Dissertatio on Capital Structure And Profitability Relationship For Ftse Firms
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CHAPTER 1
The
capital structure of a firm has long been a much debated issue for academic
studies and in the corporate finance world. It is the way a firm finances its
assets through some combination of equity, debt, or hybrid securities - the
composition or 'structure' of its liabilities. In reality, capital structure
may be highly complex and include various sources. The question whether capital
structure affects to the profitability of the firm or it is affected by
profitability is crucial one. Profitability and capital structure relationship
is a two way relationship. On the one hand profitability of firm is an important
determinant of the capital structure, the other hand changes in capital
structure changes affect underlying profits and risk of the firm.
Traditionally
it was believed that the debt is useful up to certain limit and afterwards it
proves costly. There is an optimum level of capital structure exist up to that
level increasing debt will improve profitability, beyond that it will reduce
profitability.
In
1945, Chudson carried out an extensive study that implies the possibility of a
relationship between the capital structures practised by a firm with its
profitability. The question he endeavours to answer was that, “In what way does
the structure of assets and liabilities of a firm reflect the kind of industry
in it is engaged, its size and level of profitability?”
In
1958 Merton Miller and Franco Modigliani in their famous Miller-Modigliani (MM)
propositions put forward the net operating income approach of and demonstrated
that the capital structure is irrelevant in a perfect market. It states
irrelevant of capital structure in a perfect market to its value, hence, how a
firm is financed does not matter. The MM propositions forms the basis for
modern thinking on capital structure, though it is generally viewed as a purely
theoretical result since it is based on perfect market assumptions those are
not prevailing in practice.
The
matter of capital structure has gained much interest and controversy, since the
MM Propositions which assert that the value of a firm is independent of its
capital structure. The hypothesis proposed by MM created tidal waves in the
corporate finance academia. Different theory such as packing order theory and
agency cost theory were proposed. Various aspects of capital structure have
been put to test and researched by so many researchers.
The
question is if the capital structure is really irrelevant in a real market and
whether a company's profitability and hence value is affected by the capital
structure it employs? If not, why capital structure is relevant and which
factors make the leverage matter? Apart from profitability, some other factors
such as bankruptcy costs, agency costs, taxes, and information asymmetry are
considered in determination of capital structure. This study aims and attempts
to extend the knowledge of capital structure and profitability relationship in
listed UK companies. This analysis can then be extended to look at whether
there is in fact an optimal capital structure exist the one which maximizes
profitability and hence the value of the firm.
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1.1 Context and relevance of the Study
The
topic of capital structure has been widely explored, though the study is
relevant in the different time period and different context to find out whether
the evidence concerning the capital structure issue and its various aspects are
relevant to a given set of companies in a given period. Given this
significance, current study attempts to understand and research on capital
structure and its effect on profitability, of large firms in UK in the present
context for a period of five years (2005 -2010). Thus, this study attempts to
contribute to the research on capital structure in the recent period for large
publicly traded companies on FTSE 100.
1.2 Research Objectives
The
present study is aimed at achieving one main and two secondary objectives. The
main objective is to scrutinise the relationship between the capital structure
and profitability of the large publicly traded UK firms and to ascertain
whether a firm’s profitability is related with its capital structure or not
based on the empirical evidence generated. Secondly, this study would attempt
and investigate to determine if any optimal capital structure exist among the
sample of FTSE 100 listed companies. Third objective is to find out any trend
of capital structure being exhibited by the UK companies.
1.3 Research Questions and Hypothesis
The
above objectives are translated in two research question. The main research
question is that “whether a firm’s profitability is related with its capital
structure or not?” based on the empirical evidence generated.
Hypothesis
The
first questions can be presented as following hypothesis. The present study
shall be undertaken to evaluate this hypothesis based on the tests of the null
hypothesis.
H1: The profitability of a company is significantly correlated
to its capital structure.
H0: The profitability of a company is not significantly
correlated to its capital structure.
The
secondary objectives of this study are translated in the determinant question
regarding the optimality and trend of capital structure. The second question,
will be discussed descriptively is that, Is there an optimal capital structure
exists among or any trend of capital structure being exhibited by FTSE 100
listed companies?
1.4 Scope and Limitations of the Study
Scope
This
is an academic study that would shed some light on the matter of capital
structure which has been discussed in various different perspectives since the
M&M propositions. The significance of this study is that it further
enhances the research into capital structure of listed firms in UK.
Profitability and Capital structure relationship is an ongoing issue and its
relevance may change in different period because of the changes in macro and
micro economic factors. For practitioners and corporate finance people such as
finance executives, controllers and directors of listed firms, this study is
relevant and of much interest to get insight of the capital structure and
whether it has any effect on the profitability.
Limitations
The
findings of this study will be limited from the following aspects:
This
study included only FTSE 100 listed firms on the London Stock Exchange (LSE).
Hence, its findings were not applicable for all the listed companies in UK.
The
sample of listed companies for this study included only firms with at least
five years of financial data. Firms which are younger than five years or whose
five year data could not be obtained will not be included in this study.
The
study excludes financial utility and other highly regulated industry to avoid
any distortions in the result due to industry specific requirements.
The
cross sectional correlation and regression analysis will be performed using
excel formula.
CHAPTER 2
LITERATURE REVIEW
The
various capital structure theories are developed by corporate finance academia
for analysing how a firm could combine the securities to maximise its value.
The Modigliani and Miller (MM) proposition (1958) were introduced under the
perfect capital market assumptions. It refers to an ideal market where there
are no taxes at both corporate and personal level, no transaction costs, no
agency costs as and managers are rational. It further assumes that investors
and firms can borrow at the same rate without restrictions and all participants
have access to all relevant information. Thus it provides conditions under
which the capital structure of a firm is irrelevant to total firm value.
Most
of studies focus on the determination of capital structure i.e. to what extent
each of the assumptions in the MM model contributes to the determination of the
firm’s capital structure. Many theories such as the pecking order theory, the
trade-off theory and the agency cost theory have been developed.
Though
much attention was not given to one major aspect of the capital structure,
which is the impact of the value of the firm. The value comes from the future
cash flow i.e. profit of the firm. Thus capital structure affects value of the
firm through the profitability and hence there is a direct relationship between
the capital structure and profitability of the firm.
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Capital Structure
The
term capital structure can be defined as: “The mix of a firm’s permanent
long-term financing represented by debt, preferred stock, and common stock
equity.” (Van Horne & Wachowicz, 2000, p.470)
It
can be defined as “The mix of long-term sources of funds used by the firm. This
is also called the firm’s “capitalization”. The relative total (percentage) of
each type of fund is emphasized.” (Petty, Keown, Scott, and Martin, 2001,
p.932)
One
of the exhaustive and inclusive description was given by Masulis (1988, pl):
‘Capital structure encompasses a corporation’s publicly issued securities, private
placements, bank debt, trade debt, leasing contracts, tax liabilities, pension
liabilities, deferred compensation to management and employees, performance
guarantees, product warranties, and other contingent liabilities. This list
represents the major claims to a corporation’s assets. Increases or reductions
in any of these claims represent a form of capital structure change.”
However
in this study, for the sake of simplicity, the capital structure will be
analysed in term of debt and equity in line with other prominent capital
structure studies and theories restricted to the debt equity mix.
Profitability
The
term profitability is a very common term in the business world. It refers to an
all round measurement and indicator for a firm’s success. Profitability can be
defined as the ability of a firm to generate net income or profit on a
consistent basis. It is often measured by price to earnings ratio. The
accounting definition of profit can be given as the difference between the
total revenue and the total costs incurred in bringing to market the product
i.e. goods or service.
Hence,
profitability had come to mean different things for different people. It can be
defined and measured in several ways depending on the purpose. It is a generic
name for variables such as net income, return on total assets, earnings per
share, etc. though the simplest and common meaning of profitability is the net
income.
3.1 Early Study on Capital Structure by W A Chudson
One
of the earliest comprehensive researches into capital structure of business
firms was done by Chudson Walter Alexander (1945) on a cross section of
manufacturing, mining, trade, and construction companies in the US from the
year 1931 to 1937. Although it has been more than two third of a century, that
study is still relevant today as before due to the seven questions which he
endeavoured to answer. Out of those questions the relevant to this study are as
follows.
In
what way does the structure of assets and liabilities of a given concern
reflect the kind of industry in which a concern is engaged, the concern’s size
and level of profitability?
Are
there any elements in the corporate balance sheet, either on the asset or the
liability side, whose range of variation is so narrow that it is possible to
speak of a “normal” pattern of financial structure?
The
questions posed by Chudson could be interpreted into the research questions
pertinent to this study which are the relationship between profitability and
capital structure, the existence of an optimal capital structure, and also the
trend of capital structure being practised by a sample of firms.
Chudson’s
research showed there were undisputable relationships between corporate
financial structure and the firm’s profitability. As far as this study is
concerned, Chudson had successfully proved the relationship between the
profitability of a company with various capital structure variables including
debt and equity capital.
3.2 M & M Propositions
In
1958 Merton Miller and Franco Modigliani in their famous Miller-Modigliani
(M&M) propositions put forward the net operating income approach of and
demonstrated that the capital structure is irrelevant in a perfect market.
Accordingly, the first Proposition holds that the value of a firm is
independent of its capital structure. While the second proposition stats that
when first proposition held, the cost of equity capital was a linear increasing
function of the debt/equity ratio.
As
miller wrote subsequently these propositions implied that the weighted average
of these costs of capital to a firm would remain the same no matter what
combination of financing sources the firm actually chose. (Miller, 1988)
In
1962, Barges tested and evaluated the M&M propositions predominantly on the
validity of the hypothesis that the cost of capital to the firms is unaffected
by capital structure. According to Barges (p. 143): “With respect to the
empirical methods employed by M&M it was found that, under very frequently
encountered conditions, their methods will result in tests which are biased in
favour of their propositions and biased against the traditional views.”
Barges
had empirically proved the existence of some weaknesses in the research design
and methodology of Modigliani and Miller’s study and concluded that (p. 147)
“Thus, on the basis of the evidence presented herein, the hypothesis of
independence between average costs and capital structure appears untenable.”
Subsequently
many studies were conducted with focus on the determination of capital
structure and many theories were presented.
3.3 Profitability and Leverage theories
Since
MM propositions presented, many studies were conducted by releasing MM
assumptions focusing on the extent to which each of the assumptions contributes
to the determination of the firm’s capital structure. All these theories
explains the relationship between leverage and the value of the firm and hence
profitability of the firm. There are various theories in order to further
explain this relationship. Nevertheless, these theories are actually based on
asymmetric information (Myers, 1984), tax deductibility (Modigliani and Miller,
1963; Miller 1977), Bankruptcy costs (Stiglitz, 1972; Titman, 1984) and agency
costs (Jensen and Meckling, 1976; Myers, 1977). Two main theories are the
pecking order theory and the trade off theory.
Pecking Order Theory
The
Pecking Order Theory is based on information asymmetry between management and
investors. So, the stock price of a firm may not reflect correct value of the
firm. Myers and Majluf (1984) and Myers (1984) suggest that management issue
the security which is overvalued and therefore, undervalued firms tend to avoid
issuing equity. They argue that in imperfect capital markets, leverage
increases with the extent of information asymmetry.
They
provided theoretical support to Donaldson’s (1961) findings that firms prefer
to use internally generated funds as a financing source and resort to externals
funds only if the need for funds was unavoidable. According to (Myers 1995),
the dividend policy is “sticky” and the firms prefer internal to external
financing. Firms prefer using internal sources of financing first, then debt
and finally external equity obtained by stock issues.
Therefore,
asymmetric information models seldom point towards a well-defined target debt
ratio or optimal capital structure. All things being equal, the more profitable
the firms are, the more internal financing they will have, and therefore we
should expect a negative relationship between leverage and profitability.
The
various studies such as Ross (1977), and Myers and Majluf (1984), Harris and
Raviv, 1991; Rajan and Zingales, 1995; Booth et al., 2001have supported this
relationship that is one of the most systematic findings in the empirical
literature.
Agency Costs Theory
The
Agency Costs Theory (Organizational Theory of Capital Structure) emphasize that
capital structure was influenced by conflicts between shareholders and
managers, and between debt holders and equity holders. Major study into this
area was done by Jensen and Meckling (1976) that showed managers’ natural
tendency to extract too many perquisites and stresses on self-interested
behaviour. Obviously, agency costs would increase as the managers’ personal
ownership stake in the firm decreases. This supplied an argument for debt
financing and against ‘public’ equity which was contributed by non management
investors who cannot monitor management effectively. Fama and Miller (1972),
using agency cost theory, proved that leverage was positively associated with
firm value. Firms with longer credit histories would have lower cost of debt.
The Trade of theory
The
trade-off theory is based on the considerations of benefits and the costs of
debt. This theory argues that firms optimise their capital structure by trading
the tax deductibility of interests, bankruptcy costs, and agency costs. This
theory is consistent with traditional approach of capital structure. This
theory leads to an opposite conclusion. Accordingly if the firms are
profitable, they should prefer debt to benefit from the tax shield. Further as
the past profitability is a good proxy for future profitability, profitable
firms can borrow more because the likelihood of paying back the loans is
greater. However after a certain level of leverage, the profitability and the
value of the firm will reduce due to interaction of bankruptcy costs and agency
costs.
3.4 Various Studies on Capital Structure
As
the issue of capital structure gained prominence and interest, a number of
studies had been done over the years to explore the relationship between
capital structure and a firm’s various characteristics e.g. growth
opportunities, non-debt tax shields, firm’s volatility, asset systematic risk,
asset unique risk, internal funds availability, asset structure, profitability,
industry classification, and firm size. This study is concerned particularly on
the relationship between capital structure and profitability.
Most
of the studies had concluded that capital structure measured by debt/equity
ratio had an inverse relationship with profitability measured by Return on
Investment (ROI). Professor Myers of MIT had written in 1995 that “the strong
negative correlation between profitability and financial leverage” is one of
the ‘most striking facts about corporate financing” (p.303). It is worthy to
mention here that the aforesaid studies were the most comprehensive ever
carried out in the US.
One
significant research was conducted by Bradley, Jarrell and Rim (1984) using
Ordinary Least Squares method to analyze the capital structure of 851
industrial firms over a period of 20 years (1962-81). They concluded that an
optimal capital structure actually existed as proposed by finance theorists.
Bradley,
Jarrell and Kim’s findings were supported by El-Khouri in 1989 who studied a
sample of 1,040 Companies in US from 27 different industries covering a period
of 19 years (1968-86). El-Khouri’s major findings were that there exists an
optimal capital structure, and profitability was significantly but negatively
related to capital structure.
3.5 Rajan and Zingales’ Study
Rajan
and Zingales (1995), in their study of determinant of capital structure find
that profitability is negatively or inversely related to gearing consistent
with Toy et al. (1974), Kester (1986) and Titman and Wessles (1988). Given,
however, that the analysis is effectively performed as an estimation of a
reduced form, such a result masks the underlying demand and supply interaction
which is likely to be taking place. More profitable firm will obviously need
less borrowings, although on the supply-side such profitable firms would have
better access to debt, and hence the demand for debt may be negatively related
to profits.
Most
of such studies were conducted in US using local companies and hence represents
financing and profitability relationship in US economy and might not be
applicable in other countries around the globe. Some of the studies conducted
in UK as well though changing business and economic environment and time period
may have their impact on such capital structure and profitability relationship.
Further as discussed earlier much attention was not given to one major aspect
of the capital structure, which is the impact on the profitability and hence
the value of the firm. So understanding the effect of capital structure on the
profitability and hence the value of the firm in the current economic and
business environment is the main motivation for this study.
CHAPTER 3
RESERCH FRAMEWORK
I
intend to use two major sets of variables (Ratios) i.e. Debt and Profitability
to ascertain the relationship between the capital structure and profitability.
The first set includes Gearing ratios Debt/Equity Ratio and Debt Ratio. The
other set includes profitability ratios Return on Equity, and Return on Assets.
The variables will be analyzed using the descriptive/time-series Correlation
and regression technique.
2.1 Data Sample
The
data used for the empirical analysis will be derived from Hemscott database
contains balance sheet, profit and loss and certain Key Ratio information for
FTSE 100 companies in UK. For the purposes of this dissertation, I expect to
utilise this data to obtain the required variables for all non-financial
companies.
2.2 The Model and Research Methodology
The
following model outlines the framework for research. It consist two major
components i.e. the profitability of a firm as the dependent variables and the
capital structure of a firm as the independent variables. The arrow pointing to
the right indicated the expected direction of causality. However profitability
and capital structure relationship is a two way relationship.
DEBT
RATIO ROE
DEBT/EQUITYRATIO
The
model gave the foundation for analysis which was to explain the relationship
among the two main groups of variables. In as much as possible, variables will
be selected on the basis of the literature being reviewed. Thus, while this
study is expected to give exciting results, there will be direct ties to
earlier studies although may reflect the changing requirements of the time.
One
prominent issue here is the direction of the causality in the model. This
research is based on the notion that the capital structure being practised by a
firm would affect its profitability. This particular cause-and-effect
relationship had been proved in various studies as found in the literature
being reviewed. Though it should be kept in mind that there were a number of
researchers who had argued that it was profitability which would influence the
capital structure (Chudson 1945, Lamothe 1982, Bowen, Daley and Huber 1982).
However, it is not within the scope of this study to determine the direction of
causality in this particular relationship but rather to focus on the
significance of such a relationship.
2.3 Variables
In
the first instance, great care was taken to define the dependent and
independent variables to be used in the descriptive, co variance and regression
analysis. As there are several alternative measures of profitability and
gearing, only relevant measures are chosen for this cross-sectional analysis.
Dependent Variable
Profitability
is dependent variable in this analysis and two measures of profitability
employed in this analysis are Return on Equity (ROE) and Return on Assets
(ROA).
ROE
is the return on equity and is measured as earnings before tax (EBT) divided by
owners’ capital or equity.
ROE
= EBT/EQUITY
ROA
is return on assets and is measured as earnings before interest and tax divided
by total assets (Titman and Wessels, 1998; Fama and French, 2002 and Flannery
and Rangan, 2006). The ratio of earnings before interest and tax (EBIT), to the
book value of total assets (TA)
ROA
= EBITDA/TA
Independent Variables
Gearing
Ratio represents capital structure. Therefore, in order to examine the
sensitivity or otherwise of their cross-sectional results to the profitability
following two ratios are used in this analysis and defined as:
Debt
to Total Assets: This is a simple ratio of total debt to total assets
DEBT
RATIO= TD/ TA
Debt
to Equity Capital: This is the ratio of total debt to capital, with the capital
calculated as total debt plus equity, including preference shares.
DEBT/EQUITY
RATIO = TD / (TD + ECR + PS)
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