The Impact of Equity Ratio on Firms Financial Performance - Research Proposal Example

THE IMPACT OF DEBT/EQUITY RATIO (LEVERAGE LEVEL) ON FIRM'S FINANCIAL PERFORMANCE: EVIDENCE FROM EMERGING MARKET, SAUDI ARABIA AIMS AND CONTEXT OF PROJECT The Kingdom of Saudi Arabia was founded in the year 1932 and is the largest country in the Arabian peninsula. Besides, it is also the biggest economy in the G.C.C. region and have undergone tremendous transformations in the recent years from being a agricultural dominant society to global economic power equipped with all the modern infrastructural facilities (Research and markets, 2009). Being the world's largest producer of petroleum, it is the integral part of Saudi Arabia's economic system. The kingdom have undergone diversification of its economy and thus producing and exporting different type of industrial goods to most of the countries across the world. The initiates taken by both the government and the private sector players have promoted the investment opportunity in Saudi Arabia by creating effective partnerships with the Saudi Businessmen in effort to bring newer industries or modern technology to the country. Added emphasis is being given on attracting the infrastructure promotion and power generation but the investments made in these sectors are yet to exhibit the financial attractiveness in it. The existing capital investment from foreign institutions specifies three conditions (U.S. department of Commerce , n.d. ), 1. The initiative must be a "development project. 2. A technology transfer component must be explicitly included in the investment. 3. A minimum of 25 percent share would be held by the Saudi partner. The Saudi Arabia is a rapidly growing region among Arab countries and hence the empirical evidence gained from the choice each firms make on their capital structure (Leverage ratio) could be used to gauge their financial performance in the emerging scenario. This aspect as been considered on the reason that detailed and more exhaustive studies are needed to make valid conclusions on the best capital structure for any company (Rajan & Zingales, 1995, Harris and Raviv, 1991). Further, a few researchers have alos raised an opinion of the influence of organizational characteristics on the corporate leverage level, thus making this research more valid (Fan et al., 2004; Hall et al., 2004; De Jong et al., 2007). Thus, in order to understand the better performance of business organizations in the emerging market the criteria it is proposed to adopt the debt / equity ratio as the most appropriate parameter. Further, Saudi Arabia has a highly conservative financial market where the interest from debts is considered as illegal. Thus this creates a situation of very low leverage. Thus as companies have decided to undergo the process of financial planning the present approach would be turned from the debt to be linked more to equity approach. Thus this study could open newer vistas of academic research in the area of financial planning for the companies and proposing better investment options. 2: CONTRIBUTION TO KNOWLEDGE & STATEMENT OF SIGNIFICANCE The topic of capital structure is very important considering the potential of investment that the Saudi Arabian companies claim to have. The leverage signifies the amount of the debt securities the is issued by an establishment in event of the capital requirement. Hence, the extend of leverage that the firm carries in its capital structure is very important to understand the exact picture of financial performance. Thus the uncertainty of future profitability would loom large as the company would have to make regular interest payments besides the principal repayment. While the increased use of debt would result in a higher value of debt to assets ratio which explains the proportionate amount of fund the firm have borrowed with respect the assets owned by it. Thus the leverage or debt/equity ratio highlights the profits for a firm with positive earning while exposing the loses for a firm with negative records in earning. Thus in the research would help to evolve an appropriate framework for analysing the financial performance in the high investor friendly scenarios as existing in Saudi Arabia. 3: LITERATURE REVIEW AND CONCEPTUAL FRAMEWORK The economists have recently started paying major attention to the structure of the capital base in a business firm as a parameter for analyzing the investment rate. From the earlier attempts of financial research, Modigliani and Miller (1958) have categorically stated, "the average cost of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a pure equity stream of its class." These propositions were made on various assumptions. Absence of corporate income tax, well performing capital market, low cost in transactions are the major assumptions made in this process. Another observation that has been made is the increase in the interest rate on debt in line with the rise in the debt-equity ratio of the levered firm. The cost of capital could remain cost as it is often estimated as the weighted average of cost of debt and equity. Such a situation can be anticipated when a higher dependance is on debt which is the cheaper source. Thus, if the chances for any damage could be suitably ignored, it could ensure a consistency on the cost of capital and would remain profitable due to the lower interest rate of debt much less than the equity capitalized value of unlevered firms. It is observed that when the rising average cost of capital is in tune with the rational arbitrage operations when the risks from damages are taken into account. Also, when the earning expected from earnings is assumed to be independent of capital it is equivalent of considering an occurrence of bankruptcy. The influence of the four hypothesis namely -passive informant, active informant, financing, and stock market pressure, on the stock returns on investment have already been researched in detail (Bolbol and Omran, 2005). The study was undertaken from 83 firms in the Arab region and showed that sales and debt growth are the basic determinants of the capital expenditures and used passive informant hypothesis for this purpose. It was observed that the cash flow had no effect on investment and it was mostly from the dividend policy of Arab financial establishments. Saudi Arabia, one of the largest stock markets among the gulf countries liberalized its policies to allow the foreign financial institutions to enter into investment schemes. In this connection, another study was undertaken to assess the prevailing relationship between the stock returns and variables in the emerging markets in Saudi Arabia using a test period ranging from 1994 to 2004. The significant attention on the Saudi stock market was based on the stock market characteristics like was gained the increased capitalization, high liquidity, and return on investments. Another development in the analysis of capital market was Pecking Order theory (Myers, 1984) which critically examined the future impact of debts and equity issues for a firm. According to this theory, the firms shall consider all the financing methods available and the least expensive nee to be chosen. This also gave a framework for financing new projects according to which the internal equity shall be considered first followed by debt and finally external equity. The signaling theory in financial management says that the equity holders collectively shares the risk in investment while the sharing of wealth is eliminated in the debt issue. Contrary to this, the tradeoff theory suggest that if the firm could opt for the debt if they are able to claim high amount of tangible assets and could opt for equity if significant portion of its assets are intangible (Harris and Raviv, 1990). Further, the Trade off theory understands the advantages offered for the tax liability in spite of the large threats from the bankruptcy. A comparative study undertaken over large period spanning from 1971 to 1998 have shown that when ever internal financing was inadequate to cover the investment the external sources was depended on and equity financing was comparable to debt financing also thus contradicting the Pecking Order theory (Frank and Goray, 2003). And the research undertaken on the capital structure also revealed that the large firms are not worried about the bankruptcy and considered the issue of common stock as the most cheapest and used all means to issue them (Bancel and Mittoo, 2004). Earlier studies have shown that the manner of proportioning the debt and equity in connection with the capital structure of the firms remains ambiguous. The industries classified under similar sector have often have different levels of debt - equity ratio. The earlier theories fails to establish the reason behind the high profitability of conservative companies than the leveraged firms. Thus the researchers have proposed that the optimal capital structure of a firm is often dynamic in nature and justifies that this is the prime reason behind the high variability in debt ratios across companies under similar industrial sector (Welch, 2004). The high technological companies with higher quantities of intangible assets is said to opt for less debt than those with significant tangible assets. Thus it is obvious that the existing information on the capital structure is inadequate to give valid conclusions especially in Saudi Arabian situation. The research would bring out significant outcomes that could be used in the analysis of capital of structure and linking them with the financial performance of the firms. 3. APPROACH AND METHODOLOGY The selection of an appropriate research tool to address the proposed research is the most vital step in any business management investigation. This section gives adequate emphasis on the ability to understand the characteristics of the data and the techniques required to collect them. The primary objective of the data collection exercise is to generate adequate information to understand the investment strategies taken by various institutions in Saudi Arabia and the impact of Debt/Equity ratio on the firms performance. The data collected through this exercise is broadly divided into two classes - primary and secondary information. The primary information refers to the direct information collected from the samples selected or chosen for the data collection process. This is carried out using either structured or unstructured interviews, discussions, questionnaire survey etc. The outcome from such exercises would result in huge volume of qualitative and quantitative information for analyzing the research objectives.. The quantitative information refers to the statistical information and the qualitative approach would relate on the broad aspects or the qualitative details about the target information. . Quantitative information is collected for establishing precise answers to the observed behavior of the sample. The results of the analysis could be represented as numbers, percentages, mean value etc. The qualitative information would be of significant advantage to understand the situation, thoughts, opinions or circumstances (Remenyi et al, 2005 ; Creswell, 2003). The secondary information, on the other hand, is collected from the already published information by judiciously choosing the most relevant aspects from the available literature or documents. The either approaches adopted in the whole process must ensure the desired level of consistency in the information collected (Saunders et al, 2000). The initial data collection exercise would be undertaken using email to all the senior mangers for the obtaining their vision on the current strategy being followed in investment promotion. Atleast 30 institutions in diverse sectors of different operational scale are chosen for the collection of responses. In addition, the responses from industrial units, agriculture and related sectors would also be included for the data analysis segment. The information collection would focus on the issues faced by the establishments on attracting the investments and also the current pattern of the choice of the investors. In addition to the parameters related to the capital structure the investment categorization into the long term and short focus on different sectors that need financial support is also included. Further, how the public issue of bonds by different institutions is being preferred by the common public is also included in the data collection programme. The preferences shown in the selection of publically issued bonds would give the clear idea on the nature of capital structure influencing the investment. In addition to the online mode of data collection, personal interviews and discussions shall also be held as part of he survey process. The major source for the secondary information is the reports and publications from Ministry of Saudi Arabia. These documents contain wealth of information on the process of consolidation and the expectations from the economic reforms in this country. In addition, the annual reports from the individual establishments and companies would also be able to provide wealth of information that could supplement the research significantly. REFERENCES Bancel, F and Mittoo, U. (2004), Cross-Country Determinants of Capital Structure Choice: A Survey of European Firms, Financial Management , 33(4) , pp 103-132. Bolbol, A.A. and Omran, M.M. (2005), Investment and the stock market: evidence from Arab firm-level panel data , Emerging Markets Review, 6(1), pp 85 - 106. Creswell, J.T. (2003). Research Design: Qualitative, Quantitative, and Mixed Method, Thousand Oaks, CA: Sage Publications. De Jong, A., Kabir, R., and Nguyen, T. T. (2008), Capital Structure around the World: The Roles of Firm- and Country-Specific Determinants, Journal of Banking & Finance, 32 (9), pp 1954 - 1969 DeAngelo, H. and Masulis, R. (1980), Optimal Capital Structure Under Corporate and Personal Taxation, Journal of Financial Economics, 8, pp 3-29. Fan, P. H. J., Titman, S., and Twite, G. J. (2008), An International Comparison of Capital Structure and Debt Maturity Choices, SSRN, ID: 423483; Frank, M. and Goray, V. (2003), Testing the Pecking order Theory of Capital Structure, Journal of Financial Economics 67, pp 217-248. Hall, G., Hutchinson, P and Michaelas, N. (2004), Determinants of the Capital Structures of European SMEs, Journal of Business Finance and Accounting, Vol. 31, No. 5&6, pp. 711-728. Harris, M. and Raviv, A. (1990), Capital Structure and The Informational Role of Debt, Journal of Finance, 45,pp 321-349. Harris, M. and Raviv, A. (1991), The Theory of Capital Structure, Journal of Finance, 46 (1), pp. 297-355. Hatch, J.A. (2002). Doing Qualitative Research in Education Settings. University of New York: Albany, NY Modigliani, F. and Miller, M. H. (1958), The Cost of Capital, Corporate Finance and The Theory of Investment, American Economic Review, 48, 261-297. Myers (1984), The Search For Optimal Capital Structure, Midland Corporate Financial Journal, 1, pp 6-16. Rajan, R. G., & Zingales, L. (1995). What do we know about capital structure Some evidence from international data. The Journal of Finance, 50(5), pp 1421-1460., Remenyi , D., Willliams, B., Money, A., Swartz, E., (2000), Doing research in business and management, Sage publications, London. Research and Markets (2009), Kingdom of Saudi Arabia : Industrial Sector Overview 2009 [Online] Available at [Accessed on 3 October 2009] Saunders, M., Lewis, P. and Thornhill, A. (2000) Writing your research proposal, Pearson Education. U.S. department of Commerce (n.d. ), Saudi Arabia Investment Climate, [Online] Available at [Accessed on 3 October 2009] Welch, I. (2004), Capital Structure and Stock Returns, Journal of Political Economy, 2004, 112 (1), pp 106 - 131 Read More