Financial leverage involves changes in shareholders' income in response to changes in operating profits, resulting from financing a company's assets with debt or preferred stock. Similar to operating leverage, financial leverage also can boost a company's returns, but it increases risk as well. Financial leverage is concerned with the relationship between operating profits and earnings per share.
In the financial sense, leverage is the process by which a business person, entrepreneur or investor is able to greatly increase the return on an investment through the use of borrowed money. In the financial world, leverage is the amount of risk a person is willing to take. It has been noted that, the greater the risk, the greater the potential payoff. Of course, the greater the risk is, the greater the investor's chance is to lose the investment. This is why, not everyone uses financial leverage and those who uses it, why many fail.
Companies with significant amounts of debt in contrast with their assets are referred to as being highly leveraged and their shareholder earnings are more unpredictable than those for companies with less debt. Lenders and financial analysts often measure a company's degree of financial leverage using the ratio of interest payments to operating profit. From the perspective of shareholders, financing using debt is the riskiest, because companies must make interest and principal payments on debt as part of their contract with their lenders, but they need not pay preferred stock dividends if their earnings are low.
"If only we knew more about the determinants of investment! But, unfortunately, our knowledge in this direction is still very meager. One might well ask, What is wrong with the theory of investment? Or, perhaps, What is wrong with the subject matter itself! For one thing, this variable, -- the pivot of modern macroeconomics -- has apparently lived a somewhat nomadic life among the various chapters of economic theory. Perhaps it has not stayed long enough in any one place. Perhaps it has been ill-treated."
(Trygve Haavelmo, A Study in the Theory of Investment, 1960: p.3)
Investment theory encompasses the body of knowledge used to support the decision-making process of choosing investments for various purposes. It includes portfolio theory, the Capital Asset Pricing Model, Arbitrage Pricing Theory, and the Efficient market hypothesis. A key aspect of investment decisions is how to finance these investments, one of the means being financial leverage. Financial leverage is a process that involves borrowing resources that are paired with existing assets and utilized to bring about a desired outcome to a financial deal. In some cases, the financial leveraging is used to enhance the chances for increasing the return earned on equity or some type of investment in the stock market. As a matter of fact investment is the lifeblood of any company.
Theoretical Background
In this section a brief summary of the theoretical literature on the different theories developed on financial leverage and investment is provided. However, this is simply a summary of the main arguments presented in the last fifty years and, by no means; it should be considered as a complete survey.
Modigliani-Miller Theorem
Nevertheless it is helpful to start with the Modigliani and Miller Irrelevance Theorem. The Modigliani-Miller (MM) theorems, developed by economists Franco Modigliani (1918-2003) and Merton Miller (1923-2000) in a series of papers, represent a major milestone in corporate finance theory. Modigliani and Miller had even won Nobel prizes in economics in 1985 and 1990, respectively, in part for their contributions to what are often referred to as the leverage irrelevance theorem. Modigliani and Miller (1958) presented the idea that, assuming perfect financial markets and in the absence of taxes, the value of a levered firm is the same as that of an unlevered firm if both firms represent the same investment opportunities. They argued that the investment policy of a firm is only influenced by factors that increase the profitability, cash flow or the value of a firm. Therefore, financial leverage does not influence investment decisions although it is basically a source of financing.
They also argued that management tries to maximize the firm's value and when a firm undertakes an investment project; its value is basically increased by the future cash flows from the project discounted at the firm's weighted average cost of capital (WACC). The Modigliani and Miller irrelevance proposition assumes: (1) no taxes and, (2) no bankruptcy costs. In this simplified view, it can be seen that without taxes and bankruptcy costs, the WACC should remain constant with changes in the company's capital structure. Additionally, since financial leverage does not affect the value of the firm, logically it should not affect the investment policy undertaken by management.
Modigliani et al (1963) state that we should not „waste our limited worrying capacity on second-order and largely self correcting problems like financial leveraging‟. In other words, it means that firms should not be worried about growth till they are having good projects in hand; they will be able to find means of financing those projects.
Modigliani and Miller Tax implications
However, the corporate world is characterized by various market imperfections, owing to transaction costs, Institutional Restrictions and asymmetric information. The interactions between management, shareholders and debt holders will generate frictions due to agency problems. Modigliani and Miller (1963) review their original paper (1958) introducing taxation in their analysis and show that the value of a firm is effectively increased with financial leverage via the debt tax shield. It can be seen that substituting debt for equity generates a surplus by reducing firm tax payments to the government. Firms can then pass this surplus on to investors in the form of higher returns. Miller (1977) also emphasized that a firm could generate higher after-tax income by increasing the debt-equity ratio, and this additional income would result in a higher payout to stockholders and bondholders, but the value of the firm need not increase. They also argued that, when there are corporate taxes then interest payments are tax deductible, 100% debt financing is optimal.
Modigliani and Miller seem to omit the fact that financial leverage involves financial distress costs. Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy and sometimes it only means skating on thin ice. Investors know that levered firms may fall into financial distress and thus they worry about it. That worry is reflected in the current market value of the levered firm's securities. It is easy to see how increased leverage affects the present value of the costs of financial distress. For instance with growing leverage, shareholders find their risk following the same trend, because now their dividend is paid out of residual profits after paying interest. In case of bankruptcy, debt capital has repayment preference over equity capital which indicates a disagreement between management and shareholders due to leverage.
Under-investment Theory
Myers (1977) demonstrates that shareholders of a firm with debt on its balance sheet may bypass investments in positive NPV projects. The reason is that by making an investment, the shareholders increase not just the value of equity, but also the debt holders' claims on the firm. If the increase in the value of bondholders' claims exceeds the NPV of a project, then a positive NPV project from the perspective of the firm as a whole turns out to have a negative NPV from the perspective of its equity holders, and, therefore, would not be undertaken. This effect is usually referred to as debt overhang or underinvestment. A crucial assumption underlying the models that demonstrate the underinvestment effect of debt is that debt matures after the return on the investment is realized. A natural outcome of these models is that the shareholders of a levered firm underinvest relative to the equity holders of a firm with no debt in its capital structure, and, in general, that debt is negatively related to investment.
Myers (1997) has examined possible difficulties that firms may face in raising finance to materialize positive net present value (NPV) projects, if they are highly geared. Thus, the under-investment theory is based on the belief of financial leverage having a liquidity effect on firms such that highly geared firms invest less irrespective of their growth opportunities. This implies for firms with high growth opportunities that there is a negative relationship between debt financing and investment. In theory, as financial leverage creates underinvestment incentives, the effect of such incentives can be reduced by the firm's corrective measures. Therefore, provided future growth opportunities are recognized sufficiently early, it is possible to lower leverage.
Over-investment Theory
There is a complementary effect - the accelerated investment effect, which is called Over-investment, which forces the shareholders of a levered firm to invest more intensely. Importantly, the under-investment and over-investment effects work in opposite directions. While the Under-investment effect cause a levered firm to reject some positive NPV projects and invest less than a similar unlevered firm, the over-investment effect causes a firm to invest more than its unlevered counterpart. In a dynamic setting, a firm may optimally delay an investment in a positive NPV project if by waiting it is able to increase the value of its investment opportunity. In other words, the value of the option to wait must be taken into account when assessing the profitability of an investment.
The over-investment theory can be explained as a situation where the firm makes investment expenditure beyond the required level to maintain assets in place and to finance new investment ventures producing positive NPVs. This situation may arise out of the perception of management to seize any opportunity of growth available to the firm even though it means investing in poor projects and thus, reducing shareholders' welfare. As such, there is conflict of interest between managers and shareholders. Leverage in such circumstances is seen as the ideal solution to deal with the over-investment incentives. When management issues debt, it commits the firm to pay cash as interest and principal, hence reducing the amount of internal funds available to management.
Jensen's free cash flow theory
Jensen's (1986) free cash flow theory explains the importance of the role of debt in motivating organizational efficiency. Free cash flow is cash flow in excess of that required to fund all projects that have positive NPV when discounted at the relevant cost of capital. The free cash flow problem follows from a conflict of interests between equity-holders and managers, as opposed to the one between equity holders and debt holders. These conflicts are especially severe in firms with large free cash flows--more cash than profitable investment opportunities. Jensen (1986) predicts that managers of firms with high free cash flow, especially with low growth opportunities, are likely to make value destroying mergers.
Jensen (1986), via his free cash flow theory, argues that with financial leverage, the ability of management to undertake over-investment is particularly restrained by the non-availability of cash flow since a part of these cash flows is being diverted towards interest payments and the principal repayments. Therefore, for firms which have more internally generated funds than they have positive NPV investment projects, debt servicing is seen as the instrument for curtailing the overinvestment problem, preventing management from investing those funds in negative NPV ventures at the detriment of shareholders' interest. This suggests that there is a negative relationship between debt and investment for low-growth firms.
Impact of bankruptcy risk on financial leverage and investment decisions
Much research on bankruptcy risk emerges to explain the theory of capital structure. In response to the MM proposition as modified by income tax, Baxter (1976) introduced financial leverage in the study of bankruptcy risk, and explained the reason why firms did not choose to use debt exclusively when raising capital. He believed under the condition of bankruptcy risk, firms cannot continuously increase their financial leverage. As debt ratio increases, a firm's bankruptcy risk will rise, thus increasing its expected bankruptcy cost and offsetting the benefit of tax savings of debt interest. Under this scenario, a firm's cost of capital does not always decrease when debt rises, but will increase at higher debt level. Therefore, the optimal debt ratio is between 0 and 1.
Stiglitz (1972) believed that the probability of bankruptcy significantly affects a firm's investment behavior, such as merger and acquisition. If a firm considers the potential bankruptcy risk and its resultant high bankruptcy cost, they may abandon their merger and acquisition plans. Under this view, Jensen (1986) concluded that under the bankruptcy mechanism, debt financing would usually create a corporate governance effect on a firm's investment decisions. This is due to the fact that debt financing would increase bankruptcy risk, thereby increasing the risk of a manager's loss of control power. In order to reduce bankruptcy risk, a manager may reduce his/her business expenses, work harder, and invest more carefully. Therefore, increase in debt financing may lead to less investment activities. Myers (1977) examined the negative impact of bankruptcy risk from the perspective of investment deficiency. He believed that, under high debt level, a firm may not invest in projects with expected positive net cash flows. He explained that if a firm goes bankrupt, creditors may be able to recover their losses but stockholders would have to bear the consequences of bad investment decisions.
Martin and Scott (1976), Hong and Rappaport (1979), and Rhee and McCarthy (1982) explored how debt capacity and capital investment decisions affect bankruptcy risk. They believed that bankruptcy cost is determined by the probability of bankruptcy times total debts. Bankruptcy is the inability of a firm's cash flows in meeting its debt and interest obligations. As a result, the probability of bankruptcy of a firm not only depends on the amount of debt financing, but also the distribution of its cash flows. Accordingly, a firm can use investment to manage its cash flows and fluctuation, which will affect bankruptcy risk and the optimal debt level. Jensen and Meckling (1976) concluded that in diversified shareholding in most business, ownership and management are separated. Because of self interest such as power and compensation, a manager may sacrifice the interest of shareholders and pursue the growth of a firm, causing excessive investment (Jensen, 1986 and Stulz, 1990). At this time, the firm's investment may increase bankruptcy risk and discourage the increase of debt level. As a result, investment and financing decisions would affect a firm's bankruptcy risk, and bankruptcy risk will also affect investment and financing decisions.
Previous Theories
The optimal level of debt reflects a tradeoff of the under-investment and over-investment possibilities as emphasized by Myers (1977) and Jensen (1986), respectively. The theories of Jensen (1986), Stulz (1990), and Grossman and Hart (1982) also suggest a negative relationship between leverage and investment, but their arguments are based on agency conflicts between managers and shareholders. Cantor (1990) showed that investment is more sensitive to earnings for highly levered firms. Kopcke and Howrey (1994) have utilized balance sheet variables as separate regressors in the investment equation and find that these effects are not important. Accordingly, Mc Connell and Servaes (1995) showed that for high growth firms the relation between corporate value and leverage is negative, whereas for low growth firms the relation is positively correlated. Lang, Ofek and Stulz(1996) find that there exists a negative relation between firm's leverage ratios and their investment rates, regardless of how leverage is measured.
Empirical background
Many researchers have tested the various theories in different markets with varying results. Many empirical literatures have challenged the leverage irrelevance theorem of Modigliani and Miller. While some authors find evidence to the over-investment and underinvestment theories.
The negative relationship between financial leverage and investment
There are many empirical literatures which support the negative relationship between financial leverage and investment, thus acting as evidences for the overinvestment and under-investment theories. For example, Smith and Watts (1992) report a negative relation between leverage and growth opportunities in cross-sectional regression and their findings are consistent with the under-investment theory for high-growth firms and with the over-investment theory for firms with lower growth opportunities. On the other hand, Kopcke and Howrey (1994) use balance sheet variables as separate regressors in the investment equation, and argue that these effects are not important, thus supporting the leverage irrelevance theorem.
Other empirical research however show that leverage does influence growth; most of them establishing a negative relation between debt financing and investment expenditure in firms. For instance DeAngelo and Masulis (1980) predict that leverage and investment are substitutes, reinforcing the results of other empirical studies, which state that there is a negative relationship between investment and financial leverage. On the contrary, Dammon and Sebet (1988), while trying to gouge the production-finance interaction, find nevertheless that the interaction between capital expenditures and debt financing consists of what they call a "substitution" and an income effect.
Stein (2003) comments on the negative relationship between debt financing and investment but according to him we do not know why such is the case. Several authors subsequently study the impact of leverage on investment, taking into consideration the credit constraints on firms, either in a static, one-period model or in a multi-period model. Hamilton (2000), Davydenko and Franks (2007) and
Mûller (2008), via their respective studies, argue that the negative impact of marginal increases in leverage on investment expenditures is likely to rise increasingly with the debt ratio in the static model. The reasons being the unwillingness of banks to lend to already highly indebted firms and the fact that management worrying about firm survival, decide to forego investment projects today. Due to such credit constraints, we find that there is a negative relationship between financial leverage and investment in the static model.
On the other hand, Boyle and Guthrie (2003), says that with high level of gearing, the value of options to wait and invest in the future, decreases as the likelihood of future financial constraints increases. This effect reduces the incentive to postpone or forego investments today in order to initiate more profitable projects in the future. Childs et al (2005) argued that financial flexibility encourages the choice of short-term debt that reduces the agency costs of under-investment and over-investment. However the reduction in the agency costs may not encourage the firm to increase leverage, since the firm's initial debt level choice depends on the type of growth options in its investment opportunity set.
Another reason advocated for the negative impact of leverage on investment is debt conservation adopted by firms. Quite recently, several qualitative studies, including Graham and Harvey (2001) for the United States, Bancel and Mittoo (2004) and Brounen et al. (2006) for Europe, provide proof of the interaction between financial and investment decisions of firms. They report that firms, in order to maintain financial flexibility, adopt debt conservatism, thus, adopting low gearing policy in the present to undertake investment in the future. Likewise Roberto Mura (2005), studying a large sample of United Kingdom non financial listed firms between 1991 and 2001, show that low leverage policy is only transitory and thus after a period of low leverage, financially flexible firms are able to make significant capital expenditures. It should be noted, however that the focus of these studies differ from ours since our research concentrates on present investment rather the future investment opportunities available to the firms.
Investment level in high-geared firms versus low-geared firms
Many studies try to show whether the impact of financial leverage on investment level in highly-geared firms is different from the situation in low-geared firms. Whited (1992) has shown how investment is more sensitive to cash flow in firms with high leverage as compared to firms with low leverage. Cantor (1990) showed that investment is more sensitive to earnings for highly levered firms. As high risk is associated with high- geared firms, the firm is expected to invest less. Bernanke and Gertler (1989) in their study based in USA show the high variability of investment to an increase or decrease in financial leverage. As a matter of fact highly geared firms are expected to be more sensitive to further leverage and their investment is expected to suffer as a result. On the other hand, Mills, Morling and Tease (1994) provide empirical evidence for the high sensitivity of leverage in highly geared up firms compared to low-leveraged firms.
Low-growth firms and high-growth firms.
Some studies concentrate on the interaction of financial leverage and investment in low-growth firms and high-growth firms. For instance, Lang, Ofek and Stulz (1996), also consistent with the two theories, document a negative impact of financial leverage on growth. They find that this negative relation holds only for firms with fewer profitable growth opportunities. As a result, their study appears to be more consistent to the overinvestment theory in low-growth firms. Lang et al (1996) has use a pooling regression to estimate the investment equation and most of other studies have also used a pooling regression method. They have shown that there is a negative relation between leverage and future growth at the firm level and for diversified firms, at the business segment level. Also debt financing does not reduce growth for firms‟ known to have good investment opportunities. But it is negatively related to growth for firms whose growth is either not recognized by the capital market.
Accordingly, Mc Connell and Servaes (1995) have examined a large sample of non financial United States firms for the years 1976, 1986 and 1988.They showed that for high growth firms the relation between corporate value and leverage is negative, whereas that for low growth firms the relation between corporate value and leverage is positively correlated. Also the allocation of equity ownership between corporate insiders and other types of investors is more important in low growth than in high growth firms. Furthermore, Aivazian et al (2005) found a negative relationship between investment and leverage and that the relationship is higher for low growth firms rather than high growth firms. They analyzed the impact of leverage on investment on 1035 Canadian industrial companies existing at the end of 1999. They conclude that debt financing promotes a greater level of investment than does all equity financing, provided that the risk less rate is large enough. A similar study carried out by Odit and Chittoo on Mauritian firms support the results of Aivazian et al (2005).
Johnson (2003) and Billett et al. (2006) on the other hand examine the impact of growth opportunities on the leverage decisions and debt maturity of firms. They show that high-growth firms adopt low leverage and/or short-debt maturity policies in order to control the agency problems and to attenuate the negative effect of leverage upon growth opportunities. Also, Viet Anh Dang (2007), while examining the interactions between firms' financing and investment decisions in the presence of underinvestment and overinvestment incentives, study an unbalanced panel of 1,683 firms in United Kingdom from 1995 to 2003. In addition, this study as well dwells on the impact on debt maturity of the financing and investment decisions of the companies. He finds that firms with valuable growth opportunities control the under-investment problem by reducing leverage, but not by shortening debt maturity. Thus, firms prefer a low leverage strategy to a short debt one.
Pecking order theory
The pecking order theory is from Myers (1984) and Myers and Majluf (1984). The pecking order theory of capital structure is among the most influential theories of corporate leverage. Firms prefer internal finance, since the funds are raised without sending any adverse signals that may lower the stock price. If external finance is required, firms issue debt first and issue equity only as a last resort. This pecking order arises because an issue of debt is less likely than equity issue to be interpreted by investors as a bad omen. The Pecking Order Theory does not deny that taxes and financial distress can be important factors in the choice of financial leverage. However, the theory says that these factors are less important than manager's preference for internal over external funds and for debt financing over new issues of common stock.
It is necessary to also look at the pecking order theory in explaining financial policy of firms. The pecking order theory suggests that, firms follow a certain hierarchical order in their financing decisions. It is argued that due to information asymmetries between insiders and outsiders, firms will initially rely on internally generated funds to finance new projects. They will then turn to debt if additional funds are needed and then finally to equity. The pecking order theory explains why the bulk of external financing comes from debt. It also explains why more profitable firms borrow less: not because their target debt ratio is low-in the pecking order they do not have a target-but because profitable firms have more internal financing available. Less profitable firms require external financing, and consequently accumulate debt. Since the pecking order does not explain broad patterns of corporate finance, it is natural to examine narrower sets of firms. According to the pecking order theory, financing behavior is driven by adverse selection costs. The theory should perform best among firms that face particularly severe adverse selection problems. Small high-growth firms are often thought of as firms with large information asymmetries.
According to Myers (1984), due to adverse selection, firms prefer internal to external finance. When outside funds are necessary, firms prefer debt to equity because of lower information costs associated with debt issues. Myers (2001) reports that external finance covers only a small proportion of capital formation and that equity issues are minor, with the bulk of external finance being debt. These key claims do not match the evidence for publicly traded American firms, particularly during the 1980s and 1990s. External finance is much more significant than is usually recognized in that it often exceeds investments. Equity finance is a significant component of external finance. On average, net equity issues commonly exceed net debt issues.
Shyam-Sunder, and Myera (1999) find support for the Pecking Order hypothesis utilizing data from New York Stock Exchange for various sectors, over period 1971-1989. Frank and Goyal (2003) observed little support for Pecking Order hypothesis also using American publicly traded firms for the period 1971 to 1998, and argued instead that net equity issues are more closely correlated with financing deficit than are net debt issues. Fama and French (2005) examine the financing decisions of many individual firms and observe that these decisions are in conflict with the Pecking Order hypothesis. Seifert and Gonenc (2008) in their study titled, The international evidence on Pecking Order hypotheses, find little overall support for Pecking Order behavior in the US, UK and Germany for the period 1980 to 2004. They indicate that this is largely attributed to the information asymmetry due to widespread ownership of stock where insiders how more than outside investors. They find evidence to support Pecking Order behavior in Japan during the 1980s and 1990s. Ni and Yu (2008), also find little support for Pecking Order Theory amongst Chinese listed firms in 2004. They conclude that in China, large companies follow the Pecking Order hypothesis while small and medium companies do not.
Tong and Green (2005) support the pecking order theory over the trade-of hypothesis using Chinese listed companies' data. However in their paper the relation between investment and financial leverage is inconclusive. Adedeji (1998), pecking order theory does not make a definitive prediction about the interrelation between investment and financial leverage. In his paper, the results obtained show that there is no significant interaction between financial leverage and investment. While investment has a positive influence on financial leverage, financial leverage does not have a significant influence on investment. The interrelations between them are complicated. For instance, higher leverage can increase bankruptcy risk and push ahead investment projects. Adversely, as a fund raising method, debt can arise with increasing investment.
The pecking order theory predicts that high-growth firms, typically with large financing needs, will end up with high debt ratios because of a manager's reluctance to issue equity. Smith and Watts (1992) and Barclay, Morellec, and Smith (2001) suggest precisely the opposite. They suggested that High-growth firms consistently use less debt. The pecking order theory implies a negative relationship between firm size and debt ratio, since information asymmetrical is less severe issue in big firms. Thus, Rajan and Zingales, 1995; Zou and Xiao, (2006) suggested that big firms' cost of capital should be less than that of small firms.
Determinants of investment
Relationship between cash flow and investment
Fazzari, Hubbard and Petersen (1988), classify firms according to whether they were likely to be financially constrained on the basis of their size, dividend payouts and capital structure and this characteristic determines whether they are more sensitive to the supply of internal funds measured by cash flow. The highest sensitivities to cash flow are found for firms categorized as financially constrained. They further explain this phenomenon with the presence of information asymmetries and agency problems.
Kaplan and Zingales (1997) show that firms that are financially constrained, investment is more sensitive to cash flow than in firms with lesser financial constraints. Similarly, Aivazian et al. (2005) and Almeida, Campello and Weisbach (2006), while analysing the influence of leverage on investment, find that there is high positive correlation between cash flow level of a firm and its investment.
Sales Level
Several authors, including Fazzari et al. (1988) argue for the inclusion of sales as a determinant of investment so as to control for demand effects that are not reflected in 'Q'. Also, Miils and others (1994) find a positive relationship between investment and sales level in both highly leveraged and low-leveraged firms in Australia. Aivazian et al. (2005) demonstrate similar results in their study of Canadian firms.
Growth opportunities
The use of the proxy for the quality of growth opportunities is believed to be the more accurate among most economists, namely Tobin's q. Tobin's q is defined as the ratio of the market value of the firm's assets to their replacement cost. Under the hypothesis of the study of Lang, Stulz and Walking (1991), firms with high 'q' are likely to have investment opportunities with positive NPV, and thus they are likely to use their funds productively. Firms with low 'q', on the contrary, are likely to have only investment opportunities with negative NPV and thus they should pay excess funds out in dividends to shareholders. Studies such as Aivazian et al (2005) and Odit and Chittoo (2005) document a positive relationship between lagged Tobin's Q and current investment level.
Liquidity
Meyer and Kuh (1957) is one early empirical study of liquidity effects; many other papers have built on their work. A standard criticism of these studies is that liquidity proxies for other unobservable determinants of investment, in particular the profitability of investment. High liquidity signals that the firm has done well and is likely to continue doing well.
Thus, more liquid firms have better investment opportunities; it is not surprising that they tend to invest more. As per the study carried out by Meyer and Kuh (1957) in the short run there is "a clear tendency for liquidity and financial considerations to dominate the investment decision…" It is widely accepted that liquidity matters in investment decisions. Empirical studies find credit constraints to be the main reason explaining this phenomenon. Financial constraints make investment higher for firms which come up with cheaper internal finance, which is only possible if the firm is liquid enough.
Profitability
Profitability is another important variable that are utilized to measure growth opportunities as it tries to explain how much the assets that the firm is employing in contributing to the total profitability. According to Fazzari et al. (1988), profits are therefore likely to become an important source of finance, especially under financial constraints. Furthermore, Odit and Chittoo (2005) have worked on a sample of Mauritian firms. As a result, they find a positive and highly significant relationship between profitability and investment. Profitability is as such an important factor since high profitability ensures the possibility to plough back profits to invest in venture with positive NPVs.
