Effects of Capital Structure on Profitability of a Firm

Question: Discuss the Effects of Capital Structure on Profitability of a Firm. Answer: Introduction Capital structure is the combination of debt and equity finance that a company utilizes in its operations that involves a mixture of various securities. Generally, companies can opt for alternative ways of raising capital. Some of the methods of raising capital include warrants, issue convertible bonds, or swapping trading bonds. In addition, firms can choose numerous types in order to maximize its market value (Abor, 2005). According to Azhagaiah and Gavoury (2011), the firms best choice is a mix of equity and debt finance to fund its capital operations. In situations where interest is not taxable, firms would be undecided as to whether to seek equity or debt financing whereas when interest is taxable company owners would seek maximization of the companys value by fully utilizing debt finance. Agency costs arise from use of debt financing. An agency cost is the association between the shareholders and the managers of the firm and that between the owners of debt and the shareholders (Jensen and Meckling, 1976). According to the pecking order theory, companies may opt to sell equity when there is an over-valuation in the market. This is based on the hypothesis that the managers will opt for the current shareholders concerns (Myers, 1984; Chittenden et al., 1996). Accordingly, they deny issuing under-valued shares unless the transfer value from the initial shareholders to the new ones covers the NPV of the prospect of growth. Abor (2005) concludes that new shares are issued only when the price is high than that of the real market value of the shares. Consequently, investors infer equity issuance as a sign of overpricing. In situations where external funding is indispensable, the firm will choose secured debt as opposed to debt that is risky and as such, firms issue ordinary share as a last option (Ibid). 2005) Settling on an erroneous combination of capital structure serious affects the firms performance and its survival is thereby threatened. Therefore, a companys decision to choose financing options involves a variety of policy decisions that may be beyond the control of the board of directors. Such decisions may jumpstart stock securities growth, determination of share prices as well as price regulation and interest rate. The decisions made affect capital structure, corporate governance and firm growth at the grass root level (Green et al ,2002). Booth et al. (2001) and Bas et al.(2009) postulate that awareness of capital structure strategies have relied on developed economies since they possess similar institutions. Distinct social and cultural aspects need to be investigated since levels of economic advancement contribute to how a firm chooses its capital structure. As such, this study will endeavor to establish the effects of capital structure on profitability by examining the factors that influence capital structure decisions for firms in Australias such this paper attempted to determine the effect of profitability, firm size and liquidity on capital structure... Literature review: The idea of capital structure and its relationship with profitability and firm value has always been a subject of debate among scholars. Various researchers affirm that there exists a good combination of capital structure to a firms unique needs while others argue that the degree of debt finance is not important to determine the profitability of a company. Hence, the concept of capital structure is arguably debatable. According to Brealey and Myers (2003) the selction of capital structure is fundamentally a problem associated with marketing. They argue that a firm may issue various mixtures of capital strategies but should also try to seek specific capital mix that maximizes the value of shares. Wald and Brigham (1992) add that the optimal capital structure is one that will maximize the value of shares. The capital structure concept provided an opportunity for various theories to be formulated (Modigliani Miller, 1958). In situations where a firm is new or is a going concern, it needs funds for its daily operations to achieve success. The funds sought are for the daily operations of the firm and or expansion of the company. This indicates the importance of capital in the life cycle of a company (Azhagaiah Gavoury, 2011). When capital is acquired especially from external sources, it becomes a concern to the business because it is other parties funds that are utilized that need to be compensated while the company derives full benefit from those funds. In such a case, such finances become a liability to the firm in their books of accounts (Ibid). Myers (2001) notes that there is no universally accepted theory on the choice of a firm choosing between debt and equity finance but notes that some theories have endeavored to expound on capital structure combination. He cites the trade-off theory that states, Firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. The way a company funds its operations is determined by its capital structure. This can be between a choice of debt finance or equity finance (David, 1979). The theory of capital structure is attributable to Modigliani and Miller who concluded that the way a firm finances its operations has no effect on its value and that the value is not connected to the firms funding strategy. Other theories have been suggested to explain capital structure. Notably the pecking order theory, life cycle theory and the trade-off theory that have continuously been the bone of contention among critics. Interest rates are costs associated with borrowing for a specific period of time. Interest rates are normally pegged on the prevailing inflation of an economy hence a major issue for a firm when choosing capital structure strategy. Research suggests that interest rates have an effect on the firms choice of capital. According Jalilvand and Harris study of 1984 in the United States results obtained suggested that firms funding decisions are intertwined and that the size of the firm, interest rate situations and levels of stock price affect the rate of adjustment to capital structure suggesting that they are manipulated by it. According to Singh (1993), an interest rates increase, investment reduces and as interest reduces, investment activities are revamped. This may mean utilizing more debt finance. Singh concluded therefore, that there is an association between investment, utilization of debt finance and interest rate. In his study of the relationship between capital structure and profitability of listed non-financial firms in Kenya, Kinyua (2014) using regression analysis revealed that a firms profitability (using return on equity ROE as an independent variable) had a positive relationship with short-term debt. In another study, Githire and Muturi, (2015) found the short-term debt had a significant negative correlation with performance of the firm. They used the explanatory non-experimental research model using multiple regression to test and test the hypotheses. Accordingly, the empirical studies cited above found conflicting results of the relationship between capital structure and profitability based on different economies (developing or developed) and or methodologies used. For instance Kebwars study of 2014 on the effect of debt on corporate profitability using the French service sector, examined the influence of debt on profitability by using Generalized Method of Moments (GMM) on an unequal panel consisting of 2,240 French firms for the period 1999 to 2006. His analysis involved examining the linear and non-linear effect by approximating a quadratic model that considers the square of debt variable in the regression equation. The results of the study showed that there neither a linear nor a non-linear relationship between debt and profitability. This further evidenced Baum et al, (2007) study on American firms. However, Nima et al (2012) had found a significant relationship between profitability as the dependent variable replaced by ret urn of equity (ROE) and total debt. They studied Tehran Stock Exchange firms between 2006 and 2011 by measuring performance using gross profit margin, return on assets (ROA) and Tobins Q and three-capital structure ratios that included total debt ratios as independent variables. Similarly, Arbabiyan and Safari, (2009) investigated the effect of capital structure on profitability by using 100 Iranian listed firms from 2001 to 2007 and found that total debt is positively related to profitability proxied by ROE. These differing results and others not cited have prompted the researcher investigate further the effects of capital structure on the profitability of a firm. In addition, no current study has been done in Australia on the effects of capital structure on profitability therefore prompting the researcher to undertake this study. Research questions The study will be guided by the following research questions; What is the effect of long-term debt on profitability of firms listed at Australian Securities Exchange (ASX)? What is the effect of short-term debt on profitability of firms listed at Australian Securities Exchange (ASX)? What is the effect of total debt on profitability of firms listed at Australian Securities Exchange (ASX)? Research Hypotheses H0: There is no significant effect of long-term debt and profitability of firms listed at Australian Securities Exchange (ASX). H0: There is no significant effect of short-term debt on profitability of firms listed at Australian Securities Exchange (ASX). H0: There is no significant effect of total debt on profitability of firms listed at Australian Securities Exchange (ASX). Description of the Research Process Methodology As opined by Flick (2015) while conducting a research, it is important for the researcher to select the right methodology of research. It can be identified as one of the major prerequisites of successful achievement of the declared research outcome. This study will utilize data derived from the Australian Securities Exchange (ASX) website and published financial statements of joint stock companies listed on the Australian Securities Exchange (ASX) 2011-2015. Financial sector including banks and insurance companies will be excluded from this study as they differ from non- financial firms as Diamond and Rajan (2000a) point out, bank assets and functions are not the same as those of industrial firms. In reality, banks and insurance companies are controlled by regulations such as rules of depositing minimum capital. The researcher will use the following variables listed in the table below adopted from Madah et al (n.d). 1 ROE Return on Equity Dependent Variable 2 LDA Long Term Debt Independent Variable 3 SDA Short Term Debt 4 TD Total Debt 5 FIRM SIZE Log of Sales Control Variable 6 SG Sales Growth Table 1: Research Dependent, Independent, and Extraneous Variables Source: Adopted from Madah et al. Project Plan Figure 1 below shows the project plan with the various timelines with milestones for each process that will take place. Figure 1: Gantt chart Research process Figure 2 below depicts the entire research process. Figure 2: The Research Process Source: Developed by the Researcher (2016) Data collection and analysis Sample The sample size will be from all the firms listed in Australian Securities Exchange excluding banks and insurance firms. Technique: The study will be carried out using a longitudinal research design, utilizing secondary quantitative data. This type of research design involves a researcher conducting numerous observations of the same cases over a period normally for several years. It is a study that involves examining data for a long period (Cooper Schindler, 2003). The study will rely purely on accounting data of firms listed at Australian Securities Exchange (ASX). Analysis: Descriptive statistics will be carried out on the quantitative data by measuring the mean, median, mode and the standard deviation. Inferential statistics will be used to determine the cause and effect between the independent variables (Long-term debt, short-term debt and total debt) and the dependent variable (profitability). Analysis of variance (ANOVA) will be used for the extraneous variables which is this case will be sales growth and firm size. ANOVA will assist the researcher determine whether there is an association between the variables and if so, whether it is significant. This will be done by observing the p-value and where it is less than alpha level of 0.05 we will reject the null hypotheses. The researcher will also adapt the Madah et al two models One will determine the association between all the variables while the other will be a regression model. Multiple regression analysis will be used to determine the relationship between the independent variables and the dependent variable and whether the relationship is significant to reject or retain the null hypotheses. This type of analysis will be chosen since it will also reveal the degree of variability between the dependent and independent variables. An alpha or significance level of 5% (0.05) will be preferred throughout the analysis. The results of regression analysis 1203 observations of 201 firms .The regression formula adapted from Madah et al for the analysis will be: ROE it = 0 + 1 (LDA it) + 2 (SIZE it) + 3 (SG it) + ROE it = 0 + 1 (SDA it) + 2 (SIZE it) + 3 (SG it) + ROE it = 0 + 1 (DA it) + 2 (SIZE it) + 3 (SG it) + Where: ROE i,t is EBIT divided by equity for firm i in time t; LDA i,t is long term debt divided by the total capital for firm i in time t; SDA i,t is short term debt divided by the total capital for firm i in time t; TD i,t is total debt divided by the total capital for firm i in time t; SIZE i,t is total debt divided by the total capital for firm i in time t; SG i,t is total debt divided by the total capital for firm i in time t; and is the error term. Expected outcome: As the literature review shows, there are different outcomes of results on the effect of capital structure on profitability. The results of the current study are expected to shed more light in inconclusive debate of effects of capital structure on profitability of firms. The results will be beneficial to different stakeholders key among them the firm owners, stockholders, lending institutions and various government institutions. It will also provide a reference point for other researchers to explore further the effects of capital structure on profitability. As studied from the literature review it can be expected that a sheer impact of the advertisements on the customers buying decision will be established. The first hypotheses can be expected to be supported by the research outcomes. The result will provide a light on the factors those can be manipulated by the advertisements and it can be surly utilized by the entrepreneurs and future studies. References and Bibliography Arbabiyan, Ali-Akbar Safari, Mehdi, (2009). 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