Impact of Capital Structure on Firm Profitability

Table of Contents
1. Introduction .......................................................................................................................................... 3

1.1. Aims and Objectives .................................................................................................................. 4

2. Literature Review ................................................................................................................................. 4

2.1 Relationship between capital structure and firm performance .................................................... 4

2.1.1 Modigliani and Miller theory ........................................................................................... 5

2.1.2 Pecking Order theory ....................................................................................................... 5

2.1.3 Static Trade off theory ..................................................................................................... 6

2.1.4 Signaling theory ............................................................................................................... 7

2.2 Empirical evidences on capital structure and firm performance ................................................. 8

2.3 Measures of Leverage ................................................................................................................ 9

2.4 Research Gap ............................................................................................................................ 13

References .............................................................................................................................................. 13
1. Introduction

This research will determine how firm profitability has been affected by the capital

structure of firms listed on the FTSE Index. Capital structure is a significant metric

which shows the level of leverage in an organization. It also indicates the philosophy

of capital management in an organization. It is important to have capital structure at

an optimal level for acquiring financial goals in the further future. Companies with

capital structures having high level of debt, tend to produce higher returns. However

in conditions of decreasing profitability, such companies will find it difficult to

service interest obligations and thus, might go bankrupt. Alternatively, capital

structure with lower level of debt is capable of expanding the business of firms as

development of business needs capital, but have lower profits available for

distribution to equity holders. Thus, each firm must strive to achieve an optimal

proportion of equity and debt. The profitability of the firms is impacted by many

factors, out of which, capital structure is one of the most significant ones.

Different theories associated with the debt-equity ratio and their impact on firm

profitability will be reviewed in literature review chapter along with the results from

studies conducted previously by other authors, on companies from different regions

and sectors. The date will be collected from Fame Database and quantitative analysis

such as uni-variate and multivariate analysis will be carried out on the same. To

analyze the collected data, SPSS package will be implemented. The dependent

metrics taken will be Return on Equity (ROE), Return on Asset (ROA), Earnings per

share (EPS) and Net profit Margin (NPM) as measures of firm profitability. The
independent metrics taken will be LTDE, STDE and DTA as measures of capital

structure.

1.1. Aims and Objectives

The objectives of this study would be as follows:

 To determine the key metrics of capital structure and the metrics for profitability

 To determine whether capital structure has a significant correlation with firm

performance

 To analyse whether the impact of capital structure on firm profitability is positive

and negative

2. Literature Review

Numerous studies have been done to determine how the firm profitability has been

affected by capital structure of the firm. But, the outcomes were not consistent for all

the researches that were performed. Studies have observed favourable results as well

as adverse results for the impact of capital structure on the profitability of firms. In

this chapter, an overview of the existing literature on the topic exploring the

relationship between capital structure and firm performance is studied.

2.1 Relationship between capital structure and firm performance

2.1.1 Modigliani and Miller theory

In the year 1958, one of the significant study was performed by Modigliani and Miller.

As per MM, the market assessment of an organization must not rely on level of debt

and thus, the firm’s management is different to the capital structure. They considered

an idealistic circumstances without taking any transaction and taxes expenses into

account. In 1963, the authors integrated tax into the study and observed that the

assessment of an organization raises with raise in debt level because of the tax shield.

With the increase in level of debt as well as interest obligations, the firm’s tax

obligation reduces because of the decline in profit before taxes. Thus, companies with

higher amount of debt are capable of raising their earnings. Alternatively, companies

with higher amount of debt also address more losses if interest obligations outperform

the profit before taxes.

The previous work carried by Modigliani and Miller was enlarged by other experts,

incorporating factors that model reality more accurately to identify the effects of

capital structure on firm performance. As per the theory of Modigliani and Miller,

organizations will adapt 100% debt because of generating tax shield. This indicates

that there are few trade offs connected with tax yield. However, the amount of debt

must consider other expenses like bankruptcy expenses, agency expenses, tax, etc as

well as asymmetric information of the market. As per theory of trade off, firm should

opt for 100% amount of debt even if there is chance of earning more profits (Ebaid,

2009).

2.1.2 Pecking Order theory

As per theory of Pecking order theory, internal reserves are implemented by

companies for extension and signing on new projects. If internal reserves are
insufficient, firms must go for debt. If the amount of debt is also insufficient, firms

must opt for equity. However, this also shows that more profitable the firm, the lesser

the need for the firm borrow funds externally. Hence, capital structure and the choice

of nature of debt and size of it will be determined based on the needs of the firm and

debt would be the preferred source of external financing rather than equity because of

the additional costs involved with raising equity.

Also, the optimal capital structure chosen would be such that reduces the agency costs

of the firm i.e. reduces the conflict between shareholders and lenders to the firm. In

the study done by Harris and Raviv (1991), it was found that the use of more debt was

would be preferred by managers and shareholders as it would mean availability of

more cash at hand, thereby reducing the agency conflict. However, in such instances

managers might most often be underestimating the costs of associated with

bankruptcy and lead to a greater proportion of debt in the capital structure than

appropriate, thereby reducing firm performance. Therefore firms with higher agency

costs would be found to have more debt in their in capital structure.

In the instances where the cost of debt is lower than the cost of equity, it is seen that

firms with higher leverage are seen to be more profitable. Gleason (2000) found that

managers strategically use the choice and extent of use of debt and equity in the firm

structure to improve financial performance by reducing the cost of capital.

2.1.3 Static Trade off theory

According to the Static Trade off Theory, firms have a target static debt ratio and

strategically take steps to achieve this goal. The target ration is reached when the

deductible tax benefit, as result of taking debt equals the cost for financial distress

(Hiller et al., 2014). Hence indicating that, that the optimal capital structure is
achieved when the advantages of using debt match the costs associated with taking

debt (Myers, 1984). However during a financial crisis, the more the leverage, the

lower the performance as increased presence of debt in the capital structure increase

firm risk.

2.1.4 Signaling theory

Signaling Theory states that by sending a credible signal about its quality a good firm

distinguishes itself from a bad firm. To determine if the signal is credible or not is

assessed only if the bad firm fails to copy the signal sent by the good firm. Ross

(1977), it showed that debt was a costly signal to distinguish firms performance. Due

to the asymmetry that exists between what is known by the management and investors,

about the firm performance, signals help firms to access capital from the market. A

firm with higher debt would be identified as having a better future than a firm having

smaller amount of debt in their capital structure, assuming investors would not be

aware of the distribution of firm revenue as compared to the management of the firm.

As a result of this, a good firm would make itself for conspicuous than a poorly

performing firm.

The figure below shows the results on studies performed based on how the firm

performance was affected by capital structure. It was observed that the signaling

theory, free cash flow theory, trade off theory and MM theory forms a positive

association between firm profitability and capital structure. Alternatively, agency

theory and pecking order theory observes a negative association between firm

profitability and capital structure (Onaolapo,Kajola,2010).

2.2 Empirical evidences on capital structure and firm performance

In a study done by Abor (2005), for Ghana identified that ROE of the firm shows

significantly positive relationship with the short term debt of the firm and argued that

as compared to long term debt, short term debt was less expensive. Also, went on to

identify the negative correlation between profitability and long term debt. In a study

done by Arnold (2008), that firms used short term debt to pay back long term debt, to

avoid bankruptcy. Baum (2006) studied German industrial firms between 1988 to

2000, and concluded from the results of his study that was firms were more profitable

when relying more on short term liabilities.

Stiglitz (1969), had shown results indicating that higher the debt in the capital

structure, higher the chances of bankruptcy, which in turn lowers the value of the firm.

However, higher the proportion of debt higher is the tax shield.

Also it has been seen that size of the firm affects effects the performance of the

company. Larger firms have easier access to debt as stated by Rajan and Zingales

(1995). In the study conducted by Glancey (1998), small firms were examined for the

effects of size, ag, sector and location on profitability and growth. It was found that
larger firms find it difficult to adapt to changes as confirmed to smaller firms due to

their larger rigid structure as compared to smaller firms.

Magaritis and Psillaki (2010) reviewed French manufacturing firms through 2002 to

2005, with them concluding that higher leverage was associated with higher

efficiency.

Mehran (1995) performed a study on Malaysian companies and observed that firm

profitability was negatively affected by capital structure. Additionally, the studies

performed on Australia, Taiwan and Singapore firms observed similar result that is

firm profitability was negatively affected by capital structure (Mehran, 1995).

In the study conducted by Valeriu and Nimalathasan (2010), Sri Lankan

manufacturing company, it was seen that increased use of debt had a positive effect

on the profitability ratios of firm. Kebewar (2013) carried out a study on French firms

whic indicated no correlation between debt and profitability ratios. However, in the

study done by Zeitun and Tian (2007) on 167 Jordanian companies showed a

significantly negative relationship. Also the study done by Rajan and Zingales (1995),

found a negative relationship between debt and performance, based on the study done

on G7 countries. In short, there are numerous studies that have been done that indicate

a negative relationship between financial performance and debt, including the studies

done by Nassar (2016) on Turkish industrial companies between 2005-2012, done by

Chandrapala and Knapkova (2013) study on Czech firms between 2004-2008 and the

one study by Vatavu (2014) on Romanian listed firms between 2003-2012. All of

these studies used different methodologies to conduct studies on the samples selected

to arrive on their conclusions.

2.3 Measures of Leverage

Given the recognized differentiation in the proportion of liabilities before doing any

analysis of level of leverage and thus, it is relevant to explain the meaning of term

“leverage”. The term leverage and its related measures relies on the purpose of the

investigation. For example, the agency issues related with debt was highly related to

how the company has been invested earlier and also, on the claims associated with the

firm value held by debt and equity (Zietun and Tain, 2007). Hence, the effective

metric is the level of debt based on value of firm. However, Bond (2002) study was

focused on leverage as a medium of converting control from shareholders to

bondholders when the company is distressed economically. Thus, the significant

question that arises was whether the company can acquire its limited amount of cash

and thus,therefore would a flow determinant such as the interest coverage ratio (ICR)

is become more appropriate (Booth, et al., 2001). Rather than determining all

probable theories and their related determinants of leverage, it was suggested to

implement the determinants of leverage that have been discussed above. Stock

leverage can be defined as the total liabilities (TL) divided by total assets (TA). This

can be considered as a measure that is left for shareholders in terms of cash during

liquidation. Consequently, it does not give a proper indication signification of whether

the company will face any issue in the future by default (Gleason, et al., 2000).

Further,Even though total liabilities consists of items like creditors, which might be

implemented for transactions objectives instead of for funding, but it is possible that

total liabilities might exceed the value of leverage. Likewise, pension liabilities

appearing from labor market bonds would affect the stock leverage ratio. A more

relevant description of financial leverage (FL) is defined by the sum of the long term

debt (LTD) and short term debt (STD) divided by TA. However, this factor fails to

consolidate consider the situation that there were there are few assets which can be
compensated by definite non-debt liabilities (Levinsohn and Petrin, 2003). For

instance, a raise in the overall value of trade credit is emulated reflected in a

minimization of the FL. It appears relevant to implement a determinant of leverage

that is not affected by the overall level of trade credit as the level of creditors and

debtors might be affected jointly by industry considerations. Leverage can be

described as the total debt (TD) divided by net assets (NA) whereas NA can be

defined as the difference of creditor and other liabilities from TA. Though this factor

is not affected by trade credit, but it is influenced by determinants that might not be

related to funding. For instance, assets carried over pension liabilities (PL) might

minimize this determinant of leverage (Lins, et al., 2002). Thus, the consequences of

previous funding decisions can be probably defined by the TA divided by the capital

where capital is the combination of TD and equity.

2.4 Measures of firm performance

In existing literature, there are many ways in which the performance of firms can be

measured. Some of the ways to calculate the performance of firms include the

following:

a) Return on Equity: The Return on equity can be calculated from the financial

statements as the ratio of the profit after tax to the equity of the firm(Kothari, 2008).

A higher return on equity signifies higher returns per dollar invested in acquiring the

equity in the company. Return on equity is one of the best performance metrics as it is

based on the bottom line of the company. The profitability of any company is a

measure of how sustainable a business is and whether firm can generate enough

profits to pay back the investors or plough back into the business. In this dissertation,

return on equity has been used as a measure of firm performance(Chadha, 2015).

b) Tobin's q: Tobin's q is a commonly used metric that is the ratio of the value of the

assets to the replacement cost of the assets of the company.

c) Stock market returns: The returns on the index returns of stock market can be

used as a proxy for measuring the financial performance of the company.

2.5 Reverse causality

Although this dissertation focus on impact of capital structure on firm performance

but it is also possible that the performance of the firms can impact how manager

select the capital structure of the firm. One of the studies(Berger, di Patti, 2002)

focusing on banking sector in US studied the reverse causality problem between

performance and capital structure. The researchers used an equation model and

proposed two hypothesis. One of the hypothesis was efficiency risk hypothesis and

another was called franchise value hypothesis.

According to the efficiency risk hypothesis, with increase in profitability the chances

of bankrupty also falls. This is because a firm with higher profitability has better risk

rating and will expect a higher return on its capital. A return which is high enough to

be used as a substitute of equity as it can be helped to reduce the portfolio risk. As the

relationship between capital structure and firm performance is positive and

considering the relationship between the expected returns and capital structure, the

firms which make use of less equity in the capital structure will potentially have

higher performance. As an implication of this hypothesis, the firms which has higher

leverage will have better performance.

According to the franchise value hypothesis,the firms which report better performance

can also have economic rents. Hence, such firms are keen to have low leverage in

order to defend the value of their franchise. The firms which have higher performance
need to have a higher level of equity in the capital structure. As opposed to

efficiency risk theory, according to the franchise value hypothesis, the relationship

between the leverage in the firm and the performance is negative.

2.6 Research Gap

Although this topic has been well researched, there has been little work done based on

FTSE index and hence there exists a gap in the current understanding of influence of

capital structure on financial performance of companies listed on the index. This

study will focus on top 30 companies in FTSE 100 index and hence findings will be

representative of the index. Also, the findings on the relationship between capital

structure and firm performance has not been consistent. Some researchers have found

the relationship to be positive while others have found the relationship to be negative.

Hence, it will be interesting to explore the relationship between capitals structure and

firm performance for top 30 firms in UK.

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