Capital is a fundamental element throughout the life cycle of
any firm. The manner, in which a firm structures its capital can either
positively or adversely influence its overall financial performance and
profitability. This paper seeks to establish
the relationship between capital structure and the financial performance and profitability
of firms. This essay will also attempt to answer two main questions; does it
matter if finance comes from stocks or debt? and What determines choice between
stocks and debt? (These questions were taken from the lecture slides).
Financing options involve how a firm utilizes different
sources of finance to maximize shareholders’ wealth with minimum risks as well
as improve its competitiveness. Debt and equity financing are the two primary
sources of capital. By issuing debt instruments, a firm is able to obtain funding
to finance its operations. The purchasers of these instruments are in return,
promised a stream of payment as well as a variety of other covenants relating
to the firm’s behavior. Through the covenant, the purchaser has the right to
repossess collateral presented by the issuer or force the issuer into
bankruptcy in situations where the issuer fails to fulfill its obligation by
not making scheduled payments. However, debt financing allows shareholders to
retain ownership and also tax advantages since the interest is tax deductible.
On the other hand, through the sale of a firm’s shares or
ownership interest, the firm avoids the obligation of making regular payments
and the risk of being forced into bankruptcy. On the downside, this option
results in the dilution of firm’s ownership. With regards to the option of equity
as opposed to debt, this decision is ultimately influenced by the type of firm
in question. It is worth noting that these sources of financing are not strict substitutes
for each other firms adopt both but try to find the right balance for each.
The concept of capital structure as described by Besley and
Brigham 1 is a blend
of long-term debt, preference shares and net worth used as a means of permanent
financing by any firm. Van Horne and Wachowicz 2 also described capital
structure as a method of long term financing which is a mixture of long-term
debt, preference shares and equity. The concept of capital structure can be
said to be a mixture of debt and equity by a firm to finance its operation and
An optimal capital structure is realized where there is the
right balance of debt and equity financing; that maximizes a firm’s return on
capital thereby minimizing cost of borrowing and maximizing profit. A wrong mix
of debt and equity may adversely affect the profitability and long term
survival of the firm, hence internal and external stakeholders devote a lot of
attention to it.
Many studies by scholars have been conducted to inspect and
find evidence for the relationship between capital structure and the
performance of a firm. Among these is Modigliani and Miller 3 (M), according
to them, in a world without taxes, bankruptcy costs, agency cost and under perfectly
competitive market conditions, the value of a firm is free from the influence
of how that firm is financed but rather the value of a firm depends solely on
its power of earnings. The reason for the irrelevance of capital structure is
that, where there are no taxes, there will be no tax advantage for interest
paid on debt. This will provide no incentive for a firm to opt specifically for
debt financing; making them indifferent as to the choice of financing. Shortly
after making this hypothesis, Modigliani and Miller 4 restated that if we
move to a world where there are taxes with all other things being equal, due to
tax advantage of debt, the firm’s value can be increased by incorporating more
debt into capital structure. Based on this hypothesis, one could say that
optimal capital structure is one that has 100% of debt.
However, there are debates on the fact that the assumptions
made by Modigliani and Miller 3 are unrealistic and unpractical in the real
world. In light of this, other researchers have come up with several theories
to explain the relationship between a firm’s capital structure and its profitability.
Peking order theory by Myers 5 believes that due to information asymmetry
between firms and investors there is no optimal capital structure rather firms
have particular preference of financing. Information asymmetry is the situation
in which management have more knowledge and information about the value of a firm
than investors since they work in the firm. Firms prefer to use internal sources
of funding i.e. retained earnings as opposed to external financing; which is
only employed when the internal funds have been fully utilized. Debt, as an
external source of financing, is preferred over equity in such cases according
to Muritala 6. Based on this theory, profitable firms will use less debt
since they will have enough funds internally from retained earnings. However,
this analogy is also affected by the dividend policy and the fact that firms
want to signal market of their good performance. If firms have a dividend
policy that makes pay out more dividend, even though they are profitable they
might end up using more debt.
According to Jensen and Meckling 7 who developed agency
theory, debt and equity should be mixed in a proportion that minimizes total
agency cost. Agency cost can be divided into agency cost of debt and agency
cost of equity. Agency cost equity arises from the fact the goals of managers
may differ from maximizing shareholder’s fund so in order to keep managers in
check shareholders engage monitoring and control activities which comes at a
cost. Debtholders in order to prevent management from favoring shareholders at
their expense also give rise to agency cost. Actions of management that may
favor investors at the expense of shareholders could include engaging in risky
investments and projects, which yield high returns for which shareholders turn
to enjoy majority of the gains when the investment succeeds but debtholders
suffer the consequences of the failure of such investments.
As a result of the
debates with respect to the assumptions by Modigliani and Miller 3, static
trade-off theory was developed.
According to this theory, by including tax in Modigliani and Miller’s
3 argument, earnings can be protected by taking advantage of tax benefits
from interest payments. Firms therefore seek to achieve optimal capital
structure by taking into consideration the pros and cons of debt financing. Citing from (Myers, 2002, P.88) firms will
use debt until the marginal gain of tax advantage on additional debt is
nullified by the increase in the present value of realizable costs of financial
discomfort. Brigham and Houston 8 assert that optimal
capital structure of a firm is determined by the trade-off between the tax
advantage from employing debt and the cost of debt such as agency cost,
bankruptcy cost and as a result the firms’ value is maximized and cost of
capital is minimized. The graphs below explains tax shields and cost of
financial discomfort from the use of debt influence capital structure.
In the first graph, it could be seen that weighted average
cost of capital (WACC) decreases as a result of tax shield until it reaches its
minimum and then begins to increase due to the cost of excessive debt. While in
the second graph, as debt increases, the market value of the firm also
increases until it reaches its maximum and then it begins to decline as debt
continues to increase, due to the cost of financial discomfort. Firms need to
find the tradeoff point between tax shield and the cost of financial discomfort
where cost of capital is at its minimum and the value of the firm is at its
maximum. At this point debt is at its optimal level.
Variables of Study
As a measure of a firm’s performance almost all authors used
the profitability ratios ROA, ROE, and EPS (dependent variable) and leverage
ratios STDTA, LTDTA, DC, TDTA as capital structure indicators (independent
Return on Asset (ROA) is shows how efficient a firm is at
using its assets to generate income. It is calculated as net income before
taxes divided by average total assets. Return on equity (ROE) reveals how much
profit a firm generates with the fund shareholders invested thus how well a
firm generates earnings growth using investments. It is derived by net profit
divided by average shareholder equity. Earnings per share (EPS) which is
computed by dividing net profit minus preference share dividend by number of
outstanding shares helps measure the amount of net income earned per firm’s
Leverage ratio helps measure the financial risk of a firm. It
helps determine the firm’s ability to meet its obligations. Short term debt to
total asset (STDTA) is short term debt divided by total assets of the firm.
Long term debt to total asset (LTDTA) is computed by dividing long term debt by
total assets of the firm. Debt to capital (DC) ratio is total debt (short term
and long term) divided by total capital (includes firm’s debt and shareholders’
equity). Total debt to total asset ratio (TDTA) is total debt divided by total
assets. The higher the ratios, implies high level of leverage hence high level
of financial risk.
The dependent variable is an important variable since the
financial risk faced by a firm is strongly affected by its profitability. The
likelihood of failure and bankruptcy of a firm is lower when profits are high.
Also high profit increases the ability of a firm to borrow thereby increasing
the use of tax savings. From another angle, high profit implies firms will be
able to finance itself through retained earnings hence a decrease in the
reliance on external funding. As a result of the fact that firms with high
profit have greater capacity to borrow hence increasing the use of tax savings,
there is a positive relationship between profitability and leverage ratio in a
capital structure of a firm based on Trade off theory. However, based on Peking
theory there is an inverse relationship between profitability and leverage
ratio in its capital structure since high profits implies companies will resort
to using internal financing rather than external financing.
In order to examine the relationship between capital structure
and profitability, all the research papers referenced later utilized the
multiple regression, ordinary least squares estimator model. The only difference
among the models is the some of the models included firm specific variables
such as liquidity (LQ), firm size (SZ), growth opportunities of the firm (GOP)
and some macro-economic variables such as inflation (INF) and economic growth
(GDP)). These additional variables are to serve as control variables, which seek
to single out the impact of capital structure on a firm’s performance. The
performance of a firm is usually influenced by its size. Large firms turn to
have greater capacity and capabilities. By including firm specific variables in
the model, differences in the operating environment of the firm is controlled
for. Also the inclusion of macroeconomic variable controls for the effect of
macroeconomic state of affairs. The ability of a firm to meets its short-term
liabilities when they become due is inversely related to profitability since
liquid assets yield low returns; hence low profits. The effect of inflation on a
firm’s profitability has no definite conclusion. In the short run, if there is
a demand pull inflation with rising economic growth as a result of increase in
demand, prices of goods and services will increase hence leading to increase in
profits of firms. However, if there is a cost-push inflation with competitive
markets and high demand, firms will be forced to absorb the increasing; thereby
reducing profits. In the long term, low inflationary economy induces higher
investments and growing demand thereby increasing profitability 16.
Trujillo-Ponce 17 confirmed that inflation and ROA of banks are positively
related while Sufian and Habibullah 18 observed an inverse relation. Economic
growth goes hand in with profitability since in times of recession, firms are
unable to perform well and make profits while the inverse is true in economic
Below is the regression model;
= ? + + + + + + + + + + ?
= ? + + + + + ?
= firm’s performance
in terms of profitability ratios
, , , and = regression
coefficient for the independent variable
, , and= regression coefficient for the bank specific variables
and = regression
coefficient for the macroeconomic variables.
According to the study by Ramadan and Ramadan 9, there was
statistically significant inverse effect of capital structure, expressed by
long-term debt to capital ratio, total debt to capital ratio and total debt to
total assets ratio, on the performance of the Jordanian industrial companies
listed at ASE expressed by Return on asset ratio (ROA). Their research was
based on 72 industrial companies in Jordan that were listed on Amman Stock
Exchange and the time frame of their data was from 2005 to 2013.
Nassar’s 10 study aimed to investigate the impact of
capital structure on industrial companies listed under UXSIN index on the
Istanbul Stock Exchange (ISE). Data on 136 out 290 firms over the period,
2005-2012 was used. In this study, a firm’s performance was defined by EPS,
ROA, and ROE while capital structure was defined by total debt to total asset
ratio. The study concluded that there is a statistically significant negative
relationship between capital structure and profitability since using high level
of debt affects a firm’s ROA, EPS, and ROE negatively.
Using data of 22 banks over the period; 2005-2014, the study
by Siddik, Kabiraj and Joghee 11 on impacts of capital structure on
performance of banks in a developing economy, using evidence from Bangladesh,
observed that empirically there are significant negative effects of capital
structure choice on Bangladeshi banks’ performance. In their pooled ordinary
least square regression model, banks’ performance was defined by ROA, ROE, and
EPS, while capital structure was defined by STDTA, LTDTA and TDTA. They also
included firm specific variables and macroeconomic variables mentioned earlier
for which they observed that growth opportunities, size, and inflation have
positive relationship while GDP and liquidity have negative relationship with
performance of banks in developing economy, viz., Bangladesh.
Contrary to the empirical results of negative impacts, many
studies have also observed positive impacts. In attempt to analyze the impact
of capital structure on banks’ performance in the Tehran Stock Exchange using
data over the time period 2008-2012, S.F. Nikoo study results showed that there
is a significant positive relationship between capital structure expressed by
debt to equity ratio and bank’s performance expressed by ROE, ROA, and EPS
In the study by Abor 13 where the author investigated the
effect of capital structure on the profitability of listed firms on the Ghana
Stock Exchange during a five year period, it was evident that STDTA and TDTA
had a positive relationship with ROE; while LTDTA has a negative relationship. In
his study, ROE was the only measure of a firm’s performance. The study suggests
that profitable firms have debt as their main source of finance.
While it is evident in some studies that there is a
relationship either positive or negative between capital structure and the performance
of a firm, there are also other studies that points to the fact that there is
no relationship at all. Al-Taani in his study to identify the association of
capital structure with profitability using data from 2005-2009 on Jordanian
listed companies concluded that STDTA,LTDTA and TDTA which are capital
structure indicators do not have any significant relationship or effect on ROA
and profit margin which are indicators of firms’ performance 14.
Based on data over the period; 1997-2005 on non-financial
Egyptian listed firms with the aim of investigating the effect of capital
structure choice on the performance of firms in Egypt, the research conclusion
of Ibrahim El?Sayed Ebaid was: there is weak-to-no impact of capital structure
choice on a firm’s performance 15.
Comments on the
The negative relationship results from these studies
mentioned above support the Peking order theory, which states that highly
profitable firms are less dependent on external source of finance and thus
there is an inverse relationship between profitability and borrowing hence
capital structure. While the positive relationship results from these studies
support the trade-off theory. Varying results from the various papers shows
that there is no conclusive or particular impact of capital structure on firm’s
performance. Other factors such as business risk, tax laws and asset structure
of the firm can affect how capital structure impact profitability.
Equity over Debt?
In order to achieve optimal structure which leads to
profitability, analyzing whether the firm is over or under levered or has the
right mix is important. For over-levered firms with the threat of bankruptcy,
adopting equity for debt swaps will reduce. While without the threat of bankruptcy,
a reduction of debt can be based on whether the firm has good projects i.e. ROE
and ROC is greater than cost of equity and cost of capital respectively. In
cases where they are greater, the projects are financed through retained
earnings or new equity whereas in the cases where they are not greater debts
are paid off using retained earnings or issuance of new equity. For such firms
more equity is preferred to debt.
For under-levered firms; which are takeover targets, leverage
is increased through debt for equity swaps or borrowing money to buy shares. In
the case where the firm is not a takeover target, and the firm has good
projects i.e. ROC greater is than cost of capital, the projects are financed
using debt otherwise dividends are paid to shareholders or the firm buys back
stocks. For these firms more debt is preferable to equity.
This essay provides evidence from various researches that
analyze the impact of capital structure on profitability of a firm. Although
there is no clear cut conclusion as to whether it is a positive or negative
relationship it is evident from the various studies mentioned earlier that debt
financing does not always lead to improved firms’ performance. Before employing
debt finance firms should to large extent exhaust shareholders’ funds the risks
associated with debt financing e.g. interest on debt exceeding the return on
assets financed by the debt will be minimized. In situations where firms have exhausted
equity financing and needs to finance the expansion of its operation, reference
should be made to the firm’s asset structure to ensure that assets financed
using debt financing earn higher returns than the interest to be paid on the
debt. This capital structure choice would have a positive impact on
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structure on Financial Performance of the firms: Evidence From Borsa Istanbul.
11. Siddik, M.N.A.; Kabiraj, S.; Joghee,
S. (2017) Impacts of Capital Structure on Performance of Banks in a Developing
Economy: Evidence from Bangladesh
12. Nikoo, S.F. (2015) Impact of Capital
Structure on Banking Performance: Evidence from Tehran Stock Exchange.
13. Abor, J. (2005) The effect of capital
structure on profitability: an empirical analysis of listed firms in Ghana.
14. AL-Taani, K. (2013) The relationship
between capital Structure and firm’s performance.
15. Ebaid, I. E. (2009) The impact of
capital-structure choice on firm performance: empirical evidence from Egypt.
17. Trujillo-Ponce, A. (2013) What
determines the profitability of banks? Evidence from Spain.
18. Sufian, F.; Habibullah, M.S. (2009)
Determinants of bank profitability in a developing economy: empirical evidence