The results of the study of the mutual relationship between profitability and capital structure of the firm and its impact on the value of firm among large UK firms those constitutes FTSE 100 index on London Stock Exchange were obtained by employing OLS regression method and presented in chapter 4. Those results are evaluated for the understanding of the said relationship and its impact on the value of firm. The findings of the model 1 and 2 of the study are based on book value measures of profitability and leverage and are consistent with prior research on capital structure by Rajan and Zingales (1995), Bevan and Danbolt (2002) and Bevan and Danbolt (2004) in UK and elsewhere.
5.1 Model 1 & 2 - Debt and Profitability
The relationship between profitability and capital structure is a two way relationship this study takes in to account this notion. The results show a negative relationship between gearing and profitability in large UK firms, which is consistent with the pecking-order theory. All three independent control variables Growth (market to book ratio), Size (log of sales) and Tangibility (FA/TA) were found significantly correlated with profitability and capital structure. Both leverage and profitability are positively related to the level of growth opportunities and size and negatively correlated with tangibility. The effect of size is consistent with prior studies. The growth and tangibility shows unexpected relationship with debt and profitability, however it is in conformity with recent UK studies.
Profitability and leverage affects in two ways, higher profitability usually provides more internal financing which lead to a lower level of debt for financing already planned investments. In the pecking order a new equity issue is considered only when leverage is already high enough to make additional debt materially expensive because of the financial distress cost or equity is overvalued. It suggests that high leverage would result in low profitability.
The problem is that leverage and profitability are linked both ways, and that the causal direction is uncertain. This problem could be avoided empirically by adopting an approach in which a system of two equations is used instead of one equation. Therefore in this study causality is expected both ways and efforts are made to control these two effects by a system of two equations.
In Model 1 two different equations for dependent variable DEBT and DER shows the standardised coefficient for ROA are -0.481 and -0.162 respectively. It makes clear that there is negative relationship exist. In model 2 it is clear that the profitability is negatively related with the leverage. In two different equations for dependent variables ROA and ROE the coefficient for Debt are -0.415 and -0.433 respectively. Those results are supported by appropriate p value and t statistics.
Hypothesis
The null hypothesis of no relationship was rejected on the basis of findings at 99% confidence level and hence alternative hypothesis was accepted based on t statistics. The profitability is negatively related to the capital structure.
The results are consistent with the pecking-order theory and contradict the trade off theory. The regression coefficients for the effect of Debt on the profitability of the firm are systematically negative. This is quite a significant statistical relationship. Rajan and Zingales (1995) also find a negative correlation between profitability and gearing in their study of capital structure in the UK. However their coefficient at book value is not as significant as market value. Allan and Danbolt (2002) have noted that the profitability has generally the strongest explanatory power of the cross-sectional variation in UK gearing levels and not definition dependent.
The pecking order theory does not suggest any well-defined target debt ratio (Myers 1995).The interest tax shields and cost of financial distress are generally considered less important in financing decision. Debt ratios change due to changes of internal cash flow net of dividends and when real investment opportunities arise. The firms those are highly profitable generate positive free cash flow, in general, which can be used to lower the debt rather than to pay dividends as dividend policy is sticky. Due to such sticky dividend policy, the less profitable firms having less internal funds for new investment and will tend to borrow more. Thus this theory gives an immediate explanation for the negative correlation between profitability and leverage.
5.2 Model 3 the value of firm
Model 3 represents the regression of Tobin's Q as the proxy of the value of firm, which is based on Market capitalisation of the equity of firm. Contrary to first two models, the findings related with the value of the firm were rather mixed. It was found that the value of the firm is positively related with the return on equity. However it does not show a consistent relation with the debt. Model 3A is analysing the effect of return on equity and leverage on the value of firm in a single equation. This is how Nissim & Pennman (2003) have regressed for dependent variable price to book ratio as a proxy for the value of the firm in their analysis. While regressing for the value of firm with independent variables return on equity ROE and Debt Ratio DEBT the value of firm shows negative relationship with debt, these results are similar to that of the research of Nissim and Pennman (2003) and McConnell and Servaes (1995) who found their results for high-growth firms were consistent with the pecking order theory.
Hypothesis
The null hypothesis of no relationship was rejected on the basis of findings at 99% confidence level and hence alternative hypothesis was accepted based on t statistics. The value of firm is positively related to profitability and it is negatively related to the capital structure.
It shows that the value of firm is increasing with return on equity but on employing additional debt, profitability reduces and the required rate of return increasing for equity investors, hence the value of firm is negatively correlated with debt. Such negative correlation is suggested by between firm value and leverage is suggested by the 'pecking order' theory.
According to the pecking order theory Myers (1984), internally generated funds are used by the firms to finance their projects. So the profitable firms use their profit first. The firms opt to debt financing, once the internally generated funds are exhausted. Finally they go for additional equity issue as a last resort only. The manager always wants to issue safer securities. When the market overvalues the firm, the manager would like to issue the most overvalued security i.e. equity and not debt. On the other hand if the firm is undervalued, the manager would prefer to issue debt to protect his own and existing investors' interest.
So the profitable firm may have less debt and the value of such firm will show positive correlation with profitability and negative correlation with the leverage. Thus the results of this study are consistent with the pecking order theory.
The significant negative relationship of the value of firm (proxy Tobin's Q) with leverage can be explained through the effect of agency cost. Shareholders are trying to pass the risk to the debt-holders to increase their benefits by investing in high-risk projects sub-optimally. Therefore debt holders require monitoring and restrictive covenants are attached to the debt. Jensen and Meckling (1976) argued that monitoring cost is born by shareholders which hinder profitability on equity and reduce the value of firm. On the other hand debt holders will charge high interest rate (risk premium) if there is less monitoring. Both this situation will reduce profitability and value of firm.
These results contradicting the results obtained by Masulis (1982) who found that the firm value is positively related to Debt level and leverage, senior security prices are negatively related to those variables, consistent with optimum capital structure.
However while Tobin's Q separately regressed for ROE and DEBT, the findings were surprising as the results for leverage alone shows a negative coefficient but not supported statistically through t statistic for any impact on the value of the firm. Tobin's Q shows positive relation with ROE but fails to show any statistically significant relationship with debt while regressing without controlling for profitability. As the value of firm is positively related to profitability which is negatively related with leverage, one should expect a proven negative relationship between the value of firm and leverage. This was not found clearly. This finding is close to original Modigliani and Miller (1958) proposition that financial leverage is irrelevant to the value of the firm, in an efficient market such as FTSE 100 on LSE.
It should be noted that Hatfield at al. (1994) in their study of relationship between the firm value and capital structure concluded that the relationship between a firm's debt level and that of its industry do not appear to be of concern to the market. These findings were consistent with the Modigliani and Miller (1958) proposition that financial leverage is irrelevant to the value of the firm. However in this study it is not supported by a positive correlation between profitability and the value of firm hypothesised in MM proposition, which need further research.
5.3 Control Variables
This study includes some commonly used control variables. The purpose of using most common control variables was to capture correct effect of relationship among the main variables and to find out the impact of such variables on the said relationship. Further the results for control variables size, tangibility and risk shows negative correlation with the value of firm. Thus the results of those control variables were rather mixed and are presented as follow.
Growth (market-to-book ratio)
The regression results show that profitability variables ROA and ROE and leverage variables DEBT and DER positively related with growth (the market-to-book ratio). Such a highly significant positive correlation coefficient between the growth (the market-to-book ratio) and profitability and between growth and leverage means firms with high growth opportunities are more profitable and use more debt. These results contradicts pecking order theory and are contrary to prior researches and the popular literature. Firms having no internally generated funds available to invest in growth opportunities are driven to borrow more and more. Highly levered firms are more likely pass up profitable investment opportunities (Myers 1977), therefore, firms expecting high future growth use a greater amount of equity. On the other hand firms having no internally generated funds available to invest in growth opportunities are driven to borrow more and more. Therefore there should be negative correlation with profitability and leverage which is not the case.
However it is in line with the recent finding s in UK by Bevan and Danbolt (2002) and Bevan and Danbolt (2004). They have noted that a significant positive coefficient for growth appears to be driven by the trade credit and equivalent sub-element. Further financial distress cost argument says that distress risk affect largely the low growth firm which may lead to negative correlation. The large publicly traded firms having considerable growth opportunities may prefer short term flexible and less restrictive debt and thus avoid financial distress cost. In this study data contain large publicly traded firms having considerable growth opportunity, which may lead to positive correlation in the absence of distress cost.
Tangibility
The regression results show a small negative correlation coefficient between the tangibility (fixed asset/total asset ratio) and profitability variables ROA and ROE and between tangibility and leverage variables DEBT and DER. However those results are not statistically significant as p value is high. Negative coefficient means firms having more tangible assets are less profitable and use less debt. These results are contrary to prior researches and the popular literature. However, it should be noted that tangibility does not easily and directly fit in the basic frame work of the pecking order theory.
Bevan and Danbolt (2002), however, argue that if the tangibility provides a reasonable proxy for the availability of depreciation tax shields, there should be an expected negative association between leverage and tangibility according to the tax-based hypothesis of De Angelo and Masulis (1980).
According to Bevan & Danbolt (2002) tangibility show a negative correlation with short-term forms of debt as long-term debt forms are used to finance fixed assets while non-fixed assets or current assets are financed by short term debt. Consequently, the negative coefficient indicate changing pattern of debt financing. More profitable firm will opt for more flexible short term debt without any restrictive covenants. So the tangibility shows negative correlation with profitability and debt.
The static trade-off theory gives explanation for a negative relationship between intangible assets and dependent variable. Accordingly of costs of financial distress is most serious for firms with valuable intangible assets and growth opportunities, and hence they will prefer less debt. On the other hand profitable cash generating firms having high level of tangible assets should borrow more compare to growth firms which may lead to negative relationship.
This significant negative relationship with the value of firm (proxy Tobin's Q) which refute the effect of agency cost effect of tangibility. Jensen and Meckling (1976) argue that, if debt is secured against assets, creditors have an enhanced guarantee of repayment. Hence firms having high tangibility i.e. fixed assets would have higher level of debt as the tangibility may help in securing cheaper debt which may enhance profitability and value of firm. However in this study and in previous studies in UK profitability is found systematically negatively related to leverage. So increasing debt may lead to decrease in profitability as shown in model 1. As a result the value of the firm will reduce as shown in model 3. It indicates a negative relationship with the value of firm which is proven in the results of this study.
Size
The regression results show that profitability variables ROA and ROE and leverage variables DEBT and DER positively related with Size given as log of sales. Such a highly significant positive correlation coefficient between the size (log of sales) and profitability and between size and leverage means large firms are more profitable and use more debt. Thus regression results show an expected and significant positive coefficient between the size and profitability and between size and leverage. Such positive relationship implies that large firms have better access of debt and hence they opt for more debt and have better profitability due to diversified operations.
The cost of issuing debt and equity securities is also related to firm size. According to Bevan and Danbolt (1995), small firms pay much more than large firms to issue new equity and hence may be more levered than large firms. Further small firms are further constrained in their debt choice, as they do not have ready access to the corporate bond market and may prefer to borrow short term Therefore there may be significant positive correlation between size and debt is observed.
The value of firm represented by TOBIN'S Q is negatively related with Size. This is expected results. McConnell and Servaes (1990) suggest that large firms tend to be more diversified and less prone to bankruptcy so such firms should be more highly leveraged. They further argued that size and firm's value may be inversely correlated due to lower bankruptcy costs.
According to Jensen (1986) and Stulz (1990) managers have no equity ownership in the firm and they have an incentive to increase the size of the firm. If the size of the firm is large it improves manager's benefits. Because of this incentive managers prefer to manage a larger firm and hence undertake negative NPV projects even if those are contrary to shareholders' interests. Therefore the value of the firm has negative correlation with the size of the firm.
Risk
The regression results show that value of firm has negative correlation with risk defined as standard deviation of the return on assets. In this study the standard deviation of ROA is used as risk variable that indicates volatility of earning.
Bradley, Jarrell and Kim (1984) found that the volatility of earnings has a strong inverse correlation with debt. Titman and Wessels (988) suggested that a firm's debt level is a decreasing function of the volatility of earnings. It is obvious as the variability in profit, influenced by DOL and DFL, may lead to variability of return on equity due to fixed charges on the debt. Hence, the required rate of return increasing for equity investors leading to a negative correlation between the value of firm and debt.
In this study a significant negative relationship was found between the value of firm and the risk given as standard deviation of the return on assets. The negative correlation with the value of firm indicates that value of firm is affected by volatility of earnings.
