
managers could have incentives to “waste” extra free cash flows. That is the
main reason, in order to discipline managers, shareholders attract debt. Also,
it is a standard practice in debt agreements between banks and debtors to
introduce some financial covenants for firms (nominal level of the free cash
flow, debt-to-EBITDA ratio, EBITDA-to-interest expenses ratio etc.). Managers
cannot break these covenants, and hence are bound to be more effective. In
addition, the law usually guarantees a right of partial information disclosure
to the company’s debt holders, which serves as additional managers’ supervision
tool. As a result, actions of managers become more transparent, and they have
more incentives to create higher value for the owners.

 

Understanding the relationship between
the company debt and value could provide useful insights for investors for two
reasons. Firstly, shareholders would be able to target optimal debt-to-equity
ratios, which may improve discipline of the managers, but does not overburden a
firm with extraneous interest payments. Secondly, debt holders would have a
tool in hand to identify overleveraged and underleveraged firms. This may help
them allocate their funds more effectively.

 

 

 

 

 

 

 

 

 

 

 

 

Review
of Literature

 

 

Empirical Evidence

 

Modigliani and Miller (1958) theory of
“capital structure irrelevance” states that financial leverage does not affect
the firm’s market value with certain assumptions. These assumptions related to
homogenous expectations, perfect capital markets and no taxes.

 

In order to find the relationship
between the capital structure and the profitability of a firm, a lot of research
has been undertaken by various researchers all over the world. The review of
some of the major studies has been undertaken so as to develop a clear
understanding about the relationship between capital structure and
profitability. The review of such major studies is as follows:

 

Sarkar and Zapatero (2003) found a
positive relationship between leverage and profitability. Myers and Majluf
(1984) concluded that firms that use less debt capital comparing with equity
are profitable and generate high earnings than those that use more debt capital.

 

Sheel (1994) showed that all leverage
determinants factors that were studied, except firm size, are important to
explain debt behavior variations. Gleason, et al., (2000) using data from
retailers in 14 European countries, which are grouped into 4 cultural clusters,
it is shown that capital structures for retailers vary by cultural clusters.
This result holds in the presence of control variables. Using both operational and
financial measures of performance, it is shown that capital structure influences
financial performance, although not exclusively. A negative relationship
between capital structure and performance suggests that agency issues may lead
to use of higher than appropriate levels of debt in the capital structure,
thereby producing lower performance. Graham (2000) integrates under
firm-specific benefit functions to estimate that the capitalized tax benefit of
debt equals 9.7 percent of firm value. The typical firm could double tax
benefits by issuing debt until the marginal tax benefit begins to decline.

 

Chiang et al., (2002) undertake a study
and the findings of the study put forth that profitability and capital
structure are interrelated; the study sample includes 35 companies listed in Hong
Kong Stock Exchange. Abor (2005) investigates the relationship between capital
structure and profitability of listed firms on the Ghana Stock Exchange and
find a significantly positive relation between the ratio of short-term debt to
total assets and ROE and negative relationship between the ratio of long-term
debt to total assets and ROE.

 

 

 

Mendell, (2006) examines financing
practices in firms in the forest products industry by studying the relationship
between taxes and debt hypothesized in finance theory. In analyzing the
theoretical association between capital structure and taxes for 20 traded
forest industry firms for the years 1994-2003, the study discover a negative
relationship between debt and profitability, a positive relationship between
non-debt tax shields and debt, and a negative relationship between firm size
and debt.

 

Gill, (2011) seeks to elongate Abor’s
(2005) findings regarding the effect of capital structure on profitability by observing
the effect of capital structure on profitability of the American service and
manufacturing firms. The Empirical results of the study show a positive relationship
between short-term debt to total assets and profitability and between total
debt to total assets and profitability in the service industry. The findings of
this paper also show a positive relationship between short-term debt to total
assets and profitability, long-term debt to total assets and profitability, and
between total debt to total assets and profitability in the manufacturing industry.

 

The other major studies undertaken by
Mesquita and Lara (2003), Philips and sipahioglu

(2004), Haldlock and james (2002),
Arbabiyan and Safari (2009), Chakraborty (2010), Huang and Song (2006), Pandey
(2004) came up with the findings which were conflicting in nature as some studies
confirm positive relationship between capital structure and profitability while
other studies confirm positive relationship between the variables.

 

 

Theoretical Studies

 

One of the first works about the role of
debt is Modigliani and Miller (1958). They claim that owners of the firms are
indifferent about its capital structure, because the value of the firm does not
depend on debt-to-equity ratio. Authors consider “an ideal world” without taxes
and any transaction costs. Later Modigliani and Miller (1963) introduce taxes into
their model and show that the value of a firm increases with more debt due to
the tax shield.

 

Modigliani and Miller’s work initiated
further discussions about optimal capital structure. Since their theory
predicts 100% debt financing (due to substantial corporate tax benefit), which
is not observed in practice1, there should be some trade-off costs against the
tax shield. The actual level of debt is determined by tax advantage and these
costs. Economists consider bankruptcy costs, personal tax, agency costs,
asymmetric information and corporate control considerations as possible
trade-off options against tax shield. This is the essence of the trade-off
theory, according to which higher profitability is related to higher leverage
due to the tax shield, but is not at the level of 100% of assets due to
trade-off costs.

 

Myers and Majluf (1984) developed a
“pecking order” theory of capital structure, according to which firms initially
use internal funds, then debt, and, if a project requires more funding, equity.
Therefore, firms which are very profitable and generate sufficient cash flows
will use less debt.

 

Studies of the relationship between firm
performance and leverage can be divided into two groups. The first one is based
on the information asymmetries and signaling. Ross (1977) came up with a model
that explained the choice of debt-to-equity ratio by a willingness of a firm to
send signals about its quality. The core idea of Ross (1977) is that it is too
costly for a low-quality firm to abuse the market and signal about its high
quality by issuing more debt. As a result, low quality firms have low amount of
debt, and the leverage increases with the value of a firm. A similar model was
developed by Leland and Pyle (1977): the higher is the quality of the project
manager wants to invest in, the higher is the willingness of the manager to
attract financing. That is why a risky firm will end up with lower debt.

 

The second group of studies describes
the connection between capital structure and firm performance through the
agency costs theory, developed by Jensen and Meckling (1976) and Myers (1977).
Agency costs are related to conflicts of interest between different groups of
agents (managers, creditors, stockholders). There could be two types of agency
problems.

 

 

A
similar idea, but from a slightly different point of view, was suggested by
Grossman and Hart (1982). Firms, which are mostly equity financed, have very
low risk of bankruptcy. Managers of such firms are not penalized in case of low
profits and have no incentives to be more effective. Besides, bankruptcy
implies some personal costs for managers, such as loss of reputation etc. To
sum up, a rise of leverage is followed by improved corporate performance according
to this type of agency problem.

 

Alternative
theory about managers acting in their own interests was suggested by Harris and
Raviv (1988). They describe higher leverage as an antitakeover instrument: –
firms with a large amount of debt will be less likely to become a target for
acquisition. That is why managers, who are afraid to lose their job after
takeover, may be willing to accumulate higher than necessary amount of debt.

 

·        
An agency problem between stockholders
and debt holders. This type of a problem is rooted in the conceptual difference
between stockholders and debt holders. The former take more risks and demand
higher return, whereas the latter take less risk and agree with lower return.
Hence, shareholders may want to take projects with higher risk than debt
holders would prefer. In the case of success of these projects stockholders
will earn extra return, while in the case of failure all losses will be between
debt holders and stockholders (Jensen and Meckling, 1976). As a consequence, more
indebted firms take lower-risk projects. On the other side, Myers (1977) showed
that discrepancies in goals between debt holders and shareholders could lead to
underinvestment. Thus, higher leverage might as well lead to lower corporate
performance.

 

 

Summary of all capital structure
theories is shown in Table 1:

 

 

Table 1. Summary of capital structure
theories.

Theory

Relationship

Causality

Modigliani
and Miller (1963)

Positive

Performance
affects debt

Trade-off

Positive

Performance
affects debt

Pecking-Order

Negative

Performance
affects debt

Free-cash-flow

Positive

Debt
affects performance

Signaling

Positive

Performance
affects debt

Agency
problem

Negative

Debt
affects performance

 

 

 It is against this background that the present
study has been undertaken so as to facilitate the existing literature.

 

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