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.
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.
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
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.
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.
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.
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.
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.
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
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.
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.
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
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)
PS - the book value of preference shares.
Research Plan and Implementation Schedule
Research work starts from week beginning from October 4, 2010 and is expected to complete in 10 weeks time. The work is scheduled as follows.
Week Star Date : 04-10-2010
Background reading and literature review
Research design and plan
Choice of methodology
Data analysis and refine
Writing up draft
Editing final document
Produce final document
Document passed to supervisor to read
I intend to use following resources
Hemscott database for data collection.
MS Excel for analysing data.
University of Wales online library, internet, and some books on finance.