Effect Of Capital Structure On Firm Profitability (An Empirical Analysis From London)

Project and Seminar Material for Business Administration and Management BAM

Abstract

This study intends to explore the effect of capital structure on firm profitability. For the purpose of empirically investigating the effect of capital structure, a sample of 30 firms have been selected from FTSE-100 index of the London Stock Exchange. The data period for the study was 2005 to 2014. The study used multiple regression analysis method to explore the impact of capital structure on firm performance. The results revealed that Interest Coverage has positive significant impact on ROA, ROE and ROIC where DE has positive significant impact on ROE but negative significant impact on ROA and ROIC. The study concluded that an optimal level of capital structure, effective utilization and allocation of resources shall be employed to achieve the targeted level of efficiency in business.

Keywords: debt to equity (DE), interest coverage (IC), return on asset (ROA), return on equity (ROE), return on invested capital (ROIC).

Chapter One

Introduction

1.1 Background to the Study

Capital structure simply means the way a firm finance itself through debts, equity or hybrid securities. It is the combination of debt and equity that is needed for a firm to finance its assets. According to Brealey, Myers and Marcus (2001) capital simply refers to the firm’s sources of long term financing which is the manager’s duty to pay for investments in real assets. Specifically, the study focus on the ability of a firm to finance its asset through debt or equity. Emphasis has been made on capital structure mix of a firm, as it often determines the return on asset (ROA).

Capital structure decision is very important since the performance of a firm is directly affected by such decision. Return on assets is a key profitability ratio which measures the amount of profit made by a firm per naira of its assets. Returns on asset examines how efficiently management uses firm’s assets to generate profit.

In an era of globalization of economic policies and financial markets, investment opportunities and financing option shave increased, causing a significant increase on the dependence of capital markets. A new business requires capital and further capital is needed if the firm is to expand. The required funds can come from various sources, which can be categorized into two major proportions comprising of debt and equity capital. The relative proportion of these two major sources in the total capital of a firm is a measure of capital structure. One of the most important reference theories in companies financing policy is the theory of capital structure.

Capital structure is the combination of debt and equity capital that composite a firm’s financing its assets.

Financing is referred to as a process of generating cash which can be used for acquisition of assets, current operations or any expected growth. Firms can use either debt or equity capital to finance their assets. Therefore, capital structure can be written as the sum of net worth plus preferred stock plus long- term debts. Besides these sources of finance, enterprises may issue hybrid securities such as income bonds. These hybrid securities possess the features of both equity and debt securities.

The capital structure decision is an important decision as it influences the investors’ return on their investment. It is therefore obligatory on the management of company to make appropriate capital structure so to maintain the interest of its investors.

1.2 statement of the Problem

The key issue of this study is that firms can finance from a mix of financing sources, which can be either internal or external financing sources. And this has direct effect on the firm’s ability to generate profit as being described in the literature. Traditional trade-off theory of capital structure refers to the idea that a firm selects how much debt finance and how much equity finance to use by balancing the costs and benefits. Pecking order theory starts with asymmetric information as managers know more about their firm’s prospects, risks and value than outside investors. Asymmetric information affects the choice between internal and external financing and between the issue of debt or equity. Firms prefer internal financing which is the pecking order theory.

The goal of the capital structure decision is to determine the financial leverage that maximizes the value of the firm or minimizes the weighted average cost of capital. In the Modigliani and Miller theory developed without taxes, capital structure is irrelevant and has no effect on firm’s value. Modigliani and Miller (1958) explained that the value of a firm is viewed as a function of financial leverage while dividend and retained earnings are not deductible for tax purposes, interest on debt is a tax deductible expense.

Another vital imperfection affecting capital structure decision is the presence of bankruptcy cost. When a firm is unable to meet its obligation it results in financial distress that can lead to bankruptcy because a major contributor to financial distress is debt. Jensen & Meckling, (1976) put forward the concept of agency cost which recognises that the interest of managers and shareholders my conflict and managers may make major financial policy decision such as the choice of capital structure. Myers (1977) mentioned another type of agency cost of debt which arises from under-investment problem.

This study attempts to analyse the effect of capital structure on firm profitability (an empirical analysis from London).

1.3 Objectives of the Study

The study is intended to undertake the following objectives:

To identify the nature of relationship between capital structure and firm performance.
To explore the impact of capital structure on firm performance.

1.4 Research Questions

The study will answer the following research questions

What is the nature of relationship between capital structure and firm performance ?
What is the impact of capital structure on firm performance?

1.5 Hypothesis of the Study

Based on above objective, the researcher formulates the following hypothesis.

Model 1

H0: There is no significant impact of capital structure on Return on Asset.
H1: There is significant impact of capital structure on Return on Asset.

Model 2

H0: There is no significant impact of capital structure on Return on Equity.
H1: There is significant impact of capital structure on Return on Equity.

Model 3

H0: There is no significant impact of capital structure on Return on Invested Capital.
H1: There is significant impact of capital structure on Return on Invested Capital.

1.5 Significance of the Study

The relationship between capital structure and profitability cannot be ignored because the long-term survivability of firm depends upon the improvement in the profitability of the firm. The interest paid on debt is tax deductible payments, so the addition of debt in the capital structure will improve the profitability of the firm. It is important to know the relationship between capital structure and the profitability of the firm in order to make sound decision on capital structure.

Findings of the study are useful for the investors as well as companies who wants to invest in FTSE-100 index. Findings are also useful for the Government sectors for collecting more taxes and boost that particular sectors.

1.7 Scope of Study

The study covers the effect of capital Structure On firm Profitability using firms selected from FTSE-100 index of the London Stock Exchange. The data period for the study was 2005 to 2014.

1.8 Limitation of the Study

The limited time at the diposal of the researcher to conclude this research project posed as a major limitation to the researcher as it was difficult to combine school work and this research work completion within the specified period of time.

1.9 Definition of Terms

Capital Structure

Capital structure is how a firm would be able to fund its future investments projects via debt, equity or mixed. Capital structure was also defined by Roshan (2009) as a mix of debt and equity capital maintained by a firm. There is a sign of stability about the meaning of capital structure if newest definition by Narayasanary (2015) is compared with the older definition by Roshan (2009) because both of them considers a mix of debt and equity capital which form a company capital structure.

Firm Profitability

This is an outcome or result of company business operations. That company result is the difference between the company revenue and expenditure. Burja (2011) defined company profit or performance as the direct result of managing various economic resources and of their efficient use within operational, investment and financing activities. In this study, company profit was a dependent variable measured by Return on equity and return on asset.

Balance Sheet

Pandey (2010) defined balance sheet and income statement of a company as follows. He defined balance sheet as a statement that indicates the financial condition or the state of affairs of a business at a particular moment in time. To provide more clarification on this, balance sheet consists of information about resources (assets) and company obligations (liabilities) and owners funds (equity) at a particular point of time. Normally balance sheet prepared at a particular date reveal the firm’s financial position at that specific date.

Profit and Loss Account

Pandey (2010) defined profit and loss account as a score board of the firm’s performance during a period of time. Since the profit and loss account reflects the results of operations for a period of time, it is a flow statement. Profit and loss account represents the summary of revenues, expenses and net income or net loss of a company, and net income is the difference between company revenues and expenses at a particular financial year.

1.10 Organization of the Study

This chapter presents an introduction of the topic for this research. It highlights the problems associated to the topic which lead to the specification of the objectives of the study geared towards addressing the problems. The chapter also provided the definitions of relevant and related concepts, the scope and limitations of this research.

The second chapter of this study consisted of literature review which clarified definition of key study concepts, theoretical literature of the study where theories related to the study were elaborated. In that section, empirical literature was also reviewed. Moreover, research gap and conceptual framework were part of that section. Chapter three of this study clarified about the methods of data collection, research methodology, data processing and analysis of the study.

Moreover, the study talked about chapter four which talked about study findings and discussion. In that chapter, empirical results of the study were discovered and compared with previous studies and theories of capital structure.

Then chapter five of this study talked about the conclusion and recommendation of the study. Finally, this study consisted of final pages which were references and appendices of company data or information used for data analysis purpose. Appendices also consisted of statistical results already analyzed by regression, correlations, and descriptive statistics with the help of STATA computer software program.

Chapter Five

Summary, Conclusion and Recommendation

5.1 Summary

The main objective of the study is to empirically investigate the effect of capital structure on firm performance of 30 companies listed on FTSE-100, London Stock Exchange, United Kingdom. For the purpose of exploring the effect, the study consists of three models including two independent variables and three dependents.

This study used panel data of companies for the period of 5 years creating 30 observations of the data. Researcher analyzed the relationship between capital structure variables (independent variables) against profitability variables (dependent variable). Fixed effect regression method was used to measure the relationship between capital structure and return on asset (ROA) while random effect regression model used to test the relationship between capital structure and return on equity (ROE). Moreover, partial correlation technique also used to measure the relationship between the study variables in order to support the regression results.

Based on the correlation analysis of the study, DE is positively correlated with ROE and ROIC while negatively correlated with ROA, whereas IC is positively correlated with ROA, ROE and ROIC. There is negative correlation between DE an IC. A positive correlation is revealed among all independent variables.

Besides, the regression results of first model reveals that DE and IC have p-value of 0.0139 and 0.0001 respectively showing significant impact on Return on Asset and the value of R-squared is 0.347279 which denotes that 34.7279% of variation in ROA is due to debt to equity and interest coverage. This shows that IC has positive significant impact on return on asset while DE has negative significant impact on return on asset.

5.2 Conclusion

The regression result of the second model reveals that variables DE and IC have p-value of 0.0000 and 0.0411 respectively showing significant impact on Return on Equity. The value of R-squared is 0.079153 which denotes that 7.9153% of variation in ROE is due to independent variables debt to equity and interest coverage. This shows that DE and IC have positive significant impact on return on equity.

The regression result of third model reveals that DE and IC shows p-value of 0.0284 and 0.0000 respectively meaning that independent variables have significant impact on Return on Invested Capital Both independent variables (DE and IC) showing significant value 0.0284 and 0.0000 respectively showing significant impact on return on invested capital. The value of R-squared is 0.441113 which denotes that 44.1113% of variation in ROIC is due to independent variables debt to equity and interest coverage. This shows that IC has positive significant impact on return on invested capital where DE has negative significant impact.

Based on the empirical finds the study concludes that there is significant effect of capital structure on firm performance.

The study concludes that there is significant effect of capital structure on firm performance. The results of the study determines that the higher the value of debt, higher will be the tax benefits (tax shield) received by firms. Therefore, the firms’ executives and managers shall maintain optimum level of capital structure in order to achieve the targeted level of efficiency in business.

5.3 Recommendation

The researcher has conducted the research on effect of capital structure on firm performance evidence from FTSE-100 index over the period of 2005-2014 by using two independent and three dependent variables. If anyone else wants to conduct the research on the same topic:

The researcher must incorporate more independent variables
The period of the study should be more than 20 years for better results
The researcher must collect the data more the 50 companies for better results

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Frequently Asked Questions

How does capital structure decisions affect firm value?

‘Good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it’. The effect that capital structure decisions have on profitability and firm value is that, it increases value through the present value of tax savings from the use of debt.

Is there a relationship between capital structure and profitability?

Where the coefficient is positive, there is a positive relationship between Capital structure and profitability and where it is negative, we have a negative relationship.

How does capital structure affect profitability of listed firms in Ghana?

Abor (2005) [1] investigated the relationship between capital structure and profitability of listed firms on the Ghana Stock Exchange and found that 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.

What are the possible effects of capital structure policy?

The possible effects of capital structure policy are that it can increase both gains and losses of the firm. It is a ‘double edged sword’ Ross, Westerfield, & Jordan (2001, pp. 367).

How does capital structure affect the value of a firm?

The value of any firm is the net present value of its future free cash flows discounted by the Weighted Average Cost of Capital (WACC). Change in capital structure will influence the risk and cost of each capital structure component as well as on capital cost as a whole.

Can corporate management influence a firm’s value?

This leads, in turn, to the assumption that the corporate management can influence a firm’s value by changing its capital structure. If capital structure can affect value, how can firms identify an optimal capital structure and what will it look like?

What is the difference between capital structure and investment decisions?

While investment decisions are related to the asset side of the balance sheet, financing decisions are related to the liabilities and equity side. Capital structure ordinarily implies the proportion of debt and equity in the total capital of a company.

What are the major determinants of capital structure decisions?

The management control over the firm is one of the major determinants of capital structure decisions. The equity shareholders are considered as the real owners of the company, since they can participate in decision making through the elected body of representatives called ‘board of directors’.

Does capital structure affect the profitability of a firm?

Because interest payment on debt is tax deductible, the addition of debt in the capital structure will improve the profitability of the firm. Therefore, it is important to test the relationship between capital structure and the profitability of the firm to make sound capital structure decisions.

What is capital structure?

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.

Does capital structure affect profitability of listed firms on the Ghana Stock Exchange?

Abor (2005) seeks to investigate 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.

Can one ratio explain the capital structure of a company?

However, using one ratio to explain the capital structure is not sufficient since many factors impacts the capital structure. Following the prior researches, three metrics are selected for the capital structure to seek a relationship with profitability. One of the most common ratios, Total Debt to Equity (TDE), is used to indicate the

How does financial structure affect the performance of a company?

The research results showed a strong correlation between the company’s performance and its financial structure, but the direction of impact depended on the sector in which the enterprises were doing the business. … Evidence from the past studies revealed that capital structure has an impact on the firm performance.

Is capital structure an issue at company financing decision making?

The capital structure is an issue at company financing decision level. Every company has to identify the own optimal capital structure by mixing the financing sources in order to increase its own profitability. Abor, J. (2005). The effect of capital structure on profitability: an empirical analysis of listed firms

What are the four factors that affect capital structure?

Assets ratio, firm size, tangibility, inflation (Frank and Goyal, 2009; Oztekin, 2015). In Nowadays, capital structure still represents a subject of debate in finance field.

What is the capital structure of a company?

What is capital structure & dividend policy?

Capital Structure & Dividend Policy By: AsHra ReHmat 2. Capital Structure • In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. 3. Overview • A firm’s capital structure is the composition or ‘structure’ of its liabilities.

Does policy uncertainty affect capital structures?

If policy uncertainty affects capital structures through the supply effect, i.e. decreasing loan supply and rising cost of financing, it is natural to predict that this effect will be weaker for firms maintaining a relationship with banks — possibly due to less severe information asymmetry.

How does capital structure affect the profitability of a company?

Another indirect effect of capital structure on profitability is its impact on the potential availability of additional capital if it is needed in the future. A company with a particularly high debt to equity ratio may be seen as unnecessarily risky by both lenders and potential shareholders, making it difficult to raise additional funds.

What is capital structure example?

Overview • A firm’s capital structure is the composition or ‘structure’ of its liabilities. • For example, a firm that has $20 billion in equity and $80 billion in debt is said to be 20% equity- financed and 80% debt-financed. The firm’s ratio of debt to total financing, 80% in this example, is referred to as the firm’s leverage.