Impacts of Profitability and Financial Leverage on Firm’s Capital Structure
Impacts of Profitability and Financial Leverage on Firm’s Capital Structure By [Your Name] [Instructor’s Name] [Institution’s Name] [Date] Declaration While conducting the proposed research work, I, being a hard-working, innovative and conscientious researcher, come up with the factual severity of consequences allied with an act of plagiarising content from others’ work. Moreover, I do comprehend the rules and regulations my university encompasses against submitting a plagiarised document.
Adhering to all these strict and restricted rules and regulations against plagiarism, I have made all possible endeavours to keep my research report under the level of allowed percentage of plagiarism. Before presenting my research report to my esteemed research guiders and professors, I, hereby declare the authenticity and uniqueness of the presented dissertation, which is, by all means, an innovative piece of writing and is an outcome of hypothetically and logically researched facts and figures allied with the project subject matter which I meticulously researched during my investigative course project.
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Although, this dissertation is an original piece of research but still, there are some ideas, concepts and theories that are being taken and inspired from previously presented works in this particular domain for endowing my researched topic with a literal and theoretical support as well as for influencing the analyzed outcomes of the proposed research-based exposition. Signature: _____________Date: _____________ Acknowledgements The successful completion of this research work was a knowledgeable experience that comes up as an outcome of my continual endeavors for several months.
The accomplishment of this research work is not due to a stand-alone performance; in fact it is the combine effort of some dedicated and inspirational individuals who work with me and guide me through and through with their all-inclusive knowledge an d expertise in the projected context. There are several influential personages who have impacted my research work in a very constructive way but, there are some worth mentioning names, without whom, this dissertation would never reach to its end. These magnificently meritorious personalities are: •[Person 1] [Person 2] •[Person 3] Sincere thanks and gratitude to all who lend their helpful hands for the completion of my research as you all really make it commendable by all means. In addition to that, I would also like to acknowledge those interviewees who cooperatively collaborated with me and assist me in drawing some valuable outcomes for my research. Finally, I would like to thank my family and close friends who supported me in my work and give me “I can do” attitude. Thank you all for being there with me and backing me for my research-based achievements. Abstract
In this paper, a great emphasis is being given to the investigation of the effect that profitability and financial leverage of an organization has on its overall capital structure. Though the implications of proposed research work are quite vast that cover almost every industrial domain but here the chemical sector in Pakistan has been taken into account for exhaustive analysis and evaluation of relationship exist between the three attributes mentioned above. For accomplishing the predefined aims and objectives of the projected study, researcher has analyzed the capital structure of 10 KSE listed firms by means of OLS analysis model.
Five years data associated with these firms have been taken for analyzing the correlation between capital structure and firms’ profitability. Meticulously designed research methods have been employed to get the most credible and accurate results from the proposed research work. On the basis of regression analysis while evaluating the relationship occurred in the estimated model by means of Correlation Coefficient Test, the research concluded that there is an insignificant relationship between the capital structure, the profitability of the firm and its financial leverage.
Therefore, this research work stands at odds to come up with any apparent association between profitability and financial leverage and their impacts on the capital structure of a firm operating in chemical sector of Pakistan. Table of Content Impacts of Profitability and Financial Leverage on Firm’s Capital Structure1 Declaration2 Acknowledgements3 Abstract4 Chapter I7 INTRODUCTION7 Research Hypothesis11 Research Question12 Research Aims and Objectives12 General Research Methods12 Research Approaches12 Research Strategies12 Research analysis13 Validity and Reliability of Results13
Limitations of Research Work13 Research Outline14 Chapter Summary15 Chapter II15 REVIEW OF LITERATURE15 Introduction15 What are Capital Structure and Cost of Capital? 16 Components of Capital Structure18 Debt Financing18 Long Term Debt18 Short Term Debt19 Equity Financing19 Measuring Profitability20 Literal Revelations about the Relationship between Firm’s Profitability and its Capital Structure21 Chapter Summary25 Chapter III25 RESEARCH METHODS25 Introduction25 Research Philosophy25 Approaches for Data Collection26 Research Approaches26 Research Strategies27
Resources of Data Collections27 Research analysis27 Data Analysis Techniques27 Treatment of Data27 Validity and Reliability of Results28 Correlation Coefficient29 Data and Sampling30 Source of Data30 The Sample30 Variable Description31 Dependent and Independent Variables31 Capital Structure31 Profitability31 Degree of Financial Leverage32 Chapter Summary32 Chapter 432 Results and Analysis32 Chapter I INTRODUCTION Organizations use different types financing techniques to fund its assets. This type of financing refers to as Capital Structure of any corporation.
The financing techniques that build a firm’s capital structure may take account for different levels of debts, equity, and further arrangements of financial funding. Organizations, which ultimately aim to magnify the overall market value of their business, use collective approaches of financing that largely include bonds, TFCs, lease financing, bank loans and various other options allied with equity. As a matter of fact, capital structure of one organization varies from that of the other depending upon the strategy employed by these organizations for maximizing their overall inancial standing and reputation in open, international markets. These differentiating techniques of capital structure, as proposed by different organizations operating in different industrial sectors of various international markets that are segregated from one another on the basis of various economical, social and environmental factors, have come up with a number of theoretical and practical contemplations regarding capital structure so as to give appropriate explanation regarding deviations that take place in organizational capital structures with the passage of time or due to regional distributions.
Apart from that, literature in this context depicted some clear empirical evidences that substantiating one particular theory of capital structure does not always fit best for every type of businesses. In this research aim is to explore upon the relationship between capital structure and profitability of the organizations. In due course, this research has investigated and inquired about how profitability is impacted by capital structure of the organization and how this amalgamation is constructively influencing the firms operating in the chemical sectors of Pakistan.
The author has made exhaustive research in this domain and after analyzing the bits and bytes of Pakistani chemical sectors, it has been concluded that the projected research work is among the very few researches of empirical nature that have been conducted so far specifically in Pakistan, while undertaking the country’s chemical industries . Although a number of researchers investigated the impacts of capital structure on profitability but chemical sector of Pakistan is still enacted so far and so forth.
Miller and Modigliani published a meticulously researched paper in 1958, which serve as the cornerstone for strengthening the overall research domain of capital structure and it’s certain impacts on firms’ profitability. Various researchers got motivated and inspired with Miller and Modigliani’s work and since then the debate on firm’s capital structure is ongoing in developed s well as developing international trade markets.
Nonetheless, developed trade markets are investing much in exploration and elaboration of this particular field as compared to the developing economies and this is due to lack of knowledge and certain expertise in this particular field. Pakistan is one of those under-developed economies where capital structure and its relationship with profitability of Pakistani firms. These factual revelations from Pakistani industrial sectors limit and hinder the progression of the proposed research work to a considerably high extent (Joshua 2005).
These certain gaps make the overall research perplexed enough to decide whether the theoretical and empirical researches carried out in developed economies and their relevant conclusions are also applicable in industrial sectors of underdeveloped countries. Before setting up the basis of this research work, it was also taken into account that whether the set of various different factors, which are influencing the decisions on capital structuring of developed countries, are also effectual and influential for the developing economies.
In general, it cannot be distinctively established that the factors influencing capital structure and thus, the profitability of the companies operating internationally are portable across countries as well. In 2005, Rajan and Zingales carried out exhaustive study on the G-7 countries, which was later elaborated and explained by Booth et al in 2001, who incorporated data from developing economic markets of the world to come up with comprehensively studied subject matter.
These studies concluded that some common features do exist in different organizational capital structures operating in different countries; however, these features are required to be researched further so that the determinants of capital structure could be identified in particular industrial settings of developing countries (Joshua 2005). In researched industrial domain of Pakistan is considered to be emerging these days.
Pakistan, itself, is a developing country and encompasses three stock exchanges, out of which the Karachi Stock Exchange (KSE) is the largest among the rest. In KSE, the quantity of listed companies is over 700, as per recent research. Unlike other developed countries, Pakistan is also following the ritual of developing economies, where the area of capital structure is unexplored and unsearched to a great extent. Previously, researchers never integrate capital structure as a dependent variable in their researches and explorations regarding Pakistani industrial sectors.
But, this paper is aimed to set new standards and to raise the bar of research and development ahead of typically squared Pakistani industrial sector. New discussions and new conclusions are the underlining aspects of the proposed research work. 1. 1. The Background of Pakistan’s Chemical Industry The economic conditions of any country are greatly and evidently influenced by its chemical sector. It is usually contemplated that the modern structure of the world is plinth upon the effectiveness of chemical industries being operated within it.
The reason behind so much emphasis on chemical sectors globally is the valuable operation it performs in which all the essential raw materials are converted into thousands of different products that are further used in several industries to manufacture millions of other consumer goods upon which our everyday life is greatly dependent. Nowadays, chemical industry around the world is categorized into four basic operations which may include production of usual chemicals, special chemicals, study of chemicals involve in daily life, and chemicals used for consumer products.
The rapidly evolving scientific and technological advancements and breakthroughs are the main reason for the outstanding success of chemical industries in most developing countries including Pakistan, as these technologies are frequently raising the bar of newly devised procedural tools for manufacturing products of significant value for the consumers. Dated back to year 1947, there were no marks of existence of chemical industry in Pakistan. As years passed, various industrial sectors emerged and progressed in Pakistan but, its Chemical Industry has a lot of scope for further development and exploration.
Up till now, a lot of developments have been experienced by the chemical industry of Pakistan but still it is somewhere between organized and unorganized industrial domain with certain needs of improvements and enhancements proposed by governmental as well as private agencies in Pakistan. Recently, the approximated investments in chemical sectors of Pakistan ranged between Rs. 550 to 600 billion; and currently, the products related chemical sectors make up 17% of the total import bill.
Surveys and researchers explored Pakistan’s capabilities for strengthening its chemical industries and concluded that there is much potential of producing technologically-high chemical products in Pakistan; but, little efforts for improvising the administrative aptitudes and encoring more investments from governments and privately-owned companies are required to perk up the overall level of chemical production in Pakistan. Research Hypothesis In this research work, following research hypotheses are to be tested: Research Hypothesis 1: HO1: Profitability does not have any impact on the overall Capital Structure of the chemical industry in Pakistan •HA1: Profitability does have impact on the overall Capital Structure of the chemical industry in Pakistan Research Hypothesis 2: •HO2: Financial leverage does not have an effect on Capital Structure •HA2: Financial leverage does have an effect on Capital Structure Research Question This research work is commissioned to answer what are impacts of profitability and financial leverage techniques employed by a company on its overall capital structure and business strength while highlighting the Chemical sectors of Pakistan.
Research Aims and Objectives In this research, work aim is to explore upon the chemical industry of Pakistan; however, the core objective of proposed research work is to evaluate the significance of profitability and profitability on capital structure of the firm. General Research Methods The general research methods employed in this research work are highlighted below. Research Approaches The approaches to carry out this research work are Inductive as well as deductive research approaches that have been destined so that meticulous research conclusions could be achieved. Research Strategies
Owing to the extensively vast domain of the undertaken topic, considerably and thoughtfully formulated strategies have been adopted for the creditable conduction of this research work. The core research strategies that have been implemented for this research consist of pragmatic experiments, statistical evaluations and empirical studies. Research analysis As analysis is the cornerstone for any realistic research work thus, in this research it has been aimed to make the most of Descriptive as well as inferential statistics so as to analyze and describe the resulted information in more explanatory manner.
Validity and Reliability of Results Research results should be extremely accurate to enable implementation and realization of the research purposes. Therefore, the researcher will ensure that accuracy is maintained from data collection and analysis to presentation. This is done to ensure that the results are reasonable and reliable. Limitations of Research Work There are quite a number of constraints of the contemporary research with respect to time, reserves and research methodology employed.
There are different restrictions concerning the qualitative and quantitative research methodologies that will be utilized in the proposed research work. The intended research approaches will be put into practice with the help of the primary research technique of survey questionnaires. The replies to these queries are expected to be exceedingly reliant on the ability and attitudes of the employees working with different job statuses. The biasness of employees, organizations and the researcher in the whole area of research or any fraction of the research could have an effect on the conclusion of the proposed research.
The chief restriction throughout the entire research process was the utter shortage of time and a more complete research could have been accomplished if additional time was on hand. The lack of time not simply influenced the examination of the researcher the visions and thoughts articulated by the employees and managements of different companies will be affected as well because of the shortage of time. The total time needed for carrying out an effectual research goes beyond the time that is spent on the latest research.
The compilation of data through the aid of the survey questionnaires was fairly extensive and took a lot of time which caused a chief hold-up for the research course. Another inadequacy to this research is the shortage of appropriate sources that are needed to carry out an apt research. The associate had to make the most of an assortment of techniques to have an effective impact of the available resources but the limited accessibility of the current resources impacts the authenticity of research work rigorously. A superior total of resources would have facilitated the research areas to be more efficiently and resourcefully.
The extent of the intended population and the figure of companies and industry chosen for the current research are quite negligible and an efficient research could have been made possible by increasing the sample population volume. If the illustrated population is adequate enough and there are a lot of subdivisions of a variety of companies that are included in the case study subsequently the research can have an efficient and constructive conclusion. Research Outline This dissertation is being stream-lined within an arrangement of the following chapters: Chapter 2 ?
Research Methodology: in this chapter, various convincing research models would be considered which could be best suited for collecting data for this research, and along with that other supporting research clauses will also be highlighted in this section. The chapter will be dealing with data analysis procedures and instruments at its highest priority. Chapter 3 ? Findings and Analysis: Conducted statistical, theoretical and logical results will be illustrating in this chapter by using various graphical and pictorial illustrations and expressions and will be analyzed on the basis of primary and secondary research.
Chapter Summary This introductory chapter gives the brief but insightful knowledge about the whole dissertation. It spotted light on backgrounds of the study, the introduction of the concept which is being researched, the aims and objectives associated with the research work, backgrounds along with the key rationales of the study, the adopted research methodology for the research, definitions for various important terms that have been used throughout the paper and the outline of subsequent chapters. Chapter II
REVIEW OF LITERATURE Introduction In this chapter, the author has given an essence of wisdom in which he looks to establish an academic contemplation regarding the capital structure and firm’s profitability, on the basis of which both, literal and statistical analysis has been constructed evidently. The purpose of this chapter is to augment the reader’s perspective on the numerous concepts that the firm’s capital structure involves, as well as its conjectural impacts on the profitability and profitability of the company.
What are Capital Structure and Cost of Capital? In business domain, utilization of different funding types is a common practice in various organizations which is usually being employed so that business could run more smoothly (Brealey 1992). Funding for this purpose falls under the category of Capital Structure which is the composition of various different types of financing that a business entity or firm employs for acquiring resources that are necessary to affirm its operational growth and business expansion.
Capital Structure primarily comprises of long-term debt, preferred stock, and net worth (John and Ronald 1997). Financial accounting allows company to quantify its Capital Structure by analyzing different types of financing the company comes up with as a percentage of all its financing activities. Here it should be noted that Capital Structure differs from the financial structure of the company as, capital structure takes account for the short-term debt and liabilities of the company (Capital Structure Decision 2010).
Mostly companies raise their funds by means of their equity or via market debts (Nicos 1998). As far as Debts are concerned, these debts come in the form of an agreement, bond or long-term notes payable; on the other hand, equity can be attributed as the preferred stock, common stock or retained earnings. Both types of business financing depict some advantages along with some disadvantages in comparison to each other. In case of funds are raised by debt, the founders or owners of the company hold the rights of ownership of the company and have complete control over it.
But these companies are required to pay the amount in principal as well as interest to the concerned debt holders (Nicos 1998). However, in equity, this privilege is not being given because in this type of capital structure, the shareholders turn out to be a central part of the company. Most of the business expert finds debt financing to be easier and less expensive specifically for the firms operating at small scale. This is because these business experts contemplate regular payment of interest as a burden for the financial status of the company and can negatively impacts its overall earnings.
Nonetheless, equity financing comes up with no obligations for repaying the money to the outsiders. In fact, in equity financing, shareholders are allowed to take a chance on realistically logical ideas for endowing the company with better learning options and growth opportunities. As far as Cost of Capital is concerned, business experts defines it as (Modigliani & Miller, 1998): “the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. ” This signifies that the cost of capital takes account for the “cost of debt” and “cost of equity”.
The cost of capital helps companies to determine how it can raise funds in terms of money, by means of stock issuance, borrowing, or combination of both. It is the rate of return which a firm would be given if it invested in different business operations with similar risks. Capital structure is employed or improvised within the company by following either of two theories given below (Capital Structure Decision, 2010): Trade off Theory This theory suggests amplifying the debt levels for balancing interest for protecting against the outlay of financial misery.
This theory recommends the company to keep on borrowing debt until the marginal tax advantage of added debts is counterbalanced by the enhancement in current value of the predictable costs of financial misery. Pecking Order This theory suggests that those companies which have higher earnings should acquire a smaller amount debt, as they entail low requirements for funding for the reason that their funding requirements are met by their internal resources (Arun 2001). A company with high profits is capable of generating internal cash to finance their intended projects.
The most favorable capital structure is when there is a balance between risk and return rate of the company (Nicos 1998). The capital structure is satisfactory if the risks are minimized and the profit margins are maximized and also if the price of the stock is maximized and the cost of capital is minimized at the same time. Components of Capital Structure Arun (2001) defines that Debt financing and Equity financing are the main constituents of capital structure. Debt Financing In accounts books, Debt financing stands for borrowing money in order to run any kind of business.
In a broader sense leverage means the debt that any firm expands to finance its personnel assets (Voulgaris and Giomirgianakis 2004). On the basis of the type of money that one borrows from market debt can be classified as long term debt or short term debt, this can be framed under debt financing. The difference between short term and long term debt can be sorted out on the basis of interest rates that are different under various scenarios and that can vary from one firm to the other. Long Term Debt
If a firm utilize money that it has borrowed to finance its personnel assets, for a quite longer time period for say to buy more assets, in purchase of piece of some land or in order to buy machinery and other kind of stuff then it is termed as long term debt, as revealed by Rajeswararao Chaganti and Fariborz Damanpour (1993). The phrase long term loans can be used synonymously for long term debts as it specifies the long term liability of a firm. A time period of more than a year can be allotted in order to pay a long term debt . n the world of banking and finance, the sub ordinate loans approved by banks are actually long term loans because the payment structure is framed for a time period of more than a year. Short Term Debt In order to perform small scale routine business tasks short term loans or short term debts are used. The small scale activities can vary from purchase of simple inventory or to pay the wages of employees (Voulgaris and Giomirgianakis 2004). The time period allotted f or re imbursement of short term loans is within the running year. This is termed as short term financing. n an easy sense ,if a loan is taken for a few days or a few months like 3 to 6 than it is a short term loan. Practical example of short term loans is commonly seen in banks, where they borrow money from financing companies in order to perform their routine business tasks. Equity Financing The funds raised by the company itself referred to the phenomenon of Equity financing, as mentioned in financial books (Voulgaris and Giomirgianakis 2004). One way of increasing this type of business financing is addition of more investors in the ownership, which can be done by issuing and distributing the company’s shares in the open markets.
The theory behind issuance of company’s shares is simple enough to understand as company offers certain amount to the external investors, which is to be paid against the offered shares. Moreover, the shareholders receive dividends for the shares they bought or the money they invested in the company. Company’s policies as well as financial stability are the main factors on the basis of which the company’s need for capital is analyzed and shares are distributed accordingly. The companies having high rate of growth and expansion frequently use the equity financing methods for devising their capital structure.
This is because with equity financing companies are expected to distribute high returns for their potential investors and thus, can attract them by all means. Measuring Profitability Maximization of shareholder’s wealth is among the main objectives of any company. As a matter of fact, enhanced shareholder’s profitability can only be achieved if company earns significant business gains; and, business profits are directly proportional to an adequate use of company’s assets (Voulgaris and Giomirgianakis 2004).
In open markets, investors are more inclined towards knowing the financial status of the company as it is the reflection of company’s ability to return maximum benefits for the investments he made in it. Profitability of the company can be measured by various different methods, among all these influential methods, Profitability Ratio Analysis is the most frequently used method to analyze the overall capital structure of the company while interpreting its fanatical as well as reputational profits.
Profitability ratio analysis is the key driving factors for the investors that help them in making their decisions that whether to invest in a particular company or to look for some other alternatives. These ratios actual reflect the overall capital structure of the company by highlighting its financial statement ratios that reveals the business performance of the company in terms of financial gains and sales status, total assets and the net income of the firm. Other ratios that are used for analyzing the profitability of the firm are listed below: •Profit Margin ratios, •Return on Assets (ROA), •Return on Equity (ROE) and Return on Invested Capital (ROIC). Literal Revelations about the Relationship between Firm’s Profitability and its Capital Structure Modigliani and Miller (1958) made efforts to understand the association among the capital structure and income/market worth. Their observation stated that in a financial system having no corporate and special taxation issues, capital structure is of no value on the value of the firm. To put in plain words one can say, under the influence of several prescribed preventive speculations, a un-influence company had the similar market value as a company under any type of pressure.
They consequently added corporate taxes in the theory they presented and illustrated that income and market worth of the company will be at the optimum value if 100% debit is utilized by a company for providing finance for its assets (Booth 1999). Their most important speculation was that commercial risk can be reasonably evaluated by the standard variation of operating revenue (EBIT) and that all current and potential shareholders in future have some related expectations as regards to the commercial income and the likelihood of deviation in the assumed income.
One more major statement was they considered the corporation’s stocks and bonds were dealt with in an ideal marketplace. However another vital supposition was that rate of interest on debit was in a state of no risk rate for the company as well as individuals (Chiang 2002; Voulgaris and Giomirgianakis 2004). Their theory with commercial taxation illustrated that debit brings about advantages because of the accessibility of tax shield due to interest being considered as a tax expense that can be deducted.
Mandelker and Rhee (1984) in their research determined an association between Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL) and beta. They were proficiently gave you the empirical idea that DOL and DFL elucidated round about 38 to 48 percent alterations in a cross-section of information and statistics. Profitability and functionality are some fundamental point of disagreement among the two presumptions that were presented by Myers (1984) and Chiang (2002) which were the Pecking Order Theory (POT) and Static Tradeoff Theory (STT).
Myers categorized the modern-day view on capital structure into two speculative subdivisions. The initial one is the Static Tradeoff Theory (STT), which has the capability to explain about a firm and the path it goes after being the target debt-equity relation and then works on the defined conduct accordingly (booth 1999). The advantages and expenditures which are incorporated with the debit preferences places this objective relation. These take account of taxes, cost of economic distress and costs of the agency.
Subsequent to this is the Pecking Order Theory (POT) presented by Myers (1984) and Myers and Majluf (1984), stated that a corporation pursues a chain of command in executing the financial decisions when setting up their capital structure. Primarily, firms have a preference in financing their developmental objectives with the help of internal financing i. e. retained earnings. In the case where they may require external financing, they initially submit an application for a bank loan after that for public debt (Majluf 1984).
As a final alternative, the corporation will allow equity to support project’s financial aspects. Therefore according to POT the lucrative companies are less expected to sustain debt for fresh projects for the reason that they have the support of internal financing for the attainment and completion of the project. Booth (1999) revealed that for the STT, the high the profitability of the corporation, the more are the causes it will have to apply debt, by this means also reducing the tax burden on its status.
On the other hand, the POT takes this assumption for granted that bigger income works as a guide towards the increase in the most important resource that firms desire to cover up their economic shortfall: retained earnings (Majluf 1984; Guorong 2003; Booth 1999). For that reason, the STT look forward to an encouraging correlation among profitability and leverage, while the POT looks forward to precisely the opposite of the whole scenario discussed above.
In addition, for the Static Tradeoff conduct, the bigger the firm, the better are the opportunities it has of issuing debit that may result in a constructive association linking debt and volume (Mohammad 1994). One of the main explanations for this is that the bigger the firm less is the danger of an economic failure. Great companies do not think about the direct economic failure costs as a dynamic factor in settle on the intensity of leverage since larger firms, being more distinctive in their mannerisms; have fewer openings of economic failure (see, for details Titman and Wessels 1988; Guorong 2003).
Signaling Theory initially put forward by Ross (1977), elucidates that debt is taken as a technique to underline the confidence of the investors in the company, that is, if a company issues debt it gives an indicator to the markets that the company is expecting helpful cash flows in the making, as the principal and interest payments on debit are a fixed contractual duty which the firm has to pay out from the cash flows it may hold. Hence, higher point in debt depicts the manager’s self-belief in potential cash flows. An additional influence of the signaling feature in the Pecking Order Theory is the difficulty of the under-pricing of equity.
If a corporation issues equity as an alternative of debt for sponsoring its new projects, investors will comprehend the signal negatively (Ross 1977). As managers have advanced facts and figures in relation to the firm than investors, they may issue equity when it is priced highly. Larry et al. (1995) take into account that there is an existence of a negative relation linking leverage and future expansion. This relation is negative for corporation whose developmental prospects are either not acknowledged by the capital markets or are not adequately precious to prevail over the consequences of their debt extended beyond.
They also established that leverage does not trim down the development for firms recognized to have excellent profit opportunities. To look at the relation among leverage and expansion they made use of the data set over a period of 20 years and they discovered a powerful negative association between them (Mohammad 1994). In Pakistan, inadequate research work exists on the region of capital structure, for instance Booth et al (2001) considered 10 emerging countries that included Pakistan. Nevertheless, this research was restricted only to the most established 100 index companies.
Second study by Shah and Hijazi (2004) was an enhancement of the initial one as it incorporated all non-financial companies listed on KSE for the period between 1997 and 2001 (MCNULTY 2004). On the other hand, the second study as well was central in nature according to its exercise of mutual deterioration theory avoiding the fact that the permanent consequences and random consequences models. Attaullah Shah and Safiullah Khan (2007) have extensively worked on Shah and Hijazi (2004) together with more years, with the help of relevant models of grouped information as well as more descriptive variables.
Predominantly in Automobile manufacturing of Pakistan, the single most important work discovered in this regard is done by Zubairi and Zubairi and Rashid. In both of these papers, yet another time profitability of this region has been made sure by means of diverse variables. Therefore this dissertation aspires at targeting this information crack by reading through the lines as to how profitability in turns affects capital structure all along with economic leverage.
Chapter Summary So far in this chapter, all the literal information on capital structure in conjunction with organizational profitability and other allied factors has been discussed with the fullness of creditable conceptual, theoretical and figural data. This chapter concluded the influential factors that support firms to become financially stable by employing adequate capital structuring strategies in competitive market settings of developing countries like Pakistan.
In next chapter, the research methodology for exploring the realism and pragmatism of discussed information would be exhaustively at question. Chapter III Research Methodology The process of assessing past data from previous researches, books, articles and other sources while carrying out personal research in order to present original ideas which increases human knowledge on a specific topic is research methodology. The main aim of a research is to increase the knowledge in a specific area and present or prove some other facts in any subject area or discipline.
Research methodology is based on interpreting researches performed previously and explanation of details of those studies. It also includes the examination and analysis of a specific part of a discipline to provide a fresh and new viewpoint (Kumar 2002). It is not possible to carry out an effective research just by collecting and interpreting data. This analysis should be backed by conclusion from other researches as well. The methods through which data is collected, analysed and results are presented should be recognised in order for the research to be effective.
The process by which people try to study the unknown and explore new ideas is referred to as research. The methodology in a research describes the methods through which data is collected, interpreted and analysed to form a conclusion in a particular area of study (Goddard and Melville 2004). Research Approach Generally there are two research approaches i. e. the qualitative research approach and the quantitative research approach. A brief introduction of both research approaches is being illustrated in the tables below: Table:
Assumptions on the Basis of Quantitative and Qualitative Approaches (Research Models and Methodologies, 2005) AssumptionQuestionQuantitative ApproachQualitative Approach OntologicalWhat are the characteristics of reality? The characteristics of reality are singular and objectiveThe characteristics of reality in this approach is multiple and subjective EpistemologicalWhat is the relationship between research and the researcher? Researcher is autonomous of the conducted research Researcher is associated with the researched subject AxiologicalWhat is the role of values in the overall research?
The role of values in the overall research is unbiased and value-free The role of values in the overall research is biased and value-laden in this approach. Metaphorical What language is the research in? The research is in the formal language with the usage of assorted set of impersonal voice, definition and accepted quantitative words usage. The research is in informal language, with developing personal opinions, decisions and accepted qualitative words usage. ProceduralDescribe the method of research? The method of research in this approach is: Independent;
Deductive process; Generalizations that leads to explanations, understandings and predictions; Reliable and accurate by implementing appropriate testing for reliability and accuracy; Factors of effects and causes are being emphasized; and Stagnant design of isolated categories research. The method of research in this approach is: Inductive processing; Dependent; Use of theories and patterns for predictions and conclusions; verified through reliability and accuracy; Factors shaping up simultaneously; Emerging design of emerged categories research.
Table: Criteria Set on the Basis of Quantitative and Qualitative Approaches (Research Models and Methodologies, 2005) CriteriaQuantitative ModelQualitative Model The researcher’s perceptionThe researcher’s is inclined towards the, Epistemological, Ontological, Metaphorical, Axiological and procedural quantitative model’s aspectsThe researcher’s is inclined towards the, Epistemological, Ontological, Metaphorical, Axiological, and procedural qualitative model’s aspects Experience and Training of the researcher Experience and training include: Technical computer skills, writing and library skills and statistical literacy.
Experience and training include: Computer, literary writing skills, library skills and text-based analysis skills. Psychological traits of the researcher The psychological traits of the researcher in this approach include: The comfort of the researcher with guidelines and rules for conducting research, with no or low tolerance for uncertainty and working in short deadlines. The psychological traits of the researcher in this approach include: Researcher’s lack in comfort with the specifications of guidelines and rules, are able to tolerate uncertainty and unable to work in short deadlines.
Nature of research topicThe basic research subject has already been studied by researchers previously and therefore, the body of literature review is known with formerly existing theories. Exploratory topic of research in the context is unidentified and lack of theory-based framework. Audiences being studied during the research Individuals are habituated to support the approach of quantitative model Individuals are habituated to support the approach of qualitative model.
After having a comparative analysis of both research approaches, it can be established that the most appropriate research approach for the projected research work is the qualitative approach. We have employed qualitative approach to research by establishing a new hypothesis instead of testing a previously established hypothesis. In this thesis, qualitative approach is used for testing the strength, concentration and richness of an occurrence or problem by analysing life experiences and behaviour patterns.
This approach is applied to research studies involving social sciences, finance, economics and behavioural studies and our proposed research, which is an economic research, falls in this range. With the quantitative approach, our research puts emphasis on data and interpretation of data collected by the researcher. This approach is more flexible and can be moulded according to changing situations and scenarios. The elevated involvement of the esearcher in the whole process makes the research more effective than the quantitative approach. As this approach utilises more open ended questions in the questionnaire and interviews, the participants of the research provide descriptive and creative answers which are more helpful for the research process. The combined knowledge of the participants and the researcher helps in the process of drawing logical and valid conclusions. Research Purpose The purpose of research could be descriptive, explanatory and exploratory.
To get insights of these three research types, brief explanation o each of them is given below: The researches having descriptive purposes are formulated so as to endow with purely systematic information regarding any social phenomena. In such researches, researchers are not required to get started with a distinctive hypothesis; instead, this research allows researchers to establish hypotheses of their own once relevant data is collected. Here, systematic information stands for a vigilant selection of the study units along with careful measurement of research variables.
Researchers explore a setting or a social phenomenon in exploratory researches. However, usually, descriptive or explanatory researches are based upon initial exploration in the researched domain. In exploratory work, there is contextual data and facts that are required for planning a descriptive or explanatory research. In explanatory research work, the researcher starts his research by emphasizing upon the facts that possibly make grounds for any social phenomenon. In other words, in this research work, the researchers are inclined towards developing their hypotheses before the phase of data collection.
After that, the study is planned by the researcher in such a way that it can come up systematic evidences to support (or not support) the developed research hypotheses. In this research, collection of data also provides systematic description. \ For our thesis, explanatory research have been used by establishing research hypothesis regarding the subject matter which are then proved by employing statistical tests and analysis in this research work. Research Design There are three core research designs: correlational, casual and experimental. the basics of these three researches are given below: Correlational Research
This research takes account for data collection so as to find out the extent of relationship between two (or more) variables used in the research work. Variables co-vary in some non-random way if these variables relate with each other. A coefficient of correlation, say r, is used to express the strength of the relationship find between research variable. Casual Research This type of research also called a comparative or ex post facto research. In this research, the researchers make certain attempts to analyze the existing differences between researched groups while giving realistic cause or explanation for these differences.
With this research, the researcher compares two or more existing groups retrospectively. Here it should be noted that there is a distinctive divergence between the correlational and casual research in a way that casual research takes in one group and two or more variables whereas, in correlational research, there are two or more groups and one variable. Experimental Research The empirical and personal clarifications of the researcher conclude the experimental strategy. After having brief introduction of all three research designs, the most appropriate research design opted for this research work is the correlational one.
We have collected data on six variables for each group to be correlated with each other in the research study. These variables are, capital structure (an independent variable), financial leverage, current ratio, long term debt, and profitability (as dependent variables). The most widespread calculation of “association” or “inevitability” is Pearson’s coefficient of association, even though there are without a doubt numerous others. Pearson’s r, as it is frequently represents, can have an assessment somewhere between -1 and 1.
The bigger r, disregarding the sign, the more strong is the association between the two variables and the further precisely you can calculate one variable from understanding of the second variable. At its acute position, an association of 1 or -1 is a sign that the two variables are absolutely associated, illustrating that you can calculate the rate of one variable from the rate of the second variable with precision being just right. At the other acute point, an r of zero entails a deficiency of a association i. e, there is no connection among the two variables.
This means that comprehension of one variable provides you completely no data related to what the assessment of the other variable is expected to be. The indication of the association means the “course” of the involvement. An affirmative association stands for the comparatively high gain on one variable is matching with comparatively higher scores on the second variable, and small scores are corresponding with moderately low scores. On the other hand, a negative association indicates that moderately high scores on a single variable are matching with moderately low scores on the second variable. Sample
This research work has emphasized upon the Pakistani chemical sectors. Thus, the data samples were taken from all the firms listed on the Karachi Stock Exchange (KSE). But due to incoherent and incomplete data sets available against some of the listed companies, this research has only taken account for those with complete financial data while ignoring the rest. This study made the most of the six years financial data allied with these firms. In this way, this research has plenty of data for being used in employed statistical model to affirm the hypothesis proposed at the beginning of this research work.
Even though, researcher aimed to integrate the most recent data of year 2012 but this data has not yet been published by the State Bank of Pakistan. Source of Data In this research work, the core source of data collection was the publication proposed by the State Bank of Pakistan, named “Balance Sheet Analysis of Joint Stock Companies Listed on The Karachi Stock Exchange 2005-2010”. The reason behind undertaking this particular publication is that it endows with all-inclusive and credible information regarding the key financial statements of the KSE listed companies during the period of past six years.
Statistical Tools Statistical tool used for this testing the variables in this research work is Eviews, software used for econometrics data analysis, forecasting and simulation. Statistical Techniques Stationary test and OLS (Ordinary Least Square) test have been used in this research work for testing the correlation between undertaken research variables so that all-inclusively reliable conclusions related to the projected research theme can be drawn by the end of this study. Model Deterioration models are a vital source to calculate one variable from a single or more other variable.
This study brings into play a panel deterioration examination. Panel data examination smoothers the advancement of examination of cross-sectional and series of instantaneous statistics. We apply the collective deterioration type of panel statistics examination. The collective deterioration, also known as the Steady Coefficients theory which is the one where intercepts and slopes are understood to be stable. The cross section business information and time finances as well as the series records are joined as one in a particular column presuming that there is no important cross section or inter sequential consequences.
Panel information goes after a specified illustration of entities within a specific period of time, and consequently offers numerous examinations on every single distinction in the illustration. Panel information comes together with the characteristics of time series and cross-section. It gives facts and figures on a number of arithmetical elements for a specific number of years. Panel information for financial study has quite a few benefits as compared to cross-sectional or time- series sets.
Panel information more often than not presents the examiner a great figure of information points, increasing the extent of autonomy and cutting down the co-linearity between descriptive variables; for this reason making the effectiveness of econometric approximates better. CS = ? + PF + DFL +STD+LTD+CR+ ? Where ?= Constant CS = Capital Structure PF = Profitability DFL = Degree of Financial Leverage STD= Short Term Debt LTD =Long Term Debt CR= Current Ratio ?= the error term Research Variables Dependent and Independent Variables
So far this research has come up with exhaustive review of theories and contemplations allied with capital structure of the companies; here, in this section, aim is to explore upon the potential dependent and independent variables that are significant to be used within the projected research domain. Capital structure is a dependent variable in this research work; whereas, profitability, financial leverage, current ratio, long term debt and short term debt are the independent variables. All these dependent and independent variables are defined in segments below: Capital Structure
Here, in this study, capital structure is the dependent variable. Capital structure actually stands for the amalgamation between equity financing and debt financing and supports the assets side in the balance sheet of the company. As a matter of fact, capital structure has never been taken as a dependent variable. As an alternate of capital structure measurement, in this study, the debt to equity ratio is being used. As stated earlier in introductory chapter, the aim here is to investigate and evaluate whether changes in capital structure impacts the profitability or degree of financial leverage or both. Profitability
In this study, profitability is calculated as the ratio of net income before taxes divided by total assets. Analysis of previous studies depicted the usage of earnings before interest and taxes (EBIT) divided by total assets, to calculate firm’s profitability because they took it as independent of effects produce by financial leverages. However, the data we took for this study is from the publication of the State Bank of Pakistan, it does not allow us to calculate (EBIT). Degree of Financial Leverage The fixed financial costs in the income stream of the firm are considered as the financial leverage of the firm in this study.
The extent of the presence of fixed financial costs in a firm’s income stream is measured by the degree of financial leverage (DFL). Financial leverage increases expected return on equity, but it also increases the risk faced by the shareholders. The business risk part of total risk is affected by operating leverage, whereas financial leverage affects financial risk thus affecting the total risk of the firm. Though capital structure theories consider long term debt as a proxy for financial leverage but we measure “degree of financial leverage” (DFL) as the ratio of earnings before taxes (EBT) to earnings before interest and taxes (EBIT).
Current ratio The current ratio is used to evaluate the extent of financial strength a company comes up with. It is the measurement of asset conversion into cash within the time duration of one year so that the long-term or short-term debts could be paid, which are payable during the same year. Formula for calculating the current ratio of the company is: the total current assets divided by the total current liabilities (Current assets/ Current Liabilities). Long Term Debt Long term debts are the loans and financial obligations a company has over one year time duration.
Long-term debts of a company are evaluated by the business analysts for analyzing the company’s current status that how much leverage it holds as well as analyze the extent of solvency in a company. All in all, it is contemplated that long-term debt allows the company to blow up its overall financial stability. However, with higher long-term debts the company is expected to experience burdens of principal and interest payments due to excessive borrowing. Short Term Debt Short-term debts are the company loans or financial obligations which are to be paid within one year time duration.
Like long-term debts, short-term debts are also recorded in the balance sheet of the company but, within the section of current liabilities rather than long-term liabilities. According to business analysts, if any company comes up with high values of short-term debt as compared to its available cash or investments required for covering its debt’s payments, then the company is considered to be in poor financial status and thus, required to raise additional debt from markets. Chapter 4 Results and Analysis 5. 0. RESULTS AND CONCLUSION
This segment provides the explanatory information, the outcome of deterioration study and association factor. The explanation of the experimental result is accounted in this segment as well. In conclusion, imperative observations regarding the fallouts of the research work have been taken out. 5. 1. Unit Root Test To determine the existence of long run relationship among the considered variables, conventional unit root tests namely Levin, Lin and Chu is applied. Result of test is given in Table I. From table I it is clear that all variables in model are integrated of order one i. [I(1)]. This shows that different combination of these series may reveal long run relationship. We, therefore proceed with regression. Table 4. 1: Stationary Test Results VariablesLevin, Lin and Chu I(0)I(1) CC&TCC&T PR0. 3841. 320-7. 929*-8. 844* CS-1. 234-1. 671-15. 758*-15. 374* FL-0. 787-0. 253-14. 954*-14. 540* CR-0. 381-1. 332-7. 203*-9. 681* LD-0. 981-1. 537-7. 260*-9. 434* SD0. 5411. 214-9. 839*-10. 063* *, **, *** indicates significance level respectively at 1%, 5% and 10%. Source: Authors’ estimation. 5. 2. Analysis
With the application of OLS method, we run the helm of affairs of the capital structure on the extent of financial leverage and the profitability and other control variables of the company with the intentions to look into the matter whether these variables contain considerable illustrative authority. The anticipated outcomes are documented in Table II. It is simply verifiable from the data depicted in the table that the approximated value of the R-squared is just about 0. 60. This shows that the capital structure of the company is determined by these variables together.
It confirms that not more than 60% of the discrepancies in dependent variable (CS) are elucidated by the specified independent variables. . . . . . . . . . . . . . . . .. . . On the subject of the importance of specific variables, the observed end results are a sign of the firms’ capital structure is too extensively associated in a downward manner with profitability, short term debt and current ratio. Hence empirically, degree of financial leverage, short term debt and long term debt significantly has an effect on the capital structure.
Coefficient of financial leverage is greater than both other significant variable which shows that degree of financial leverage is more effective than current and non-current liability to explore capital structure. Current ratio and profitability shows insignificancy with capital structure and we do not come across a great deal evidence that this connection is important statistically. The value of prob (F-Statistics) 0. 00017 shows that the combine affect of all variables on our model significant and shows that our overall regression model is good. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . Table II: OLS METHOD VariableCoefficientStd. Errort-StatisticProb. C10. 055431. 9216135. 2328070 LOG(FL)0. 6618750. 3022082. 1901340. 0385 LOG(CR)-0. 1278880. 338757-0. 3775220. 7091 LOG(LD)0. 1508280. 0640362. 3553450. 027 LOG(SD)-0. 5257760. 148223-3. 547190. 0016 LOG(PR)-0. 1152810. 257527-0. 4476470. 6584 R-squared0. 619141 Mean dependent var 5. 043901 Adjusted R-squared0. 539796 S. D. dependent var 0. 901946 S. E. of regression0. 611865 Akaike info criterion 2. 032248 Sum squared resid8. 985102 Schwarz criterion 2. 312487 Log likelihood-24. 8371 F-statistic 7. 803095 Durbin-Watson stat1. 043397 Prob(F-statistic) 0. 000177 Hereafter, it can be finished that despite the fact that the company’s degree of financial leverage and short term debt explore capital structure more but there is insignificant effect of short term debt. As a result, it can be securely assumed that in chemical industry of Pakistan, financial leverage and current and non-current liability of companies is important in carrying out any drastic variation in their capital structure. . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . .. . Bibliography •Arun Upneja and Michael C. Dalbor. An Examination of Capital Structure in the restaurant industry. International journal of contemporary hospitality management 13/2 (2001) 54-59. •BOOTH, L. ; AIVAZIAN, V. ; DEMIRGUC-KUNT, A. e MAKSIMOVIC, V. Capital Structure in Developing Countries. The Journal of Finance. v. LXI, n 1, Feb 2001 •BREALEY, R. A. e MYERS, S. C. Principios de Financas Empresariais. Lisboa: Ed. Mcgraw-Hill de Portugal, 1992. •Chiang Yat Hung, Chan Ping Chuen Albert, Hui Chi Man Eddie.
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