Impact of Capital Structure on Firms Profitability

An empirical study to find out relationship between capital structure

and profitability of firms listed on Karachi Stock Exchange

Name:
Muhammad Junaid Iqbal
Muhammad Bilawal Ali
Zubair Rafique

Class:
MBAE

Semester:
[2011]

Submitted to
Abid Awan
Department of Management Science
SZABIST, Islamabad

Impact of Capital
Structure on Firms
Profitability
An empirical study to find out relationship between capital structure
and profitability of Firms listed on Karachi Stock Exchange

Contents
1. INTRODUCTION.......................................................................................................
1.1. General Information.........................................................................................
1.2. Background to the Study...........................................................................................
1.3. Statement of the Research Problem..............................................................................
1.4. Research Objective..................................................................................................
1.4.1. Specific Objective..............................................................................................
1.4.2. Research Questions............................................................................................
1.5. Significance of the Study...........................................................................................
1.6. Scope of the Study...................................................................................................
1.7. Definition of Terms..................................................................................................
2. LITERATURE REVIEW................................................................................................
2.1. Literature Review....................................................................................................
2.1.1. Capital Structure Irrelevance Theory.......................................................................
2.1.2. The Asymmetry of Information Theory.......................................................
2.1.3. The Pecking Order Theory..........................................................................
2.2. Empirical framework........................................................................................
2.3. Theoretical Framework.....................................................................................
2.4. Hypotheses......................................................................................................
3. RESEARCH METHODOLOGY.....................................................................................
3.1. Research Paradigm...........................................................................................
3.2. Population........................................................................................................
3.3. Sample Size and Sampling Frame....................................................................
3.4. Data Collection Tools........................................................................................
3.5. Operationalization of Concepts........................................................................
3.5.1. Profitability - Dependent Variable...............................................................
3.5.2. Debt ratios - Independent Variable.............................................................
3.5.3. Control variable........................................................................................
REFERENCES............................................................................................................

CHAPTER ONE
1. INTRODUCTION
1.1. General Information
The capital structure decision is crucial for any business organization.
The decision is important because of the need to maximize returns to
various organizational constituencies, and also because of the impact such
a decision has on a firms ability to deal with its competitive environment.
The capital structure of a firm is actually a mix of different securities issued
by a firm. In general, a firm can choose among many alternative capital
structures. It can issue a large amount of debt or very little debt. It can
arrange lease financing, use warrants, issue convertible bonds, sign
forward contracts or trade bond swaps. It can issue dozens of distinct
securities in countless combinations; however, it attempts to find the
particular combination that maximizes its overall market value. A number
of theories have been advanced in explaining the capital structure of firms.
Despite the theoretical appeal of capital structure, researchers in financial
management have not found the optimal capital structure. The best that
academics and practitioners have been able to achieve are prescriptions
that satisfy short-term goals. For example, the lack of a consensus about
what would qualify as optimal capital structure has necessitated the need
for this research. A better understanding of the issues at hand requires a
look at the concept of capital structure and its effect on firm profitability.
This study will examine the relationship between capital structure and
profitability of companies listed on the Karachi Stock Exchange.

1.2. Background to the Study

The theory of capital structure and its relationship with a firms
value and performance has been a puzzling issue in corporate finance and
accounting literature since the seminal work of (Modigliani & Miller, 1963)
(MM-1958). MM-1958 argue that under very restrictive assumptions of
perfect capital markets, investors homogenous expectations, tax-free
economy, and no transactions costs, capital structure is irrelevant in
determining firm value. According to this proposition, a firms value is
determined by its real assets, not by the mix of securities it issues. If this
proposition does not hold then arbitrage mechanisms will take place,
investor will buy the shares of the undervalued firm and sell the shares of
the overvalued firm in such a way that identical income streams are
obtained. As investors exploit these arbitrage opportunities, the price of
overvalued shares will fall and that of the undervalued shares will rise,
until both prices are equal. However, these restrictive assumptions do not
hold in the real world, which led many researchers to introduce additional
rationalization for this proposition and its underlying assumptions showing
that capital structure affects firms value and performance, especially

after the seminal paper of Jensen and Meckling (1976) which demonstrate
that the amount of leverage in a firms capital structure affects the agency
conflicts between managers and shareholders by constraining or
encouraging managers to act more in the interest of shareholders and,
thus, can alter managers behaviors and operating decisions, which
means that the amount of leverage in capital structure affects firm
performance.

1.3. Statement of the Research Problem

Since, Jensen and Meckling (1976) argument regarding the
possibility of capital structure influence on firm performance, several
researchers have followed this extension and conducted numerous studies
that aim to examine the relationship between financial leverage and firm
performance over the last decades. However, empirical evidence
regarding this relationship is contradictory and mixed. While a positive
relationship between leverage level and firm performance had been
documented in some of these studies (Taub, 1975; Roden and Lewellen,
1995; Champion, 1999; Hadlock and James, 2002). Other studies
document a negative relationship between leverage level and firm
performance (Fama and French, 1998; Gleason et al., 2000; Simerly and
Li, 2000). While the literature examining the performance implications of
capital structure choices is immense in developed markets (e.g. USA and
Europe), little is empirically known about such implications in emerging or
transition economies such as Pakistan. In such a country capital market is
less efficient and incomplete and suffers from higher level of information
asymmetry than capital markets in developed countries. This environment
of the market may cause financing decisions to be incomplete and subject
to a considerable degree of irregularity. It is, therefore, necessary to
examine the validity of corporate leverage levels impact on a firms
performance in Pakistan as an example of emerging economies.

1.4. Research Objective

The main aim of this study is to examine the relationship between
financial leverage and profitability of non financial companies listed on
Karachi stock exchange.

1.4.1. Specific Objective

To examine the relationship between Short term Debt to Capital

ratio and firm Profitability.
To examine the relationship between Long term Debt to Capital ratio
and firm Profitability.
To examine the relationship between Total Debt to Capital ratio and
firm Profitability.

1.4.2. Research Questions

Does level of Short term Debt has effect on firm Profitability?

Does level of Long term Debt has effect on firm Profitability?
Does level of Total Dept has effect on firm Profitability?

1.5. Significance of the Study

The capital structure decision is crucial for any business
organization. The decision is important because of the need to maximize
returns to various organizational constituencies, and also because of the
impact such a decision has on a firms ability to deal with its competitive
environment. Thus the findings of this study will assist financial managers
in deciding the optimal mix of capital structure. This study will produce
information which will be useful to them when choosing financing sources
(for this case debt) and in deciding the level of debt to acquire.

1.6. Scope of the Study

This study will focus on non financial firms listed on the Karachi
Stock Exchange (KSE 100 Index) basing on their accessibility and
availability of data and industry participation.

1.7. Definition of Terms

Financial Leverage is the proportion of debt in the capital structure.
There two ways of putting into perspective the levels of debt that a firm
carries i.e. Capital leverage focuses on the extent to which a firms total
capital is in the form of debt and Income leverage is concerned with
proportion of the annual income stream which is devoted to the prior
claims of debt holders.

CHAPTER TWO
2. LITERATURE REVIEW
2.1. Literature Review
The linkage between capital structure and firm value has engaged
the attention of both academics and practitioners. Throughout the
literature, debate has centered on whether there is an optimal capital
structure for an individual firm or whether the proportion of debt usage is
irrelevant to the individual firms value. The capital structure of a firm
concerns the mix of debt and equity the firm uses in its operation. Brealey
and Myers (2003) contend that the choice of capital structure is

fundamentally a marketing problem. They state that the firm can issue
dozens of distinct securities in countless combinations, but it attempts to
find the particular combination that maximizes market value. According to
Weston and Brigham (1992), the optimal capital structure is the one that
maximizes the market value of the firms outstanding shares.

2.1.1. Capital Structure Irrelevance Theory

The seminal work by Modigliani and Miller (1958) in capital structure
provided a substantial boost in the development of the theoretical
framework within which various theories were about to emerge in the
future. Modigliani and Miller (1958) concluded to the broadly known
theory of capital structure irrelevance where financial leverage does not
affect the firms market value. However their theory was based on very
restrictive assumptions that do not hold in the real world. These
assumptions include perfect capital markets, homogenous expectations,
no taxes, and no transaction costs. The presence of bankruptcy costs and
favorable tax treatment of interest payments lead to the notion of an
optimal capital structure which maximizes the value of the firm, or
respectively minimizes its total cost of capital. (Modigliani & Miller, 1963)
reviewed their earlier position by incorporating tax benefits as
determinants of the capital structure of firms. The key feature of taxation
is that interest is a tax-deductible expense. A firm that pays taxes receives
a partially offsetting interest tax-shield in the form of lower taxes paid.
Therefore, as Modigliani and Miller (1963) propose, firms should use as
much debt capital as possible in order to maximize their value. Along with
corporate taxation, researchers were also interested in analyzing the case
of personal taxes imposed on individuals. (Miller, 1977) based on the tax
legislation of the USA, discerns three tax rates that determine the total
value of the firm. These are:
(1) The corporate tax rate;
(2) The tax rate imposed on the income of the dividends; and
(3) The tax rate imposed on the income of interest inflows.
According to Miller (1977), the value of the firm depends on the relative
level of each tax rate, compared with the other two.
2.1.2. The Asymmetry of Information Theory

The concept of optimal capital structure is also expressed by (Myers

S. C., The Capital Structure Puzzle, 1984) and Myers and Majluf (1984),
based on the notion of asymmetric information. The existence of
information asymmetries between the firm and likely finance providers
causes the relative costs of finance to vary between the different sources
of finance. For instance, an internal source of finance where the funds
provider is the firm will have more information about the firm than new

equity holders; thus, these new equity holders will expect a higher rate of
return on their investments. This means that it will cost the firm more to
issue fresh equity shares than using internal funds. Similarly, this
argument could be provided between internal finance and new debt
holders. The conclusion drawn from the asymmetric information theories
is that there is a hierarchy of firm preferences with respect to the
financing of their investments (Myers & Majluf, Corporate Finance and
Investment decisions when firms has information that investors do not
have, 1984)
2.1.3. The Pecking Order Theory

This pecking order theory suggests that firms will initially rely on
internally generated funds, i.e. undistributed earnings, where there is no
existence of information asymmetry, and then they will turn to debt if
additional funds are needed and finally they will issue equity to cover any
remaining capital requirements. The order of preferences reflects the
relative costs of various financing options. The pecking order hypothesis
suggests that firms are willing to sell equity when the market overvalues
it.

2.2. Empirical framework

Most of the research concerning the relationship between capital
structure and firms performance was conducted in developed countries
and markets. A few studies empirically examined this relationship in
emerging (transition) economies. For instance, Majumdar and Chhibber
(1999) examine the relationship between capital structure and
performance of Indian firms showing that debt level is negatively related
with performance (i.e. return on net worth). Chiang et al. (2002) examine
the relationship between capital structure and performance of firms in
property and construction sector in Hong Kong showing that high gearing
is negativity related with performance (i.e. profit margin). KyereboahColeman (2007) examines the relationship between capital structure and
performance of microfinance institutions in sub-Saharan Africa showing
that high leverage is positively related with performance (i.e. ROA and
ROE).
Finally, Abor (2007) examines the relationship between debt policy
(capital structure) and performance of small and medium-sized
enterprises in Ghana and South Africa showing that capital structure,
especially long-term and total debt level, is negatively related with
performance (both the accounting and market measures). In summary,
empirical studies regarding the relationship between capital structure and
firms performance in developed countries provided fixed and
contradictory evidence, on the other hand there is a few studies
empirically examine this relationship in emerging (transition) economies.
The present study extends the literature on the impact of capital structure
on firms performance by empirically examining the relationship between

capital structure and firms performance in Pakistan. In fact, Pakistan is a

unique case because; capital market in Pakistan is less efficient and
incomplete and suffers from higher level of information asymmetry than
capital markets in developed countries. This environment of the market
may cause financing decisions to be incomplete and subject to a
considerable degree of irregularity. It is important, therefore, to explore
the validity of debt financing firms performance relationship under this
unique economic setting.

2.3. Theoretical Framework

Short term
debt/ Capital
Long term
debt/ Capital
Profitability
Total debt/
Capital

Firms Size
(Log of
sales)

(Note: The size of firm is taken as control variable (Joshua Abor, 2007)

2.4. Hypotheses
The study will be tested by the following hypotheses

The level of short term debt has positive effect on firm profitability.
The level of long term debt has positive effect on firm profitability.
The level of total debt has positive effect on firm profitability.
Debt to equity ratio has positive effect on profitability.

CHAPTER THREE

3. RESEARCH METHODOLOGY
3.1. Research Paradigm
Quantitative research approach will be used to examine the impact
of capital structure on firms profitability.

3.2. Population
The population for this study will be all non financial publicly traded
firms on KSE 100 Index.

3.3. Sample Size and Sampling Frame

The sampling frame of this study will be the list of all the listed non
financial firms on KSE 100 Index. The listed firms will then be screened
against several factors; financial services institutions (banks) will be
deleted from list, and remaining firms will then be purposely selected due
to availability of financial data and industry participation as per the expert
opinion.

3.4. Data Collection Tools

The data will be collected via firms website and annual financial
reports of the firms.

3.5. Operationalization of Concepts

3.5.1. Profitability - Dependent Variable

Literature uses a number of different measures of firms profitability;

but for the purpose of this study the common accounting-based
profitability measure (i.e. ROE, ROA and Net profit margin) will be used.
This measure will be calculated from the firms financial statements. ROE
is computed as the ratio of net profit to average total equity, ROA is
measured as the ratio of Net profit to total assets and Net Profit margin is
computed as a ratio of Net Profit to Net Sales.
3.5.2. Debt ratios - Independent Variable
Debt ratios will be measured in the study by three accounting ratios
(Joshua Abor, 2007 and Chiang Yat Hung, Chan Ping Chuen Albert and Hui
Chi Man Eddie, 2002):

Short-term debt to the total capital;

Long-term debt to total capital; and
Total debt to total capital

3.5.3. Control variable.

Prior researches suggest that firms size may influence its performance
hence larger firms have a greater variety of capabilities and can enjoy
economies of scale, which may influence the results and the inferences.
Therefore, this study will control the differences in firms operating
environment by including the size variable in the model. Size is measured
by the log of total sales of the firm (Joshua Abor, 2007) and included in the
model to control for effects of firm size on dependent variable (i.e.
profitability).

Short-term debt to the total capital;

Long-term debt to total capital; and
Total debt to total capital.

REFERENCES
Arnold, G. (2008). Corporate Financial Management. England: Financial Times
Pitman Publishing.
Brealy, R., & Myers, S. C. (2003). Principles of Corporate Finance (International
Edition ed.). Boston MA: McGraw-Hill.
Friend, & Lang. (1988). An Empirical Test of the impact of Managerial self inerest
on corporate capital structure. Journal of Finance , 43, 271-281.
Jensen, M., & Meckling, W. (1976). Theory of the Firm, Managerial Behaviour,
agency costs and ownership Structure. Journal of Financial Economics , 3, 305360.
Miller, M. H. (1977). Debt and Taxes. Journal of Finance , 32, 261-276. Modigliani,
F., & Miller, M. (1963). Corporate Income Tax and the Cost of Capital: a correction.
American Economic Review , 53, 443-453.
Myers, S. C. (1984). The Capital Structure Puzzle. Journal of Finance , 39, 575592.
Myers, S. C., & Majluf, N. S. (1984). Corporate Finance and Ivestment decisions
when firms has information that investors do not have. Journal of Financial
Economics , 12, 187-221.
Myers, S. (2001). Capital Structure. Journal of Economic Perspectives , 15, 81102.