J. Appl. Environ. Biol. Sci., 7(9)1-7, 2017 ISSN: 2090-4274 Journal of Applied Environmental
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1Associate Professor, Department of Sociology, GC University Faisalabad, Pakistan 2Assistant Professor, School of Management Studies, The University of Faisalabad, Faisalabad. Pakistan 3MS, School of Management Studies, The University of Faisalabad 4CEO, BFL Consultants, Faisalabad”
Received: April 13, 2017 Accepted: July 17, 2017
An efficient capital structure will increase the profitability of a firm. The current study aims to find out the impact of capital structure on the economic gains of the firms. Textile listed companies situated in Faisalabad city of Pakistan are taken for this purpose. Data was collected from secondary sources which includes the income statements and balance sheets of the said companies. The study applied Hausman’s fixed effect model with software E-Views 7 to obtain the results. The results found that the debt (both short-term and long-term) and the return on assets (ROA) of the companies are significantly negatively related. Similarly, the debt to equity ratio is significantly positively related to the return on equity (ROE) of the companies. The study suggests improving the capital structure of the textile sector by keeping in view the ratio of debt and equity. KEY WORDS: Textile, Hausman, fixed effect, significant, Return of assets.
Capital is defined as the portion of wealth which is solely used and invested in a business to generate more wealth and cash flows for the business [1]. A firm’s first and foremost step is to answer the question; how to finance its operations, whether with equity or debt. Capital structure is the mix of certain liabilities which are long-term liabilities (common shares, preferred shares, reserves, debentures, long-term debt etc) and short-term liabilities (bank draft, short-term loan and trade creditors etc). So one can conclude that the capital structure of a company is the composition of its long-term and short-term liabilities [2]. It is worthy to mention that responding to the question “how companies should choose the capital structure?” is very important in corporate finance. Finding the capital structure has been a focus point for a number of financial institutions. The above decision also has a strong impact on how a company competes in a competitive market [3]. The Capital structure is also considers very important in determining the level of risk of the firm [4]. Fixed cost is crucial factor either it is present in the process of production or financial fixed charges. It should be maintained at a low level if the managers are likely to enhance the shareholders wealth. The assets of the company are financed by the loaner (debt provider) or the owner (equity Provider). The share holders will demand dividends and capital increase in their shares and the debt providers will ask for the profit on the money they have lent to the company [5]. Firms can use either equity or debt to finance its operations. The best option is to use the blend of equity and debt. In the situation when interest do not provide tax shield, owners of the firm would be indifferent to use debt or equity. In the situation where interest provides tax shield then they can put maximum debt into the capital structure to get maximum benefit [6]. The more and more use of debt in the capital structure may lead to the agency cost. Agency cost happens because of the conflicts of interests of managers and the owners. Agency cost may happen also because of the relationship between debt providers and the shareholders [7].
“Pecking Order Theory” tells that companies are ready to offer its equity when it is overvalued in the market. This is backed by the assumption according to which managers of the company act in the interest of shareholders. On the other ha managers say no to issue undervalued stocks. Hence shares will only be issued when its issuance will increase the value. So investors may take the issuance of stock as overpricing. The researcher came up with the result that if the external funds are unavoidable then the firms try to go for debt financing first. If more funds are required then they will issue equity at the last [8]. The current study aims to examine the capital structure in the textile sector of Faisalabad, Pakistan. The study attempts to calculate the impact of capital structure in economic gains and value addition of a firm. It is expected that the study will help the financial managers to design the capital structure with maximum efficiency. The study intends to analyze the impact of short-term debt, long-term debt and debt to equity ratio on the performance of the textile industry of Faisalabad, Pakistan which are listed on KSE-100 index.
*Corresponding Author: Dr. Babak Mahmood, Associate Professor, Department of Sociology, GC University Faisalabad, Pakistan, babakmahmood@gmail.com.
Mahmood et al.,2017
The economic and industrial growth of an economy need the supply of funds and capital market is one of the important suppliers of funds. A growing economy needs the investment in the infrastructure. The efficiency of capital structure in a firm or an economy may always bring positive changes [9]. Although the relationship between capital structure and economic growth is not linear because increase in tax rate may enhance the availability of funds for public expenditures but it will reduce the return on capital in private sector [10]. The decisions of new investment may or may not depend on the capital structure policy as the issue is still unresolved but it is fact that capital structure brings changes in the GDP of an economy. The capital structure that maximizes the value of a firm is extremely important [11]. The primary concern of a firm is to maximize the profit so increase in corporate or personal taxes may shrink the profit and making the capital less profitable at one hand and may reduce the future private investment at other.
Numerous researches have been done on the choice of capital atructure decision and its impact on profitbility. Each work includes influential variables that can change the value of the company and provide criterias to examine the optimal levels of capital structure which are discussed below. The theory of “capital structure irrelevance” developed by [12], concludes that financial debt does not influence the firm market value with the assumptions which include perfect capital markets, related to homogenous expectations and no taxes. According to [12] because of tax shield companies prefer more debt to equity ratio which includes that companies having high profit rates would go for a high leverage to get more and more tax shields. Similarly, [13] proposed “we find very few proofs that firms follow norms made by industry regarding capital structure. Managers use ratio of debt or equity for strategic reasons such as to pressurize employees or to motivate them to work harder”. [14] proposed that profitability of the firm depends upon the selection of debt and equity ratio in capital structure and cost of capital has to be as low as possible as it has an inverse correlation with the performance of the company. According to [3] there is a difference between a debt ratio subjected on market value and debt ratio subjected on book value. Because the debt ratio subjected on market value tends to offer the future prospective of the company and the debt ratio subjected on book value tends to put some light on the past situation of the company. So it is very important to select the particular data in a study. Decisions regarding capital structure may put vital implication for the value and company’s cost of capital [15]. Wrong capital structure decisions may drive to more cost of capital which may decrease the net present value (NPV) [16]. Accurate capital structure decisions at the right time lead to lower the firms overall cost of capital and increase the NPV of investment. This will lead to get more projects which will result in increased value of the firm [17]. According to the study conducted by [18], it was concluded that the heavy usage of leverage brings the more probability to go bankrupt. The reason behind this result is because the debt provider expect and demand more return on their investment which is also called risk premium. He further stated that companies should not deploy the leverage more than the amount at which debt have more cost than the advantages acquired by the tax shield. Similarly, [19] build a model that produced the modern theory regarding the optimal capital structure. They argued that there is a strong and positive relation between the company’s level of debt and the tax shields. [19] proposed that it is found that debt ratios caused decrease in cash flows and turnover while these ratios caused increase in the investment of the firms. The study is positively attached with the “Pecking Order Theory” and is generally contradictory with the tradeoff theory. A very important study was conducted by [20] which recommended that leverage may have a dual affect either positive or negative influence on the firm’s value even in the absence of bankruptcy risk (cost) and corporate taxes. He introduced a model according to which financing through debt may both improve the problem of overinvestment and the problem of underinvestment. He further continued that as the managers do not own the firms and get paid for managing its affairs. The power of manger is that they may drive themselves to the self interested behavior and would go for to take the projects with negative present value. To solve this issue, shareholders may force the managers to have more debt ratio in capital structure. The problem with this solution is that if firms would be required to pay out funds like cost of debt then they would forgo positive present value projects. For this reason the optimal capital structure is determined by balancing the cost of managerial diplomacy and the optimal agency cost of debt. A dynamic trade-off model was integrated by [21] by taking into the consideration of the choice of leverage, real investment and distributions in the occurrence of a corporate income tax, corporate distributions and individual taxes on interest. The study elaborated various observed findings not in agreement with the trade-off theory and
J. Appl. Environ. Biol. Sci., 7(9)1-7, 2017
shows that there is no optimal and aimed debt ratio. Companies may be heavily levered and leverage differs negatively with an outside finance weighted average. Two different theories related to the relation between capital structure and profitability were offered by [22]. The first is the Static Trade-off theory which reveals that a company debt ratio has a great importance in capital structure. The target debt to equity ratio is calculated by a cost and benefit analysis on various levels of debt ratio. Basic factors investigated comprise the Agency Cost, tax impact and cost of financial distress etc. The determinants of company capital structure were discussed by [23]. These are profitability, opportunity of growth, size and tangibility. They used the panel of 33 Large Nigerian Non Financial Companies. The results of this study demonstrated that tangibility, size of the company and profitibility are directly related to long-term debt and total debt. However opportunities of growth are inveresely related with total debt. The Researcher further told that the decisions regarding how to finance in the large companies of Nigeria can be best explained by the suggested determinants in Trade-off theory. Regression Analysis was deployed to find the results It was proposed by [24] that capital structure is a financial device that directs to determine ‘how do firms choose their capital structure? “Financial Performance and Capital Structure are positively related and hence debt has significant impact on financial performance of the firm”. Correlation Analysis and Regression Analysis were carried out to interpret the results. Pooled Regression Analysis, Chow’s Test and Augmented Dicky-Fuller Test were used by [25] used to take the results. The results of the study revealed that financial debt is directly proportional to the profitability of the firm. The study found that rise in profitability is positively related with the firm size. An increase in liquidity ratio leads to an increase in firm’s profitability.
THEORETICAL MODEL
The study used the panel data taken from the income statements as well as the balance sheets of the selective firms. For this purpose the fifteen firms situated in Faisalabad and listed on Karachi Stock Exchange were taken into consideration for five years (2011-2015).
The following variables were selected based on the previous literature.
Independent Variables Dependent Variable
Source: Author’s own contribution
The model has taken Return on Equity and Return on Asset as dependent variables. Short-term Debt, Long-Term Debt and Debt to Equity Ratio have been taken as independent variables. These all analyses have been done by the software E-Views 7.
Two equations were developed to analyze the data
Mahmood et al.,2017
The results are presented into two different sections. First section represents the results with the help of descriptive statistics in the table 1 and in second section the results are discussed using Hausman’s fixed affect model in table 2 and table 3.
Fundamentally, descriptive statistics makes use of numerical and graphical techniques to interpret the patterns existing in the data set. Usually, it precise the information pertaining in the data set by exposing the average indications of the variables and offers this information in an easy way to understand [26]. Same as discussed in the earlier chapter, fifteen textile companies are considered for this work. Table 1 demonstrates the descriptive statistics for the variable which are used in this work.
Table 1: Descriptive Statistics of Performance Indicators
ROE | ROA | STD | LTD | DE | |
---|---|---|---|---|---|
Mean | 0.305200 | 0.026773 | 0.431667 | 0.267240 | 7.891867 |
Median | 0.260000 | 0.040000 | 0.410000 | 0.160000 | 6.270000 |
Maximum | 3.290000 | 0.170000 | 0.720000 | 1.310000 | 18.55000 |
Minimum | -2.510000 | -0.170000 | 0.120000 | 0.010000 | 0.640000 |
Std. Dev. | 0.851273 | 0.071352 | 0.169778 | 0.267287 | 4.725078 |
Skewness | -0.028589 | -0.745737 | -0.077779 | 1.683604 | 0.579401 |
Kurtosis | 5.378798 | 3.548541 | 1.861979 | 5.716508 | 2.074406 |
Jarque-Bera | 17.69359 | 7.891847 | 4.122780 | 58.49220 | 6.873585 |
Probability | 0.000144 | 0.019333 | 0.127277 | 0.000000 | 0.032168 |
Sum | 22.89000 | 2.008000 | 32.37500 | 20.04300 | 591.8900 |
Sum Sq. Dev. | 53.62527 | 0.376743 | 2.133017 | 5.286738 | 1652.151 |
Observations | 75 | 75 | 75 | 75 | 75 |
Source: Calculated by using E-views
Table 1 demonstrates that over the period of five years from 2011 to 2015 the ratios regarding profitability which were measured by Return on Equity (ROE) and Return on Assets (ROA) subject to the value of 30.5 % and 2.6 % respectively. The deviations in the values of companies are quite reasonable which can be seen from the maximum deviation and minimum deviation values in the above table. This scenario advocates that these textile companies situated in the Manchester of Pakistan are performing quiet well during the selected time period. The ratio of Return on Equity displays that how management is being successful to make the company’s operations efficient resulting in the increase in the value of share holders. When the researcher talks about the independent variables, the debt ratios show interesting outcomes. Between the selected time period limits, the ratio displaying short-term debt to total asset averaged 43.2 %. On the other hand the ratio displaying long-term debt to total assets averaged to 26.7 %. This is a signal that about 70% of the total capital of textile companies situated in Faisalabad is financed by the debt. So we conclude fact that these textile companies are aggressively leveraged companies. Another point of attention is that almost 43 % of these debts are short-term debts which also indicate the reality that textile companies situated in Faisalabad comparatively rely more on short-term debt to finance their activities when we compare it with the long-term debt as it was demonstrated by [2] and [27]. This tendency of textile companies towards short-term debt financing may be because of under developed and immature nature of long-term debt markets (capital markets) which creates some hurdles for the textile companies of Faisalabad to attain long-term debt financing.
J. Appl. Environ. Biol. Sci., 7(9)1-7, 2017
Now the researcher starts by disseminating the correlation existing between the variables in the following tables. With each correlation result between the variables, plus and minus signs shows the direction in which they relate with fraction times and whether they are statistically significant or not, at accuracy level of 5 %.
Table 2: Hausman Fixed Effect Model (ROE as Dependent Variable)
Variable | Coefficient | Std. Error | t-Statistic | P-value |
---|---|---|---|---|
C | 1.866150 | 0.309719 | 6.025294 | 0.0000 |
STD | -4.629911 | 0.693183 | -6.679209 | 0.0000 |
LTD | -0.719258 | 0.377227 | -1.906698 | 0.0616 |
DE R-squared | 0.084979 0.843686 | 0.016693 | 5.090573 | 0.0000 |
Source: Calculated by using E-views
The above Hausman fixed effect model a significant but negative relationship between the return on equity and short-term debt. One unit Increase in short-term debt leads to 4.68 units decrease in Return on Equity with the t value -6.68. There is an insignificant but negative relationship between long-term debt and the return on equity. On the other hand Debt to Equity ratio has a significant and positive relationship with the return on equity. A unit increase in debt to equity ratio brings 0.08 units increase in return on equity with the t value 5.09. R-Squared value suggests that 84% change is brought by said independent variables. The remaining percentage of change has been happened by some other variables which are not included in this study.
Table 3: Hausman Fixed Effect Model with Dependent Variable ROA
Variable | Coefficient | Std. Error | t-Statistic | P-value |
---|---|---|---|---|
C | 0.258757 | 0.030756 | 8.413259 | 0.0000 |
STD | -0.402580 | 0.067577 | -5.957387 | 0.0000 |
LTD | -0.233721 | 0.056992 | -4.100930 | 0.0001 |
DE | 0.000539 | 0.001415 | 0.381161 | 0.7045 |
R-squared | 0.820416 |
Source: Calculated by using E-views
The above Hausman fixed effect model shows that there is a negative but significant relationship between Short-term Debt (STD) and Return on Assets (ROA). One unit increase in Short-term debt leads to 0.40 units decrease in Return on Asset with the t value -5.96. Similarly there is a significant but negative relationship between Longterm Debt (LTD) and the Return on Assets (ROA). A unit increase in Long-term Debt brings 0.23 units decrease in Return on Assets with t value -4.10. On other hand there is a positive but insignificant relation between Debt to Equity ratio (DE) and Return on Assets (ROA). R-Squared value suggests that 82% change is brought by said independent variables. The remaining percentage of change has been happened by some other variables which are not included in this study.
The study analyzed the impact of capital structure and the profitability of the textile listed firms listed on the. The results of the study an inverse relationship between short-term debt and performance variables of the company (ROE and ROA). Similarly it was found that long-term debt inversely relates to the performance variables of the company (ROE and ROA). On the other hand as for as debt to equity ratio is concern, the study found a positive relationship with performance variables. It indicates that the increase in debt portion compared to equity portion in the capital structure would increase the value of the company.
Mahmood et al.,2017
The study suggests that the companies should avoid having excessive short-term debts to enhance the value of the companies. Similarly the companies should avoid the long-term debts to increase the value of the companies. Moreover, the companies should finance its operation with greater debt to equity ratio.
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