MS604 Term Paper

8/8/2019 MS604 Term Paper

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TABLE OF CONTENTS

TABLE OF CONTENTS......................................................................................................................... 1

CHAPTER ONE...................................................................................................................................... 31. INTRODUCTION ....................................................................................................................... 3

1.1. General Information ............................................................................................................. 3

1.2. Background to the Study....................................................................................................... 4

1.3. Statement of the Research Problem ....................................................................................... 4

1.4. Research Objective ............................................................................................................... 5

1.4.1. Specific Objective......................................................................................................... 5

1.4.2. Research Questions ....................................................................................................... 6

1.5. Significance of the Study ...................................................................................................... 6

1.6. Scope of the Study ................................................................................................................ 6

1.7. Definition of Terms .............................................................................................................. 6

CHAPTER TWO..................................................................................................................................... 8

2. LITERATURE REVIEW ............................................................................................................. 8

2.1. Theoretical Framework......................................................................................................... 8

2.1.1. Capital Structure Irrelevance Theory ............................................................................. 8

2.1.2. Trade off Theory........................................................................................................... 92.1.3. The Asymmetry of Information Theory....................................................................... 10

2.1.4. The Pecking Order Theory .......................................................................................... 10

2.2. Empirical framework.......................................................................................................... 11

2.3. Conceptual Framework....................................................................................................... 13

2.4. Hypotheses ......................................................................................................................... 13

CHAPTER THREE ............................................................................................................................... 14

3. RESEARCH METHODOLOGY................................................................................................ 14

3.1. Research Paradigm ............................................................................................................. 14

3.2. Population .......................................................................................................................... 14

3.3. Sample Size and Sampling Frame ....................................................................................... 14

3.4. Data Collection Tools ......................................................................................................... 14

3.5. Operationalization of Concepts ........................................................................................... 15


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3.5.1. Profitability Dependent Variable .............................................................................. 15

3.5.2. Financial Leverage Independent Variable ................................................................. 15

3.5.3. Control variable. ......................................................................................................... 15

3.6. Data Analysis ..................................................................................................................... 16

REFERENCES ...................................................................................................................................... 17


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CHAPTER ONE

1. INTRODUCTION

1.1.GeneralInformation

The capital structure decision is crucial for any business organization. The decision is important

because of the need to maximize returns to various organizational constituencies, and also

because of the impact such a decision has on a firms ability to deal with its competitive

environment. The capital structure of a firm is actually a mix of different securities issued by afirm. In general, a firm can choose among many alternative capital structures. It can issue a large

amount of debt or very little debt. It can arrange lease financing, use warrants, issue convertible

bonds, sign forward contracts or trade bond swaps. It can issue dozens of distinct securities in

countless combinations; however, it attempts to find the particular combination that maximizes

its overall market value. A number of theories have been advanced in explaining the capital

structure of firms. Despite the theoretical appeal of capital structure, researchers in financial

management have not found the optimal capital structure. The best that academics and

practitioners have been able to achieve are prescriptions that satisfy short-term goals. For

example, the lack of a consensus about what would qualify as optimal capital structure has

necessitated the need for this research. A better understanding of the issues at hand requires a

look at the concept of capital structure and its effect on firm profitability. This study will

examine the relationship between capital structure and profitability of companies listed on the

Dar es Salaam Stock Exchange during the period 2005-2009. The effect of capital structure on

the profitability of listed firms in Tanzania is a scientific area that has not yet been explored in

Tanzania finance literature.


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1.2.Backgroundtothe Study

The theory of capital structure and its relationship with a firms value and performance has been

a puzzling issue in corporate finance and accounting literature since the seminal work of(Modigliani & Miller, 1963) (MM-1958). MM-1958 argue that under very restrictive

assumptions of perfect capital markets, investors homogenous expectations, tax-free economy,

and no transactions costs, capital structure is irrelevant in determining firm value. According to

this proposition, a firms value is determined by its real assets, not by the mix of securities it

issues. If this proposition does not hold then arbitrage mechanisms will take place, investor will

buy the shares of the undervalued firm and sell the shares of the overvalued firm in such a way

that identical income streams are obtained. As investors exploit these arbitrage opportunities, the

price of overvalued shares will fall and that of the undervalued shares will rise, until both prices

are equal. However, these restrictive assumptions do not hold in the real world, which led many

researchers to introduce additional rationalization for this proposition and its underling

assumptions showing that capital structure affects firms value and performance, especially after

the seminal paper of Jensen and Meckling (1976) which demonstrate that the amount of leverage

in a firms capital structure affects the agency conflicts between managers and shareholders by

constraining or encouraging managers to act more in the interest of shareholders and, thus, can

alter managers behaviors and operating decisions, which means that the amount of leverage in

capital structure affects firm performance.

1.3.Statementofthe Research Problem

Since, Jensen and Meckling (1976) argument regarding the possibility of capital structure

influence on firm performance, several researchers have followed this extension and conducted

numerous studies that aim to examine the relationship between financial leverage and firm

performance over the last decades. However, empirical evidence regarding this relationship is

contradictory and mixed. While a positive relationship between leverage level and firm


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performance had been documented in some of these studies (Taub, 1975; Roden and Lewellen,

1995; Champion, 1999; Hadlock and James, 2002). Other studies document a

negative relationship between leverage level and firm performance (Fama and French, 1998;

Gleason et al., 2000; Simerly and Li, 2000).

While the literature examining the performance implications of capital structure choices is

immense in developed markets (e.g. USA and Europe), little is empirically known about such

implications in emerging or transition economies such as Tanzania. In such a country as

Eldomiaty (2007) argued capital market is less efficient and incomplete and suffers from higher

level of information asymmetry than capital markets in developed countries. This environment of

the market may cause financing decisions to be incomplete and subject to a considerable degree

of irregularity. It is, therefore, necessary to examine the validity of corporate leverage levels

impact on a firms performance in Tanzania as an example of emerging economies.

1.4.Research Objective

The main aim of this study is to examine the relationship between financial leverage and

profitability of non financial companies listed on Dar es Salaam stock exchange during a five

year period (i.e. 2005 2009).

1.4.1. Specific Objective

y To examine the relationship between Short term Debt and firm Profitability.y To examine the relationship between Long term Debt and firm Profitability.y To examine the relationship between Total Debt and firm Profitability.


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1.4.2. Research Questions

y Does level of Short term Debt has effect on firm Profitability?y Does level of Long term Debt has effect on firm Profitability?y Does level of Total Dept has effect on firm Profitability?

1.5.Significanceofthe Study

The capital structure decision is crucial for any business organization. The decision is important

because of the need to maximize returns to various organizational constituencies, and also

because of the impact such a decision has on a firms ability to deal with its competitive

environment. Thus the findings of this study will assist financial managers in deciding the

optimal mix of capital structure. This study will produce information which will be useful to

them when choosing financing sources (for this case debt) and in deciding the level of debt to

acquire.

1.6.Scopeofthe Study

This study will focus on non financial firms listed on the Dar es Salaam Stock Exchange (DSE)

basing on their accessibility and availability of data for the period under the study.

1.7.DefinitionofTerms

Financial Leverage is the proportion of debt in the capital structure. There two ways

of putting into perspective the levels of debt that a firm carries i.e. Capital leverage

focuses on the extent to which a firms total capital is in the form of debt and Income

leverage is concerned with proportion of the annual income stream which is devoted

to the prior claims of debt holders. (Arnold, 2008)


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CHAPTER TWO

2. LITERATURE REVIEW

2.1.Theoretical Framework

The linkage between capital structure and firm value has engaged the attention of both academics

and practitioners. Throughout the literature, debate has centered on whether there is an optimal

capital structure for an individual firm or whether the proportion of debtusage is irrelevant to the

individual firms value. The capital structure of a firmconcerns the mix of debt and equity the

firm uses in its operation. Brealey and Myers(2003) contend that the choice of capital structure

is fundamentally a marketing problem. They state that the firm can issue dozens of distinct

securities in countless combinations, but it attempts to find the particular combination that

maximizesmarket value. According to Weston and Brigham(1992), the optimal capital structure

is the one that maximizes the market value of the firms outstanding shares.

2.1.1. Capital StructureIrrelevance Theory

The seminal work by Modigliani and Miller (1958) in capital structure provided a substantial

boost in the development of the theoretical framework within whichvarious theories were about

to emerge in the future. Modigliani and Miller (1958)concluded to the broadly known theory of

capital structure irrelevance wherefinancial leverage does not affect the firms market value.However their theory was based on very restrictive assumptions that do not hold in the real

world. Theseassumptions include perfect capital markets, homogenous expectations, no taxes,

andno transaction costs. The presence of bankruptcy costs and favorable tax treatment ofinterest

payments lead to the notion of an optimal capital structure which maximizesthe value of the

firm, or respectively minimizes its total cost of capital.


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(Modigliani & Miller, 1963) reviewed their earlier position by incorporating tax benefits as

determinants of the capital structure of firms. The key feature of taxation isthat interest is a tax-

deductible expense. A firm that pays taxes receives a partiallyoffsetting interest tax-shield in

the form of lower taxes paid. Therefore, as Modiglianiand Miller (1963) propose, firms should

use as much debt capital as possible in order to maximize their value. Along with corporate

taxation, researchers were also interested in analyzing the case of personal taxes imposed on

individuals. (Miller, 1977) based onthe tax legislation of the USA, discerns three tax rates that

determine the total value ofthe firm. These are:

(1) the corporate tax rate;

(2) the tax rate imposed on the income of the dividends; and

(3) the tax rate imposed on the income of interest inflows.

According to Miller (1977), the value of the firm depends on the relative level of each tax rate,

compared with the other two.

2.1.2. TradeoffTheory

Bankruptcy costs are the cost directly incurred when the perceived probability that the firm will

default on financing is greater than zero. The bankruptcy probability increases with debt level

since it increases the fear that the company might not be able to generate profits to pay back the

interest and the loans. The potential costs of bankruptcy may be both direct and indirect.

Examples of direct bankruptcy costs are the legal and administrative costs in the bankruptcy

process. Examples of indirect bankruptcy costs are the loss in profits incurred by the firm as a

result of the unwillingness of stakeholders to do business with them (Myers S. C., The CapitalStructure Puzzle, 1984). The use of debt in capital structure of the firm also leads to agency

costs. Agency costs arise as a result of the relationships between shareholders and managers and

those between debt-holders and shareholders (Jensen & Meckling, 1976). The need to balance

gains and costs of debt financing emerged as a theory known as the static trade-off theory by


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Myers (1984). It values the company as the value of the firm if unlevered plus the present value

of the tax shield minus the present value of bankruptcy and agency costs.

2.1.3. The AsymmetryofInformation TheoryThe concept of optimal capital structure is also expressed by (Myers S. C., The Capital Structure

Puzzle, 1984) and Myers and Majluf (1984), based on the notion of asymmetric information. The

existence of information asymmetries between the firm and likely finance providers causes the

relative costs of finance to vary between the different sources of finance. For instance, an

internal source of finance where the funds provider is the firm will have more information about

the firm than new equity holders; thus, these new equity holders will expect a higher rate of

return on their investments. This means that it will cost the firm more to issue fresh equity shares

than using internal funds. Similarly, this argument could be provided between internal finance

and new debt holders. The conclusion drawn from the asymmetric information theories is that

there is a hierarchy of firm preferences with respect to the financing of their investments (Myers

& Majluf, Corporate Finance and Ivestment decisions when firms has information that investors

do not have, 1984)

2.1.4. The Pecking Order Theory

This pecking order theory suggests that firms will initially rely on internally generated funds,

i.e. undistributed earnings, where there is no existence of information asymmetry, and then they

will turn to debt if additional funds are needed and finally they will issue equity to cover any

remaining capital requirements. The order of preferences reflects the relative costs of various

financing options.

The pecking order hypothesis suggests that firms are willing to sell equity when the market

overvalues it (Chittenden, Hall, & Hutchson, 1996; Myers S. C., The Capital Structure Puzzle,

1984). This is based on the assumption that managers act in favor of the interest of existing

shareholders. As a consequence, they refuse to issue undervalued shares unless the value transfer


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Chhibber (1999) examine the relationship between capital structure and performance of Indian

firms showing that debt level is negatively related with performance (i.e. return on net worth).

Chiang et al. (2002) examine the relationship between capital structure and performance of firms

in property and construction sector in Hong Kong showing that high gearing is negativity related

with performance (i.e. profit margin). Abor (2005) investigates the relationship between capital

structure and profitability of listed firms in Ghana showing that STD and TTD are positively

related with firms profitability (i.e. ROE), whereas LTD is negatively related with firms

profitability (i.e. ROE). Kyereboah-Coleman (2007) examines the relationship between capital

structure and performance of microfinance institutions in sub-Saharan Africa showing that high

leverage is positively related with performance (i.e. ROA and ROE). Zeitun and Tian (2007)

examine the relationship between capital structure and performance of Jordan firms showing that

debt level is negatively related with performance (both the accounting and market measures).

Finally, Abor (2007) examines the relationship between debt policy (capital structure) and

performance of small and medium-sized enterprises in Ghana and South Africa showing that

capital structure, especially long-term and total debt level, is negatively related with performance

(both the accounting and market measures).

In summary, empirical studies regarding the relationship between capital structure and firms

performance in developed countries provided mixed and contradictory evidence, on the other

hand there is a few studies empirically examine this relationship in emerging (transition)

economies. The present study extends the literature on the impact of capital structure on firms

performance by empirically examining the relationship between capital structure and firms

performance in Tanzania. In fact, Tanzania is a unique case because; capital market in Tanzania

is less efficient and incomplete and suffers from higher level of information asymmetry than

capital markets in developed countries. Also, the capital market in Tanzania is still to now an

equity market, the debt market structure is still very immature. This environment of the market

may cause financing decisions to be incomplete and subject to a considerable degree of

irregularity. It is important, therefore, to explore the validity of debt financing firms

performance relationship under this unique economic setting.


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2.3.Conceptual Framework

Short Term

Debt

Total Debt

2.4.Hypotheses

The study will be tested by the following hypotheses

y The level of short term debt has positive effect on firm profitability.y The level of long term debt has positive effect on firm profitability.y The level of total debt has positive effect on firm profitability.

Firm

Profitability

Long Term

Debt

Firm Size


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CHAPTER THREE

3. RESEARCH METHODOLOGY

3.1.Research Paradigm

Both qualitative and quantitative research approach will be used to examine the impact of capital

structure on firm profitability.

3.2.Population

The population for this study will be all publicly traded firms on DSE because they are more

likely to be informed on issues concerning capital structure decision i.e. they can use internal

funds, issue shares or use debt in financing their operations and also.

3.3.Sample Sizeand Sampling Frame

The sampling frame of this study will be the list of all the listed firms on DSE. The listed firms

will then be screened against several factors; financial services institutions (banks) will be

deleted from list, and remaining firms will then be purposely selected due to availability of

financial data during the test period (2005-2009) and accessibility.

3.4.Data Collection Tools

The data will be collected via interviews, questionnaires and firms website. I will send

questionnaires to employees who are in the Finance Departments and I will interview finance


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including the size variable in the model. Size is measured by the log of total assets of the

firm and included in the model to control for effects of firm size on dependent variable

(i.e. profitability).

y short-term debt to the total capital;y long-term debt to total capital; andy total debt to total capital.

3.6.Data Analysis

The relationship between financial leverage and a firms performance will be tested by the

following regression models:

1. ROEI; t= 0 + 1STDI; t + 2log SI; t + eiI; t2. ROEI; t= 0 + 1LTDI; t + 2log SI; t + eiI; t3. ROEI; t= 0 + 1TTDI; t + 2log SI; t + eiI; t

Where:

ROE I, t = Net profit to equity for firm I in year t

STD I, t = short-term debt to total assets for firm I in year t.

LTD I, t = long-term debt to total assets for firm I in year t.

TTD I, t = total debt to total assets for firm I in year t.

Log S I, t = logarithm of total assets for firm I in year t.

ei I, t = the error term.


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