CHAPTER 1:
Capital structure decisions were most important for every organization. Organization needs a mix of capital structure that ultimately maximizes overall firm value and its profitability. Capital structure was a combination of debt and equity and further involved the sources used for financing to inheritance of long-term assets. Different mode of financing available to finance itself such as through issuing shares securities or taking debt. Firms achieved different mixtures small or large amount of debt. An organization takes the combinations, which increased their efficiency, profitability and its market value (Brealey and Myers, 1992; Gitman, 1997 and Weston & Brigham, 2000).
These types of decisions were very difficult in an uncertain economy. Such as; In Pakistani scenario existence of the macro environment factors such as lofty interest rates in double figures, volatility in economy and unstable political situations resulted made this decision difficult. Consequently, the financing decisions experienced a significant rise of costs, in addition the decrease of the economic activity, which also raised the uncertainty.
The ultimate objective of every company was to increase a firm's performance which in fact, associated with firm's strategic decisions. Decisions regarding choice of leverage were one of the strategic decisions; firms often take this type of decisions to increase their performance.
Modigliani and Miller (1958) argued that capital structures and relationship with firm's performance has been creating an issue in accounting and corporate finance literature. Modigliani and Miller further argued that under preventive assumptions of capital structure was unsuitable in determining firm performance or value. According to this intention, firm value was not the combination of the securities it issue but it was determined by real assets. Preventive assumptions did not apply in the real world for this reason many researchers came up with supplementary explanation for this proposition and showed that capital structure affects a firm's performance and value. After the research conducted by Jensen and Meckling (1976) revealed that leverage size in a capital structure created the agency problem between shareholders and managers. It means leverage size in capital structure affected the firm's value and performance. Many researchers Ibrahim El-Sayed Ebaid (2009) and Joshua Abor J. (2005) have conducted the study to find out the relationship between firm performance and financial leverage but the result were mixed and contradictory. Some studies have documented positive relationship between firm performance and leverage size such as Roden and Lewellen (1995). Decisions regarding choice of debt or leverage become critical that which type of debt was more associated with firm's performance. Capital structure decision was most hard in an uncertain economy like Pakistan where macro environmental factors were so volatile. Macro economic factors played the significant role in the decision of capital structure Ilyas (2000), Hijazi and Attaullah (2001).
1.2 Problem Statement
Capital structure decision was very crucial and important for any organization in any sector or economy. It was always very much difficult for organizations to identify or gets the right combination of debt and equity (Capital Structure), which ultimately satisfies them or brings favorable and profitable results for the organizations.
The ultimate objective of the study was to find out the relationship between firm's performance and capital structure of the listed nonfinancial firms on Karachi Stock Exchange (KSE-100) Index. Time period for this study was (2003 to 2008). This was based on the contention that whether short term debt divided by total capital (STD), long term debt divided by total capital (LTD), and total debt divided by total capital (TD), have positive or negative relationship with the firm's performance (ROA, ROE & GPM). It was important to work on such problem and come up with information, which gives some comfort level to investors and organizations to take correct financing decisions for firms.
1.3 Hypotheses
According to the nature of the study following nine hypotheses were used to find out the results of the study. These hypotheses previously was tested by Ebaid (2009), Josha (2005), coleman (2007)
H1: There is a positive relationship between STD and firm's performance (ROA).
H2: There is a positive relationship between LTD and firm's performance (ROA)
H3: There is a positive relationship between TD and firm's performance (ROA)
H4: There is a positive relationship between STD and firm's performance (ROE)
H5: There is a positive relationship between LTD and firm's performance (ROE)
H6: There is a positive relationship between TD and firm's performance (ROE)
H7: There is a positive relationship between STD and firm's performance (GPM)
H8: There is a positive relationship between LTD and firm's performance (GPM)
H9: There is a positive relationship between TD and firm's performance (GPM)
1.4 Outline of the study
This thesis was divided in five chapters and each chapter included different direction. Chapter one was the introduction, which included a review of the topic in an aspect of the various authors, problem statement, objectives and hypothesis of the study. Chapter two was comprised of the literature review by various studies conducted on this problem throughout the history. In chapter three was the research methods and this chapter described the variables used in this study, followed by sample size, data selection procedure and time, statistical technique, and model used in the study. Chapter four included the results interpretation and results analysis of the study. Chapter five included the conclusions, final results, discussions, recommendations and implications and future research. Final chapter six was the References and included the references used to conduct this study.
CHAPTER 2:
LITERATURE REVIEW
Enormous literature was available on the capital structure and its impact on firm performance excluding Pakistan because little literature work has available on such problem. Here, work of famous researchers described:
2.1 Modigliani and Marton (1958)
Modigliani and Marton (1958) generally known as (MM). According to MM the firm's value was not affected by its capital structure and they further contributed was that the capital structure was irrelevant to firms operations hence; MM has presented some unrealistic assumptions such: Though some of the above assumptions were quite unrealistic yet; they were important as they indicate the conditions under which capital structure was irrelevant. MM has not only given unrealistic assumptions but they have also provided different clues, which show the required relevant capital structure and also affect a firm's value. Thus MM assumptions gave way to modern capital structure research and helped to develop more realistic theories of capital structure.
2.2 Agency Theory
Jensen and Meckling (1976) discuss the potential disagreement or relationship between company's executives and shareholders; according to theory managers do not have 100% interests in the firm. Executives were the representatives of the shareholders and strive to assets away from bondholders to shareholders through captivating more loans and empowering in risky assets.
2.3 Pecking order Theory
Myers and Majluf (1984) pecking order theory defined that stakeholders usually thought business executives utilized secret information during the offer of overpriced and risky securities. This examination guided pricing of new equity issuance, it resulted noticeable loss of current shareholders. Due to this matter firms hesitate to offering fresh projects by employing equity financing and utilized internal sources of funds if firm's need huge financing then issued debt and remaining option was equity financing.
Ebaid (2009) conducted a study on the relationship between choice on firm performance and capital structure. This study was conducted in Egypt and multiple regression was used as a testing tool and data of all listed non financial firms was taken and time period 9 years from 1997-2005. Firm performance was measured by using the 3 accounting based measurements (i.e. Return on Assets (ROA) Return on Equity (ROE) and Gross Proï¬t Margin (GPM)). Result of the study exposed that firm performance has weak to no relationship with capital structure choice.
Abor (2005) conducted a study to find out the impact of capital structure on the profitability. This study was conducted in Ghana and 5 year periods were taken under consideration. Regression was used as a statistical technique to reveal the study results. Firm profitability was used with the just one accounting measurement such as Return on Equity (ROE). Finding of the study indentified that short term debt has a positive relationship with return on equity and total assets. On the other hand, Long term debt has a negative impact on assets and return on equity. Abor (2007) study further revealed the significant and positive relationship between the return on equity, total assets and total debt. According to Abor (2005), profitable firm used debt as a main financing mode and in Ghana 85% the debt represented by short-term debt.
Carpentier (2006) conducted study purpose of the research was to find out the impact of variations in capital structure on firm value. Study was conducted in Canada the multivariate and vicariate tests regression used to find out the results. 243 French firms were included in the sample and the time period was 10 years from1987-96. By consisting equal to all matters, capital structure did not describe variation in the value of a firm. Stakeholders took debt in the deliberation to settle on the stock prices. Study found the Cross-sectional relationship between debt and value of a firm, numerous factors influence firms value in the long run.
Serrasqueiro and Marcia (2009) study analyzed the firm capital structure. Result of found significant but negative relationship between the profitability and size of the debt. Study further showed a strong relationship between size, profitability and tangibility of assets with the capital structure of Portuguese firms. These results supported the Pecking Order Theory. Finding of the study revealed that the profitable Portuguese firms used low levels of debt and relied on the internal sources of finance.
Ahmed and Nazrul (2009) study followed static trade-off-hypothesis and pecking order theories in the environment of Malaysia. Pecking order model described that the internal fund and sources fund lack was the most significant in determining the possibly that explained the financing through the fresh debt. To addressing the issue of small predicting power and pecking order approach was increased by including parts of by making internal fund deficiency.
Eldomiaty (2007) conducted research purpose of the study was to find out the impact of changing leverage position on the firms' decisions in the light of assumption of the pecking order, free cash flow and tradeoff approaches. Results of the study revealed the strength of the approaches were suitable in the aspect of relatively significant and higher position of the instructive power of the approaches. To control the leverage firms used long term and long term debts, but long term t debt financed relatively greater than the short-term debt. Findings of the research revealed that pecking order and trade-off models influenced capital structure decisions at great extent.
Madan (2007) conducted a study to find out the impact of capital structure on firm performance and assessed the capital structure. Study further analyzed the different debt and equity mixtures played a role in the firm's growth and performance. Results of the study revealed that few firms had negative and few had a positive relationship with leverage and relation was found on the basis of the ROE. Findings exposed that higher and lower gearing ratios were not desirable for the companies. Financing decisions depended on few factors and important decision for firms takes place for the firms those operated at break-even and used debt in capital structure to assured the profits.
Abor (2000) conducted a study the purpose of the study was to find out the effect of capital structure on the financial performance of small and medium-Sized enterprises (SMEs); previous researches mostly focused on large firms. Six years time period data had taken for the study; from 1998-2003 to investigate the impact of debt policy on firm's performance of small medium enterprises (SMEs) in Ghanaian & South African perspective. The findings of the study exposed that long-term debt and gross profit margin (GPM) were positively related; whereas short-term debt has significant and negative relationship with gross profit margin (GPM), with both South African and Ghanaian perspective. It was also observed that the total debt ratio was also significantly and negatively related with (GPM); whereas trade credit and gross profit margin (GPM) was also significantly negatively related with each other in case of both countries such as South Africa and Ghana.
Hung, Chan, and Hui (2001) conducted a study the purpose of the study was to find out the inter-relationship between capital structure and profitability cost of capital. The findings of the study revealed that the capital structure had significant and positive impact on the total assets where as capital structure showed significant but negative relationship with firm profitability.
Vasiliou (2009) conducted study objective of the study was to test the validity of the pecking order approach in case of difference methodologies lead to various intentions. Study primarily focused to the pecking order approach and its financing approaches. Study results showed a negative relationship between the leverage and firm profitability. It did not give the intuition that pecking order hold financing hierarchy.
Rocca (2007) conducted a study the purpose of the study was to find out the relationship between capital structure and firm value. Capital structure represents a corporate governance device that can protect corporate governance capability and protect its ability to create value. Methodology used for this study was theoretical approach that can contribute in clearing up the relationship between capital structure and corporate governance. Descriptive, model also used which provides a research proposition and various suggestions, which would be used for future empirical research and precise design given for empirical analysis. Finding of this study was that, relationship between capital structure and a firm's value wants to take directly into account the role of moderation and/or mediation of the corporate governance. It was also necessary that presence of complimentary between capital structure and corporate governance variables such as: managerial ownership; ownership concentration; role of board of directors, etc.
Hijazi and Attaullah (2001) conducted study purpose of the study to reveal that bigger Pakistani companies borrowed higher than smaller firms. Findings of the study revealed that smaller firms had fear of more debt which increased the probability of bankruptcy cost and fixed share of direct cost in bankruptcy was lesser. Study further revealed that small portion of total firm's value so superior than firms did not hesitate to enjoyed more debt.
Zaitun and Gary (2007) conducted study to find out the impact of the capital structure on corporate performance. Results of the study revealed that capital structure had significant but negative relationship with firm performance and performance was measured in both market and accounting aspects. Study further revealed that short term debt ratio had a significant and positive impact on firm market performance.
Ilyas (2000) conducted research findings of the study revealed that Pakistan has not got a large amount expansion in the bond market; for that reason, Pakistani firms preferred equity as a financing source. When the negative association between firm leverage and profitability of the firm was removed the Pakistani organizations realized the importance of debt financing. Debt financing enhanced the wealth of the share holders and value of the firm.
CHAPTER: 3
RESEARCH METHODS
In this study, main concern was to find out the relationship between the firm's performance and capital structure of Pakistani firms. According to the Capital Market thickness of Pakistan, this study employed publicly listed firms on KSE-100 index. Firms were taken based on several factors. All the listed non financial firms were taken and following steps were adopted to conduct this study:
Method of Data Collection
Secondary data sources were adopted due to the nature of study. Data was comprised on non-financial firms listed on KSE-100 Index from year 2003-2008, collected from the different sources such as Karachi Stock Exchange, Balance sheet analysis report published by State Bank of Pakistan and other internet sources.
The data was comprised on following variables.
3.1.1 Dependent Variable
Return on Equity ( Net income before tax / Equity )
Return on Assets ( Net income before tax / Total assets )
Gross Profit Margin ( Sales - COGS / Sales )
3.1.2 Independent Variable:
Short Term Debt ( STD / Total Capital )
Long Term Debt ( LTD / Total Capital )
Total Debt ( TD / Total Capital )
3.2 Sampling technique
A non probability sampling such as Quota sampling technique was used because of the nature of this study. This study was limited to all listed non financial firms and those firms were taken which had complete data form 2003-2008.
3.3 Sample size
Capital structure of financial and non financial firms varied from each other. This research eliminated all the financial companies such as: banks, financial institutes financial securities all types of insurance and other financial firms. Sample of fifty two (52) non financial firms were taken which were listed on Karachi Stock Exchange 100 index. Data of six years from 2003-2008 was taken for this research. Eight (8) non financial firms were also eliminated due to incomplete data from 2003-2008.
3.4 Research Models Developed
Simple linear regression models were used in this study such as all variables were scales variables. Three dependents and three predictors (independent) variables were used. This study primarily focused on impact of predictors on dependant variable. To satisfy the regression normality assumption study used transformation on all the variables, which ultimately gave the simple linear models as described below.
ROA = β0 + (β1) STD + µ
ROA = β0 + (β1) LTD + µ
ROA = β0 + (β1) TD + µ
ROE = β0 + (β1) STD + µ
ROE = β0 + (β1) LTD + µ
ROE = β0 + (β1) TD + µ
GPM = β0 + (β1) STD + µ
GPM = β0 + (β1) LTD + µ
GPM = β0 + (β1) TD + µ
Where:
ROA is return on asset (EBIT / Total assets)
ROE is return on equity (EBIT / Total Equity)
GPM is gross profit margin (Sales - COGS / Sales)
STD is short term debt divided by total capital
LTD is long term debt divided by total capital
TD is total debt divided by total capital
µ is error term
3.5 Statistical Technique
Simple linear regression technique used for this research to investigate the impact of Capital Structure such as STD, LTD and TD on firm's performance measured as ROA, ROE and GPM as dependent variable. To find out the results Statistical Package for Social Sciences (SPSS) was used as a testing tool for the investigation of data.
CHAPTER: 4
RESULTS
4.1 Findings and Interpretation of the results
Table 4.1 present the results of simple linear regression analysis used in testing the relationship between capital structure and firm's performance. In table 4.1 results were presented about relationship between capital structures measured by ratio of STD to total capital (Model 1), LTD ratio to total capital (Model 2) and TD ratio to total capital (Model 3) and firm's performance was measured by ROA.
TABLE-4.1 Firm's Performance (ROA)
Variable
Model 1
Model 2
Model 3
Constant
.331
.281
.331
ln_STD
.026
LTD
.336
ln_TD
.053
R2
.023
.155
.079
F
6.584
52.014
24.411
Sig.
.011a
.000a
.000
log_ROA = .333 + (.026) ln_STD + µ
log_ROA = .281 + (.336) LTD + µ
log_ROA = .331 + (.053) ln_TD + µ
Model fitness was proved by R-square indicated that predictors elucidated firm's performance (ROA) model-1 by 2.3%, model-2 by 15.5 and model-3 by 7.9%. Results indicate that ROA and STD have a significant and positive relationship with each other. It means one unit increase in STD resulted to increase ROA by 2.6% which shows positive but weak association. Results further revealed positive impact of LTD on ROA, which showed that one unit increase in LTD, resulted to increase in ROA by 33.6%; it shows positive but moderate association. Results also revealed positive relationship between TT and ROA, which showed that one unit increase in TD resulted to increase ROA by 5.3% it shows positive but weak association.
Table 4.2 results were presented about relationship between capital structures measured by ratio of STD to total capital (Model 1), LTD ratio to total capital (Model 2) and TD ratio to total capital (Model 3) and firm's performance was measured by ROE.
TABLE-4.2 Firm's Performance (ROE)
Variable
Model 4
Model 5
Model 6
Constant
.605
.605
.612
ln_STD
-.037
LTD
.116
ln_TD
-.034
R2
.101
.040
.071
F
31.772
11.854
21.626
Sig.
.000a
.001a
.000a
sqrt_ROE = .605 + (-.037) ln_STD + µ
sqrt_ROE = .605 + (.116) LTD + µ
sqrt_ROE = .612 + (-.034) ln_TD + µ
Model fitness was proved by R-square indicated that predictors elucidated firm's performance (ROE) model-4 by 10.1%, model-5 by 4% and model-6 by 7.1%. Results indicate that ROE and STD have a significant but negative relationship with each other. It means one unit increase in STD resulted to decrease ROE by 3.7% which shows negative and weak association. Results further revealed positive relationship between LTD on ROE, which indicate that one unit increase in LTD, resulted to increase in ROE by 11.6%; it shows positive and weak association. Results also revealed negative relationship between TT and ROE, it indicates that one unit increase in TT resulted to decrease ROE by 3.4%, it shows positive but weak association.
Table 4.3 results were presented about association between capital structures measured by ratio of STD to total capital (Model 1), LTD ratio to total capital (Model 2) and TD ratio to total capital (Model 3) and firm's performance was measured by GPM.
TABLE-4.4 Firm's Performance (GPM)
Variable
Model 7
Model 8
Model 9
Constant
4.021
4.263
4.164
ln_STD
-.863
LTD
.618
ln_TD
-.922
R2
.273
.006
.255
F
106.410
1.606
96.955
Sig.
.000a
.206a
.000a
sqrt_GPM = 4.021 + (-.863) ln_STD + µ
sqrt_GPM = 4.263 + (.618) LTD + µ
sqrt_GPM = 4.164 + (-.922) ln_TD + µ
Model fitness was proved by R-square indicated that predictors elucidated firm's performance (ROA) model-7 by 27.3%, model-8 by 0.6% and model-9 by 25.5%. Results indicate that GPM and STD have a significant but negative relationship with each other. It means one unit increase in STD resulted to decrease GPM by 86.3% it shows negative and strong association. Results further revealed insignificant relationship between LTD on GPM, so model 2 was excluded from the study. Results further revealed negative relationship between TT and GPM, it indicates that one unit increase in TT resulted to decrease GPM by 92.2%; it shows positive but strong association.
4.2 Hypotheses assessment summary
Every study revolves around the hypothesis and hypothesis used in this study had distinctive financial characteristics and had significant impact to made the capital structure decision. Following hypothesis was used to find out the results.
TABLE 4.5 hypotheses assessment summary
S.NO
Hypotheses
Coefficients
Sig
RESULT
H1
There is a positive relationship between STD and firm's performance (ROA)
.026
.011a
Accepted
H2
There is a positive relationship between LTD and firm's performance (ROA)
.336
.000a
Accepted
H3
There is a positive relationship between TD and firm's performance (ROA)
.053
.000
Accepted
H4
There is a positive relationship between STD and firm's performance (ROE)
-.037
.000a
Rejected
H5
There is a positive relationship between LTD and firm's performance (ROE)
.116
001a
Accepted
H6
There is a positive relationship between TD and firm's performance (ROE)
-.034
.000a
Rejected
H7
There is a positive relationship between STD and firm's performance (GPM)
-.863
.000a
Rejected
H8
There is a positive relationship between LTD and firm's performance (GPM)
.618
.206a
Accepted
H9
There is a positive relationship between TD and firm's performance (GPM)
-.922
.000a
Rejected
These results were matching with the study conducted by Tarek I. Eldomiaty (2007) also match with Joshua Abor (2007). Finding of this study showed different results with previous studies such as Ebaid (2009) and Jasir Ilyas (2001), because there have been difference in environments and circumstances.
CHAPTER 5
DISCUSSIONS, IMPLICATIONS,
FUTURE RESEARCH AND CONCLUSIONS
In this study, simple linear regression analysis was used to examine the relationship between capital structure and firm's performance. Data collected from listed Pakistani 52 non-financial firms from period of 2003-2008. Firm's performance measured as ROA, ROE and GPM as dependent variable. Where as Capital structure measured as STD, LTD, TD as independent variable.
5.1 Conclusion
This study examined the effect of capital structure (debt-policy) from the viability of non-financial companies at Karachi Stock Exchange (KSE-100) Index six years data from (2003-2008) was considered. Based on a sample of listed non financial firms and using three of accounting-based measures of financial performance (ROA, ROE, and GPM), the empirical tests indicate that capital structure (STD, LTD and TD) impacts positively the firm's performance measured by ROA but long term debt was more important then STD and TD. On the other hand capital structure (STD and TD) has negative but significant impact on firm's performance measured by ROE or measured by GPM. LTD has positive and significant impact on Firm's Performance measured by ROE. LTD has positive and insignificant impact on Firm's Performance measured by GPM. These results were matching with the study conducted by Tarek I. Eldomiaty (2007) also match with Joshua Abor (2007). Finding of this study showed different results with previous studies such as Ebaid (2009) and Jasir Ilyas (2001), because there have been difference in environments and circumstances and firms make decision accordingly, it also showed that smaller firms employ more short term debt then longer term debt.
Enormous studies have been conducted in such a case, but was in Pakistan territory in the debate and very little literature or research. So it was very important to such subject, that Pakistani company information, the capital structure decision was easy to make contribution.
5.2 Discussions
As study revealed that the short term debt has positive relationship with firm performance in Pakistani scenario. Because most of the Pakistani firms depend on short-term borrowing and preferred short term financing. For small and average firms in Pakistan it was very difficult to access the capital market in terms of practical and cost difficulties. According to this study long term debt was the most important financing mode for the Pakistani firms but Commercial banks was the major suppliers of financing which discouraged the long term debt financing.
5.3 Implications and Recommendations
This study was useful to the entire Pakistani non-financial companies listed at Karachi Stock Exchange (KSE-100 Index). This research has vital information for companies on capital structure decisions. This study recommended that the long term debt most important element in Firm's Performance and long-term debt was the most important and preferred source of financing and the share of funding has been used in Pakistan. Because results showed positive relation with firm's performance measured by (ROA, ROE and GPM). So, Pakistani companies used long term debt maximizes overall firm value and its profitability.
Future Research
This thesis was just comprises of three predictors such as short term debt, long term debt and total debt. According to the results of this study, it was concluded that there are some other significant variables which affect the firm's performance. Those variables are "firm size and sales". Future research can be conducted with these variables.
CHAPTER 6:
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