EFFECTS OF CAPITAL STRUCTURE ON FIRM PERFORMANCE

1. INTRODUCTION
Capital structure is an important factor by which a company can increase its performance
at its optimum level if the firm uses it in effective and efficient way. The idea of the
modern theory is taken from the theory of Modigliani and Miller in 1958, which was
assumed under the perfect capital markets. The debt can be optimal because it provides a
shift of control in some states of the world (karine gobert). The capital structure is the
mix of debt, preffered stock and common equity with which the firm tends to increase
capital (http://www.csulb.edu/~pammerma/fin300/ch13.ppt.). Theories of capital
structure suggest may affect a firm’s debt equity choice.
(http://finance.eller.arizona.edu/documents/facultypublications/KKahle.Taxbenefitsofopti
ons.pdf). Capital structure is related to the ability of the firm to meet the needs of its
stakeholders (Boodhoo Roshan January 2009).
The determinants of capital structure such as tax benefit variables, size, profitability,
growth, collateral value of assets and uniqueness were explained by (Kathleen M.kahle
and kudleep shastri in January 2002). There is a curvilinear relationship between ROE
and debt-to-asset ratio. (Shyan- Rong Chou). The trade of theory defines the capital
structure that how much debt and equity finance should be chosen by the company to use
by balancing the costs and benefits. (Frank and Goyal).the capital structured can also
sometimes leads to the bankruptcy and has a negative and adverse affect on the
performance of the firm if properly not utilizes. A firm is the algamation of assets with
one owner that link with other assets to produce and sells merchandise (Eric Rasmusen’s
Weblog). “If firm performance affect the choice of capital structure, then failure to take
this reverse causality into account may result in regression of a firm performance on a
measure of leverage may confound the effects of capital structure on performance with
the effect of performance on capital structure” (Allen N.berger).a firm’s capital structure
refers to the mix of its financial liabilities. As financial capital is an uncertain but critical
resource for all firms, suppliers of finance are able to exert control over firms (Rahul
Kuchhar, fall 1997).

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My motivation is quiet similar to Shyan-Rong Chou. I will investigate the relation
between Return on Equity (ROE) and the capital structure.

1.2 Problem Statement

My research problem is to find out and optimum level of capital structure through which
a firm can increase its financial performance more efficiently and effectively.

1.3 Methodology
I will collect my data through questionnaire which I will be distributing in some public
and private financial institutions. Also by conducting informal interviewees with some of
the employees of those very organizations.

1.4 Objective
The main objectives of my research are;
1. To compare the relationship between capital structure and firm performance.
2. To find ways that can boost the performance of a firm.
3. How to maintain the firm’s revenue under riskier condition.

Significance of capital structure

• Reflects the firm’s strategy
• Indicator of the risk profile of the firm
• Acts as a tax management tool
• Helps to brighten the image of the firm

Literature review
Modigliani-Miller provides the basis for modern thinking on capital structure and was for
the first time introduces the concept of capital structure. Their theory states that without
taxes, bankruptcy costs and systematic information and in an efficient market, the firm’s

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value is not affected in which way the firm is financed. (June 1958 free encyclopedia).
The trade off theory of capital structure states that how much debt financed and equity
finance is chosen by the company to use by balancing the cost and benefits.(Kraus and
Lichtenberger September 1973).Capital structure is also called financial structure of a
firm because it has the ability to meet the needs of its stakeholders. (Boodhoo Roshan
January 2009).Capital structure is very important for firm because it can maximize the
stakeholders return. Moreover in dealing with the competitive environment an
appropriate capital structure is also important to firm (Boodhoo Roshan January 2009).
Jenson and meckling (1976) introduce the concept of agency costs and investigate the
nature of agency costs generated by the existence of debt and outside equity. The
relationship between capital structures is non-linear. The association is found to be
parabolic. Specifically the relation is negative up to a certain point. Then, it reverses and
turns positive (Pornist Jiraporn June 10, 2005). The issue of optimal capital structure in
the perfect market and in the imperfect market was explained by Raj S Dhankar and Ajit
S Boora (July 1996).the concept that how the capital the financial performance of the
small and medium sized enterprises are affected by the capital structure was explained by
Abor, Joshua (22nd sept 2007).
The influence of variables such as cash flows, investment expenditure and stock price
histories were examined by Andres, Aydogan and Charlie hadlock (October, 7 2003).In
May 2004, M. Kahle and Kuldeep Shastri explained that there is a negative relationship
between shot term loans and long term loans to the saize of the debt ratio from option
exercise. The impact of Ownership Structure and Corporate Governance on capital
structure on Pakistan listed companies was explained by Arshad Hassan and Safdar Ali
Butt in 2008. They further analyzed that debt to equity ratio is negatively correlated with
board size and managerial shareholding. Georges Dionne, Robert Gagne and Abdul
Hakim examined the Determinants of Insurers ‘Performance in risk Pooling, risk
management and financial intermediation activities (30th April, 2007). They also
explained how these variables affect the efficiency of financial institutions. Adrienn
Hercezg the optimal capital structure and its importance for a firm to maximize returns is
based in the ability of that very organization to deal with its competitive environment.

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