Research Proposal

Title:
Impact of capital structure on firms Financial Performance.

Introduction:
For doing successful business internationally the decision about the capital structure is more
important. This Impact directly on business because the right utilization about resource is more
important than to decide how to get finance. The capital structuring decision of a business
depends upon the different factors e.g. (economic factors, social factor). For example if the
country where the business is going to start is not a tax free zone the equity financing is not a
good decision because the tax will be deducted multiple times. So the healthy decision is
compulsory for getting success.

When Chinese companies will invest in Pakistan what structure they should adopt and on which
basis. What factors they should considers important for doing successful business?

Central Issue:
Is there only capital structure impact on financial performance of a business?

LITERATURE REVIEW

In the today’s competitive environment of business world, it has become debating concern to
decide how to finance the business operations? According To Nirajini And Priya ,(2013) the
owner and loaner can finance the assets of any business. Every business is trying to get
maximum profit to strong its financial position in the competitive market place. The firm’s
financial strength depends on its financing decision. Maximization of profit is also primary goal
of every business. This objective is achieved by the strategic decision making of managers of
that firm. The managers primarily decide, how to raise funds for financing and how it will be
utilized to generate high volume of profit? How to raise funds for financing is very crucial
decision for the managers. Before deciding the source of financing, managers must keep in mind
the cost of capital, risk level and its required return. If the cost of capital is high, then its return it
will lead to insolvency and bankruptcy). According to Mirie and Edwin Maranga ,(2015) the
firm’s financial position is judged by the position of shareholders that how much better position
at the end of period then beginning. Financial performance measures are grouped into following
categorize (liquidity, solvency, profitability, repayment capacity and financial efficiency). In
2009, Budhanwala said, the business must have to plan its capital structure in such a way that
promote the growth because the risk and return of shareholders are dependent upon the decision
about the capital structure or financing and this decision also affects the market share. The two
major sources of financing are.

 Debt financing
 Equity financing

In 2014, Chechet and Olayiwali said, to carry out its activities firms need fund either it is
ongoing or newly born. And that fund is called capital. Capital structure is the mixture of debt
and equity and having the direct effect on the financial performance of the firm. According to
Akinsulire (2002) reserve of money that is owned by enterprises or individual which is invested
time to time for the purpose to earn money is called Capital. According to khan (2011), the
financial term capital structure refers to the way of financing their assets by firms the mix of
equity and debt or hybrid securities. In 2013, Nirajini and Priya said the proportionate between
equity (includes paid up capital, all reserve, surplus) and debt (long term and short term)
represent the capital structure. (Abor ,2013) stated that the definite combination of debt and
equity of a firm that it uses to finance its assets called capital structure.

According to Nirajini & Priya (2013) To determine the risk level of the company, capital
structure plays vibrant role. The two major sources of financing for any business are debt and
equity. The firms decide to select that source or combination of sources which is not only
cheaper but also maximize the value of firm and return of shareholders. According to Ong &
Teh, (2011) financial framework of any business that entails equity and debt which is used to
finance the business operations referred as capital structure. The both way of financing keep
some advantages and disadvantages. Previous researches shows that Debt financing have
positive effect on financial performance. Because Bond holders have the lesser control in
decision making of firms. Debt financing is also having advantage of reducing the agency
problem. According to Gitman (2003) the inexpensive financing choice is debt then equity. The
debt holders bear less risk than equity holders and also have first claim on the assets. Debt
holders interest may also have protected through the institution of loan agreements. They are
rewarded through interest payments and usually claim on some collateral as security for the loans
they provide. According to Opler and Titman (1994) it was found that in the situation of
industry recession high geared firms which was enjoying the high profit, lose the market share
then their competitors which are low geared. It was due to the high interest and agency cost there
is an inverse relation. If firms that only rely on equity financing having low leverage ratio and
conservative capital structure but equity financing is the sale of real ownership which also cause
the agency problem. And if the firms rely only the debt financing. It just gives advantage of tax
shield with high interest payments such firms have high leverage ratios and aggressive capital
structure. Mohohlo stated the individuals who are the real owner of the business and also bear
the most of risk associated with their financing but have the residual claim to the assets of the
firm are called equity holders. Mohohlo said the real owners (equity holders) of the business are
rewarded for their financing primarily through the receipt of dividends and some instances
through the appreciation of the value of their stock. (Mujahid and Akhtar ,2014) said that
mangers make decisions of financing according to capital structure theories to increase the worth
of equity of shareholders. There are a number of studies conducted for understanding the capital
structure. But for the purposes of this study we will review some important of them.

MM Theory:

Modigliani and Miller presented a theory of capital structure which is also called the theory of
irrelevancy. They proposed some assumption, if those assumptions are absent the value of firm is
dependent on the return and risk of their operation and capital is irrelevant to the value of firm.
And if those assumptions are present then value of firm is relevant to the capital structure.

The assumption presented by Modigliani and Miller are following.

No transaction cost

No agency cost

No bankruptcy cost

Free access to all information

Perfect market situation

But in real sense these assumptions not exist. No perfect market situation exists, every country
has taxation policy, mostly business bear transaction cost. (Younus et.al 2014) defined that firms
market value is not affected by its capital structure, if some assumption that are given by MM
theory. (Cyril, 2016) stated that (MM) given following assumption of theory (Perfect market
where free access to information, No taxation, No transaction cost).

At all capital structure level or any choice of financing internal and external funds are perfectly
substituted. And firms are dependent only on the return and risk of its operations but not on its
financing choice. Then the firm’s capital structure is irrelevant to its market value. If the
assumption can be relaxed, then firm’s value is relevant to its capital structure. And this theory is
criticized that perfect market situation does not exist in real world. (Njeri and Kagiri 2013)
stated that according to MM theory point of view capital structure plays critical role in
determining the value of firm. Mohohlo stated that the firm’s value is dependent on the quality
and productivity of assets in which firms invested. In perfect capital market it does not matter
how firms finance its assets. Under the proposed statement of MM theory, the value of unlevered
firm is equal to the value of levered firm, no matter what is the capital structure choice because
value of firm is dependent on its return.

Trade Off Theory:

(Scott, 1977) proposed trade off theory which is opponent to the pecking order theory. It states
that debt financing has an advantage of tax shield. Every business utilizes both ways of financing
(debt and equity). So this theory provides a way to structure its capital on optimum level by
balancing the cost and benefit associated with debt financing. Cost includes bankruptcy cost, cost
of debt, non-bankruptcy cost, staff leaving, agency cost etc. The business should utilize the debt
financing as the theory stated its advantages but on optimum level. When the businesses prefer
more to debt financing the marginal benefit decreases as the further debt is utilizing from its
optimum level and marginal cost increase. According to (Nirajini and Priya 2013) Miller stated
that personal tax on interest income decreased by attractiveness of debt. This theory deals with
the concept of financing cost of distress and agency cost. In 2015 Quan and Xia included in his
study according to (Miller 1977) businesses that have higher debt enjoy high profitability due to
tax shield. Haris and Ravi (1991) stated the agency problem between manager and shareholders
are decreased due to increase in debt financing. Because debtholders have concern with their
interest income not management issues, firm has to pay cost either they succeed or fail in
generating profit. Mujahid and Akhtar (2014) include in his study (Saleem 2013) argued that
retaining the balance between the benefits and cost associated with the debt will result in
optimum capital structure. The benefit associated with debt financing is the tax shield on income
and decrease in agency problem by retaining the ownership in one hand. In 2013 Njeri and
Kagiri added in his study (Myers, 2011) stated the firm should use the debt financing up to the
point where the increased NPV of possible cost of financial distress is off set by the marginal
value of tax shield on additional debt.

Pecking Order Theory:

The pecking order theory is universalized by Myers and Majluf (1984). They argued that
asymmetric information about firm caused the increase financing cost. The agent (managers) of
principles that contain more information about the company when issue shares, the investors
think that the business is overvalued and managers are trying to get benefit by issuing shares so
they prefer less to equity financing.

In pecking order theory there is hierarchy of funds for financing the operation of firms.

external(equity)
external (debt
financing)
internal funds (retained
earning)

(Myers and Majluf, 1984) communicate pecking order theory. This theory deals with two
concepts:

Primarily asymmetric information

Low cost of financing

It states that investors have no more real information as kept by the management about firms.
The firms prefer internal sources (retained earnings) for financing because it has almost no cost
of financing when firms issue share the investors think that firms in near future will share loss
that’s why it is issuing shares and also not in position to pay interest. In 2016, Ahmad and
Mohsin included in his study that (Fama and French, 2005) said the significant determinant of
pecking order theory is the unavailability of information. (In 2015 Mwangi and Birundub) said
that Myers and Majluf (1984) suggested in the pecking order theory that businesses prefer
internal funds (retained earnings) for financing rather external financing (debt and equity) and if
internal funds are not adequate then go for debt financing and in last for equity financing and it is
the last resort of financing. Younus et.al 2014 stated that according to Myers and Mjluf (1984)
firms do not follow the certain level of leverage rather it firstly prefer retained earning then debt
and last equity for financing.nAccording to pecking order theory the equity financing is last
resort for firms. Instead the retained earnings are in first preference for financing because it has
almost no cost of financing. Cyril in 2016 stated that retained earnings is very cheaper source of
financing but equity is very high cost source.

Agency Theory:

(Jensen and Meckling ,1976) proposed the agency theory by determining the problem between
owners and managers. They state that agency theory deals with two problems of organizations.
The conflict of interest and goals and to minimize the agency cost.

To minimize the conflict and agency problem and to motivate the managers to work with the
interest of owners bears the agency cost. Mohohlo stated that the conflict of interest between the
managers and owners are called the agency cost. Cyril 2016 stated that relationship which arises
individuals (owners) and (agents) called managers in order to perform some activities on behalf
of principle by keeping decision making power refers to agency theory. There is a prof to believe
that the manager will not act in the best interest of shareholders if he is utility maximizer. This
theory deals with the resolving of two problems between manager and owner relationship and
(Conflict of goals and interest, Agency cost) It is difficult to ensure that managers attitude toward
organizational goal is positive or negative. The other problem is that how to minimizing agency
cost because of different interest and attitude. Mwangi and Birundu 2015 said that the firms
that uses more debt financing option face less agency problems by paying excess cash in interest
paymnets. Younus et al. 2014 the shareholders or real owners delegate the decision making
power to agents called managers to run the business operations but the most manager in firms
prefer their self-interest on shareholders’ interest and this attitude of manager create agency
problem. Mujahid and Akhtar 2014 said that according to the agency theory the difference in
goal of managers and owners affect the market value and profitability.

The intention of conducting research is to examine the impact of capital structure on financial
performance of firms either positively or negatively. Except capital structure many other
variables affect the financial performance like political issues of country, technological factors,
state laws, economic uncertainty, natural disasters, trends of market but the capital structure
highly and directly affect the financial performance because these factors comes after the
decision about financing. A study conducted in Nairobi on the impact of capital structure and
concluded the capital structure has positive impact on financial performance. (Kamau and Kagiri,
(2013).

Method of Data Collection:

According to research needs the primary and secondary data is collected from the companies.
Because Research is based only one sector (sugar industry) so we collect data from annual
reports of listed sugar companies in KSE and also collects data from their finance executives
through questionnaire.

Statistical Tests:
Because this is a “Quantitative Research” and we are predicting relationship between variables,
here statistical test “Correlation & Regression Analysis”. Would be apply.
Model Frame work:

Return on Gross profit Net profit

Equity margin Margin

Return on Debt to total

Asset Assets

Interest Financial Debt to

coverage Performance Equity

Capital
Structure

Debt Financing Equity Financing