One of the most important decisions that firms make is the capital structure decision. In general a firm may choose among various alternative capital structures. But the question which often arises is how much debt and how much equity to use? To this question, Brealy and Myers (2003) think that the choice of capital structure is basically a marketing problem i.e. a firm can issue different kinds of securities in any combination it wishes, but attempts to find the combination which will maximize firm value. To maximize firm value hence shareholder`s wealth, firms should be able to derive an optimal financing mix. While some academics do not believe in the existence of an optimal financing mix, managers who demonstrate the ability to identify and seek ways to arrange for the most appropriate combination of debt and equity are rewarded at the market place as such combination minimizes a firm`s cost of financing other things being equal. This makes it a source of competitive advantage as well for businesses.
The work by Modigliani and Miller (1958 and 1963) provided the cornerstones for modern thinking on capital structure and corporate finance. Much controversy has resulted from comparisons of the theory of capital structure originally developed by Modigliani and Miller to real-world situations. Several research have been conducted on capital structure since and the main theories that emerged are pecking order (Myers and Majluf, 1984), trade- off and agency costs (Jensen and Meckling, 1976) with each theory having its own conclusion on the relationship between debt level and profitability. A lack of agreement on the nature of the relationship between leverage and equity between the different capital structure theories necessitated this research. This paper partly seeks to determine what capital structure theory or theories seem to be more credible when applied to the Mauritian context. This would be determined through the results obtained in this study.
Kinsman and Newman (1999) give the following reasons as to why study the relationship between capital structure decisions and firm performance. Firstly, they argue that mean debt levels have increased to a great extent. Thus there is a need to understand the impact debt has over performance. Secondly, since managers and investors have divergences in opinions, the relative strengths of any specific effects of debt on firm`s performance should be known. Lastly and most importantly to examine the relationships between debt level and shareholder wealth as managers seek to maximize shareholder wealth.
The interplay between debt level and equity and corporate performance has been subject to many studies, many of which were conducted in USA and Europe. However, few studies were conducted in developing countries. The study of capital structure and its relationship with corporate performance becomes more important in a developing state as the business environment which prevails in such countries tend to differ greatly from their developed counter-parts. To this matter, Eldomiaty (2007) gives reasons as why to study capital structure in an emerging market by clearly explaining the features that distinguish such countries with their developed counterparts. These are
(1) Developing countries have capital and stock markets that are less efficient as well as incomplete as compared to developed ones. This causes financing decisions to be incomplete and irregular. Firms operating in emerging economies may not be able to justify their financing decisions by adhering to a specific theoretical approach. This makes it vital to go through a deep investigation of whether capital structure decisions have any effect over profitability and these results should be compared with those achieved in developed markets.
(2) Given that information asymmetry tends to be higher in developing economies, this makes those markets not readily markets for companies’ quest to raise finance and leads to non optimal financing decisions in terms of the assumptions advanced by capital structure theories.
(3) There is already an established rich literature on the relationship between capital structure and profitability in developed markets which have different institutional financing arrangements different from those in emerging ones. There is therefore a need for an in depth examination of the impact capital structure has over corporate performance in an emerging market.
The main objective of this paper is to examine the relationship between capital structure and profitability during the five-year period from 2007-2011. Regression analysis is used for this purpose. Given that Mauritius is deemed to be one of the best stock market performers in the African continent although being still small and young, it is decided that the study will be conducted on those firms which are listed on the Stock Exchange of Mauritius (SEM). This will enable a thorough understanding on the patterns of financing of such firms considered to be operating in one of the best stock market in entire Africa and the effect it has, if any, on their profitability. Furthermore Mauritius being a developing economy is more specifically a Small Island Developing State (SIDS). This means that the gap in financial and institutional arrangements might be even wider as compared to developed economies. The present study hence extends the literature made on those few developing economies and attempts to fill in the void in literature when it comes to SIDS by investigating the relationship between capital structure and profitability of Mauritian listed companies.
The rest of this paper is organized as follows. The following section gives a summary review of the literature related to the subject. The next section describes the research methodology used and involves describing the data and justification of the variables used as well as illustration and discussion of the results obtained from the analysis. The last section summarizes the results of empirical findings, provides a conclusion based on those findings and gives directions for further research.
