This chapter will highlight and summarizes the literature review on all past studies and research on capital structure and company performance. There are many variables in capital structure but for the purpose of this study, only short-term debt (STD), long-term debt (LTD) and total debt (TD) will be used. In terms of company performance, variables that been used are return on asset (ROA), return on equity (ROE) and Tobin's Q.
2.1 Literature Review
Nour Abu-Rub (2012) investigated the impact of capital structure on firm performance. The study used five performance measures which include return on equity (ROE), return on assets (ROA), earning per share, market value of equity to the book value of equity and Tobin's Q as dependent variables. Four capital structure measurements include short-term debt (STD), long-term debt (LTD), total debt to total assets, and total debt to total equity as independent variables. The study is executed by using panel data procedure for a sample consisting 28 listed companies in Palestinian Stock Exchange (PSE) from the period of 2006 till 2010. The results showed that firm's capital structure had a positive impact on the firm's performance measures, in both the accounting and market's measures. It is also statistically significant with TDTA except MBVR was significant with TDTA and with SDTA. Finally, the study findings suggest equations to determine the impact of various debts on firm performance. From the results, the independent variables are extremely related to ROE based on the value of Adjusted R square value (81%). Moreover, the results also show that there were no statistically relationship between (SDTA, LDTA and TDTA) and the dependent variables. The summary of this study indicate that the measure performance showed that Palestinian companies have a low accounting performance compare to neighbouring countries such as Jordan. However, market performance was better compared to Jordan.
Mahmoodi, I. and Abbas, Z. (2011), examined the impact of corporate governance on financial performance of banking companies in Pakistan. The sample data is form 21 leading banks of Pakistan covering the period of 2006-2009. In the regression analysis, it has been observed that large size for board of directors' resulting increased in performance for banking firms which indicate that the independence board of directors was effective governance measure for banks. The size of the bank also has the significant impact on the performance of bank as a large sized bank was in a position to benefit economies of scale. Number of board meetings has negative relationship with ROE. The impact of leverage on financial performance of banks was also evident.
Zuraidah, A., Norhasniza, M. H. A. and Shashazrina, R. (2012) studies about capital structure effect on firms' performance which focusing on consumers and industrials sectors on Malaysian firms. This study analyze the relationship between operating performance of Malaysian firms, measured by return on asset (ROA) and return on equity (ROE) with short-term debt (STD), long-term debt (LTD) and total debt (TD). Four variables are found to have an effect on firm operating performance which are size, asset grow, sales grow and efficiency that been used as control variables. This study covers 58 firms from two major sectors in Malaysia equity market which are the consumers and industrials sectors. The time period from the year of 2005 through 2010 are used as observations for this study. The study finds that only STD and TD have significant relationship with ROA while ROE has significant on each of debt level.
Saeedi, A. and Mahmoodi, I. (2011) investigated capital structure and firm performance from Iranian companies. The study uses four performance measures which are return on assets, return on equity, earning per share and Tobin's Q as dependent variable. Three capital structure measurements include long-term debt, short-term debt and total debt ratios as independent variables. The study was performed using panel data procedure for a sample of 320 listed companies in the Tehran Stock Exchange (TSE) over the period of 2002-2009. The result indicate that firm performance, which is measured by EPS and Tobin's Q, is significantly and positively related with capital structure. However, ROA is in negative relationship with capital structure. There was no significant relationship between ROE and capital structure. This study indicates that firm performance is positively or even negatively related to capital structure.
Ebaid IE (2009) examined the impact of capital-structure choice on firm performance from Egypt. The purpose of this paper is to empirically investigate the impact of capital structure choice on firm performance in Egypt as one of emerging or transition economies. This is the first study that examines the relationship between leverage level and firm performance in Egypt. Multiple regression analysis is used in the study in estimating the relationship between the leverage level and firm's performance. Using three of accounting-based measures of financial performance (i.e. return on equity (ROE), return on assets (ROA), and gross profit margin), and based on a sample of non-financial Egyptian listed firms from 1997 to 2005 the results reveal that capital structure choice decision, in general terms, has a weak-to-no impact on firm's performance.
Mesquita and Lara (2003) study the capital structure and profitability for Brazilian case. The determination of a company's capital structure is a difficult decision. It involves several factors, such as risk and profitability. The decision becomes even more difficult, in times when the economic environment in a high degree of instability. Therefore, the choice for the suitable proportion of debt and equity can affect the value of the company, as much as the return rates can. In the present study, the authors tried to examine the influence of the capital structure of Brazilian companies regarding the factor profitability. The data used in this study matching the financial statements of 70 companies collected in the past seven years. There is, the historical series covers the period immediately after the implantation of Plano Real, with its consequences in terms of reduction of inflation rates, increase of interest rates, and instability of the exchange rate politics. The Ordinary Least Squares (OLS) method was used in the estimation of a function relating the return on the equity (ROE) with the indexes of long and short-run debts, and also with the total of owner's equity. The results indicate that the return rates present a positive correlation with short-term debt and equity, and an inverse correlation with long-term debt.
Khan, A. G., (2012) examined the relationship of capital structure decisions with firm performance for engineering sector in Pakistan. The purpose of this study is to find the relationship of capital structure decision with the performance of the firms in the developing market economies in Pakistan. Pooled Ordinary Least Square regression was applied to 36 engineering sector firms in Pakistani market listed on the Karachi Stock Exchange (KSE) during the period of 2003 to 2009. This is first paper to study an individual sector like engineering industry in Pakistan on the mentioned topic. The results show that financial leverage measured by short term debt to total assets (STDTA) and total debt to total assets (TDTA) has a significantly negative relationship with the firm performance measured by Return on Assets (ROA), Gross Profit Margin (GM) and Tobin's Q. The relationship between financial leverage and firm performance measured by the return on equity (ROE) is negative but insignificant. Asset size has an insignificant relationship with the firm performance measured by ROA and GM but negative and significant relationship exists with Tobin's Q. Firms in the engineering sector of Pakistan are largely dependent on short term debt but debts are attached with strong covenants which affect the performance of the firm.
Hayat, M. M., et. al, (2010) investigated the corporate governance practices and their impact on firm's capital structure and performance for Pakistan textile sector. It finds the relationship between internal corporate governance and capital structure and internal corporate governance and firm performance in Pakistani textile sector. For the purpose of this study, a sample of 100 manufacturing companies listed at Karachi Stock Exchange(KSE) and Lahore Stock Exchange (LSE) from Textile sector. The data was collected from the period years from 2005 to 2009. Regression Analysis and Structural Equation Modelling are used to determine the relationship between internal corporate governance and capital structure and internal corporate governance and firm performance. The findings support the theories of corporate governance which are consistent with the theoretical models that good corporate governance practices lead to decrease in capital structure and improved performance. The results stress on the importance of corporate governance practices for firms to reduce their debt structure and improve their performance and if firms want to get more capital and improve investor's confidence, they would have to improve their corporate governance practices.
According to the study done by Memon, P. A., et. al, (2008), they investigated the capital structure determinants for food & personal care industry in Pakistan. In this study, it covers the sample of 16 firms in the sector which are listed at the Karachi Stock Exchange from the period of 2001 till 2008. The data are analyzed using pooled regression adjusted with cross sectional variation. Six variables consists of firm size tangibility of assets, profitability, growth, tax rate and earning volatility were tested as determinants of the leverage. The regression model is found to be significant and these six variables determine 89% of leverage .Only two variables- growth and size of firms were found significant and have positive relationship with leverage. So, capital structure of firms in F&PC industry mainly depends upon their sizes and growth opportunities.
According to the study done by Huynh, K. P. and Petrunia, J. P. (2009), they investigated the age effects, leverage and firm growth. This study was using a unique administrative data set to evaluate the impact of growth rates of new firms in Canadian manufacturing from a financial perspective. Financial components such as leverage and initial financial size also were included. As a result, leverage has little impact on age and size relationships with firm growth.
Based on the study done by Pratheepkanth, P., (2011), examined the capital structure and financial performance from selected business companies in Colombo stock exchange Sri Lanka. For purpose of this study, companies' financial performances were taking into consideration. The analyzed has been made on the capital structure and its impact on financial performance during the period of 2005-2009. The results have shown the negative relationship between the capital structure and financial performance. It showed the insignificant level of the business companies in Sri Lanka. Therefore, company mostly depend on the debt capital.
Iorpev, L., Kwanum, I. M., (2012) examined the capital structure and firm performance from manufacturing companies in Nigeria. Multiple regression analysis was applied on performance indicators such as Return on Asset (ROA) and Profit Margin (PM) and also for capital structure variables such as Short-term debt to Total assets (STDTA), Long term debt to Total assets (LTDTA) and Total debt to Equity (TDE). The results show that there is a negative and insignificant relationship between STDTA and LTDTA, and ROA and PM. TDE is positively related with ROA and negatively related with PM. STDTA is significant using ROA while LTDTA is significant using PM. This study concludes that capital structure is not a major determinant of firm performance. It recommends that managers of manufacturing companies should exercise caution while choosing the amount of debt to use in their capital structure as it affects their performance negatively.
Bhagat, S., Bolton, B., and Subramanian, A. (2011) investigated the manager characteristics and capital structure. Long-term debt declines with the manager's ability, inside equity stake, and the firm's long-term risk, but increases with its short-term risk. Short-term debt declines with the manager's ability, increases with her equity ownership, and declines with short-term risk.
Awan, T. N., et. al, (2011) analysis the determinants of capital structure in sugar and allied industry. In this study, a specific industry's capital structure exhibits unique attributes, which are usually not apparent in the combined analysis of many sectors as done by Shah & Hijazi (2005). The data were analyzed using pooled regression in a panel data analysis. It has four independent variables which are firm size tangibility of assets, profitability and growth. Effects on leverage were further analyzed. The results, except for firm size and growth were found highly significant.
Onaolapo and Kejola (2010) examined the impact of capital structure on firm's financial performance using a sample of thirty non-financial firms listed on the Nigerian Stock Exchange during seven-year period, 2001-2007. Panel data for the selected firms were generated and analyzed using Ordinary Least Squares (OLS) as a method of estimation. The results showed that a firm's capital structure surrogated by Debt Ratio had a significant negative impact on the firm's financial measures (Return on Asset and Return on Equity).
Anup Chowdhury and Suman Paul Chowdhury (2010) tested the influence of debt-equity structure on the value of shares given different sizes, industries and growth opportunities with the companies incorporated in Dhaka Stock Exchange (DSE) and Chittagong Stock Exchange (CSE) of Bangladesh. For the robustness of the analysis, samples were drawn from the four most dominant sectors of industry i.e. engineering, food & allied, fuel & power, and chemical & pharmaceutical to provide a comparative analysis. A strong positively correlated association was evident from the empirical findings when stratified by industry.
Debt policy and equity ownership structure "matter" and the way in which they matter differs between firms with many and firms with few positive net present value project (McConnel and Servaes, 1995). Leland and Pyle (1977) proposed that managers would take debt-equity ratio as a signal, by the fact that high leverage implied higher bankruptcy risk (and costs) for low quality firms. Since managers always have information advantage over the outsiders, the debt structure may be considered as a signal to the market. Ross's (1977) model suggested that the values of firms would rise with leverage, since increasing the market's perception of value.
However, Brigham and Gapenski (1996) argued that an optimal capital structure could be attained if a tax sheltering benefits provided an increase in debt level existed was equal to the bankruptcy costs. They suggested that managers of the firm should be able to identify when the optimal capital structure was attained and tried to maintain it at that level. This is the point at which the financing costs and the cost of capital (WACC) are minimized, thereby increasing firm value and performance. The agency theory initially put forward by Berle and Means (1932) also contributed to the capital structure decision. According to the theory, agency conflicts arose from the possible divergence of interests between shareholders (principals) and managers (agents) of firms.
The primary duty of managers is to manage the firm in such a way that it generates returns to shareholders thereby increasing the profit figures and cash flows (Elliot and Elliot, 2002). However, Jensen and Meckling (1976) and Jensen and Ruback (1983) argue that managers do not always run the firm to maximize returns to shareholders. As a result of this, managers may adopt non-profitable investments, even though the outcome is likely to be losses for shareholders. They tend to use the free cash flow available to fulfill their personal interest instead of investing in positive Net Present Value projects that would benefit the shareholders. Jensen (1986) argued that the agency cost was likely to exacerbate in the presence of free cash flow in the firm.
In order to mitigate this agency conflict, Pinegar and Wilbricht (1989) argued that capital structure could be used through increasing the debt level and without causing any radical increased in agency costs. This would force the managers to invest in profitable ventures that would be of benefit to the shareholders. If they decided to invest in non-profitable projects and they were unable to pay the interest due to debt holders, the debt holders could force the firm to liquidation and managers will lose their decision rights or possibly their employment.
The contribution of agency cost theory was that leverage firms are better for shareholders as debt level could be used for monitoring the managers (Boodhoo, 2009). Thus, higher leverage was expected to lower agency costs, reduce inefficiency and thereby lead to improvement in firm's performance (Jensen, 1986, 1988, Kochhar, 1996, Aghion, Dewatripont and Rey, 1999, Akintoye, 2008). Empirical supported for the relationship between capital structure and firm performance from the agency perspective were many and in support of negative relationship, Zeitun and Tian (2007), using 167 Jordanian companies over fifteen year period (1989-2003), found that a firm's capital structure had a significant negative impact on the firm's performance indicators, in both the accounting and market measures. Majumdar and Chhibber (1997) and Rao, M-Yahyaee and Syed (2007) also confirmed negative relationship between financial leverage and performance. Their results further suggested that liquidity, age and capital intensity had significant influences on financial performance.
Modigliani and Miller (1958), Hamada (1969), and Stiglitz (1974) supported capital structure irrelevant theory, where the financial leverage does not affect the firm's market value under perfect market condition. However, this theory has been criticized because it is inconsistent with the real world, where firms generally employ only moderate amounts of debt (Campello, 2006) and it has limited applicability to small firms only (Chaganti et. al, 1995). In the revision of their previous study, Modigliani and Miller (1963) stated that firms are able to maximize their value by employing more debt due to the tax shield benefits, which interest on debt is considered as tax allowable expenses. According to Miller (1977), the value of firms depends on the relative level of each tax rate. Myers and Majluf (1984) suggested that firms will initially rely on internally generated funds, no existence of information asymmetric, and profitable firms will generate high earnings and are expected to use less debt capital.
Gleason et. al, (2000), Agarwal et. al, (2001), and Hammes and Chen (2004) found that debt ratio is negatively related to ROA. However, size is positively related to performance. Philips and Sipahioglu (2004) also found that there is no significant relationship between debt level and financial performance, which indicated that borrowing, does not necessarily lead to higher performance as stated in asymmetric information theory, but could actually contribute to low performance as stated in agency theory. Study by Mesquita and Lara (2003) showed that long term debt has negative relationship with ROE, while short term debt has positive relationship, suggested that short term debt become a common practice among the most profitable companies, due the easiness of sourcing the fund from financial institutions. Hadlock and James (2002), and Abor (2005) concluded that profitable firms use more debt. In contrast, Carpentier (2006) found no significant relationship between the change in debt and change in value.
Rajan and Zingales (1995) suggested that the ratio of total debt to capital, which capital is equal to total debt plus equity, as the best accounting based proxy for leverage. Huang and Song (2005) found it is appropriate for increasing debts instead of stock issuance to prevent from decreasing of manager's share of ownership interest, since when the manager's increase stock is high, this inefficiency decreases. Stulz (1990) believed that debts payment decreases cash flows available for managers therefore decrease the opportunities of profitable investing. Thus, companies with less debt have more opportunities for investment and also have more liquidity. Meyers (1984), and Fama and French (2002) analyzed the "Pecking Order" theory, described a firm's debt position as the accumulated outcome of past investment and capital decisions, where the firm's financial structure is the outcome of past cash flows and investment opportunities.
Dimitrov and Jain (2003) argued that if manager have access to private information about becoming worse in future operational performance, they will increase debt, and since increasing the leverage is a negative sign, it demonstrates poor forward performance. Bradley et. al, (1984) demonstrated that the firms with less operational profits have less leverage. Titman and Wessels (1988), Harris and Raviv (1991), and Rajan and Zingales (1995) confirmed that increase of leverage will decrease profitability. Wald (1999) believed that there is a positive and significant link between profitability and debt-asset ratio. Cai and Zhang (2005) found that converse link between leverage changes and return on stock existed is stronger when there is high leverage. Rajan and Zingales (1995) stated that larger firms tend to have less asymmetric information problems should tend to have more equity than debt and thus have lower leverage. Moreover, larger firms are often more diversified and have more stable cash flows hence the probability of bankruptcy for large firms is smaller compared with smaller ones.
Demsetz (1973), and Berger and Bonaccorsi di Patti (2006) analyzed the effects of efficiency on capital structure using two competing hypotheses. As for efficiency-risk hypothesis, more efficient firms may choose higher debt to equity ratios because higher efficiency reduces the expected costs of bankruptcy and financial distress. In contrast, as for franchise-value hypothesis, more efficient firms may choose lower debt to equity ratios to protect the economic rents derived from higher efficiency from the possibility of liquidation.
Brander and Lewis (1986) and Maksimovic (1988) assumed that the firm's objective is to maximize the wealth of shareholders. Furthermore, market structure is shown to affect capital structure by influencing the competitive behavior and strategies of firms. According to Pandey (1999), the financial leverage employed by a company is intended to earn more on the fixed charges funds than their costs. The surplus (deficit) will increase (or decrease) the return on the owners' equity, referred to as a double-edged sword, where the financial leverage provides the potentials of increasing the shareholders' wealth as well as creating the risks of loss to them. Nimalathasan and Valeriu (2010) studied listed manufacturing companies in Sri Lanka about the impact of capital structure on profitability, and found that Debt Equity Ratio is positively and strongly associated to all profitability ratios, which are Gross Profit, Operating Profit and Net Profit Ratios.
2.2 Capital Structure Indicator
Short-term debt (STD)
Formula:
Short-term debt (STD) = Short-term debt
Total Capital
Long-term debt (LTD)
Formula:
Long-term debt (STD) = Long-term debt
Total Capital
Total debt (TD)
Formula:
Total debt (TD) = Total debt
Total Capital
2.3 Company performance Indicator
Return on Assets (ROA)
Return on assets (ROA) is a measurement used to reveal the profit of a company relative to its total assets. It is an implication on how effective the manager is using the company's total assets to make a profit. ROA ratio is calculated by comparing annual net income to average total assets. The higher the percentage of return, the more efficient the manager is utilising the company's total assets.
Formula:
Return on Assets (ROA) = Annual Net Income
Total Assets
Return on Equity (ROE)
Return on equity (ROE) is a measurement to indicate how effectively a manager of a company uses investors' money. ROE ratio is calculated by comparing its annual net income to its average shareholders' equity. The higher the ratio percentage, the more efficient the manager is utilising its equity base.
Formula:
Return on Equity (ROE) = Annual Net Income
Average Shareholders' Equity
Tobin's Q
Tobin's Q is the ratio of the total market value of a firm's assets (as measured by the market value of its outstanding stock and debt) to the replacement cost of the firm's assets. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets:
Tobin's Q = Total Market Value of Firm
Total Asset Value
