Effect of Capital Structure on Profitability in Thailand Firms - Literature review Example

The effect of capital structure on profitability: An analysis of listed firms in Thailand during period 2009 Table of Contents Literature review3 Optimal capital structure 4 Relationship between capital structure and profitability 5 Theory of capital structure 11 Reference List 15 Literature review According to Strebulaev (2007), capital structure has a vital impact upon profitability of a business. The term, capital, broadly refers to the amount of money invested in business for its start up. The capital raised by a firm through different sources is utilized for purchasing assets, making investments of different types, buying stock of raw materials and so on and so forth. Without availability of capital, it is not possible for a business to establish itself. The capital raised by an organization is generally used for investing in fixed assets such as, land, building, machinery and equipments as well as in different types of projects or other businesses for earning returns. Xu and Birge (2008) have stated that the capital is essential in a business so as to be able to develop business activities, initiate and continue production. By investing and acquiring different types of assets, a company can produce various types of goods and services. Through sales of the finished products and services, a firm is able to earn revenue. This revenue is utilized in order to provide returns to shareholders, pay interest on debt, make re-investments in the business, invest in new business proposals and acquire assets. It is important that a business firm is capable of earning sufficient revenue so as to provide timely and adequate returns to shareholders. One of the primary motives of conducting business is to maximize shareholder’s wealth. Utilizing capital in the most profitable and optimized manner is, therefore, necessary (Sogorb-Mira, 2005). Broadly, there are two types of capital; equity and debt capital. Equity capital refers to the capital that has been raised through the issuing of shares. The shareholders are required to be informed about general meetings of the company. They are also given voting rights during such meetings for making decisions. Shareholders are generally of two types; ordinary shareholders and preference shareholders. Preference shareholders are given primary preference while distributing dividends. Equity share capital also includes the retained earnings of an organization. Retained earnings are profits of the business from previous years and are shown in the balance sheet so as to strengthen its financial position and expand business size or make investments (Strebulaev, 2007). Tang and Jang (2007) have stated that equity share capital is considered to be one of the most expensive types of capital as it involves incurring certain costs, which a firm is required to earn back for attracting investors. In other words, equity share capital requires organizations to earn sufficient returns on investments so that shareholders’ wealth can be maximized. A mining firm seeking silver in a remote African region would find it difficult to earn sufficient returns on capital. This would attract less number of investors. On the contrary, a firm like, Procter & Gamble, which sells a variety of products ranging from toothpaste to beauty products, is able to earn a higher level of revenue, thereby facilitating greater number of shareholder investments. According to Tarazi (2013), debt capital refers to the borrowed money that a firm incorporates in its capital structure. It generally consists of long-term bonds, borrowings from banks and other financial institutions. This type of capital is considered to be highly risky. A firm using debt capital is required to pay fixed rates of interest out of the revenues earned. In case of shareholdings, a firm has to pay dividend based upon the level of profits earned. When profits are high, the firm pays higher dividends. On the other hand, when the profits are low, firms are required to pay only a marginal portion of revenue. In case of debt capital, irrespective of the amount of profits earned by the firm, it is essential that fixed rates of interests are paid on a periodical basis. So, it is essential for organizations to earn revenue for meeting interest obligations (Tarazi, 2013). Apart from equity and debt capital, a firm may also acquire other sources of finance such as, factoring, commercial papers, leasing and vendor financing. Such sources of finance help organizations to maintain adequate liquidity. Such sources of financing mostly enable organizations to maintain adequate levels of liquidity; meet daily operations of the firm; and invest in short-term business proposals (Thomsen and Pedersen, 2000). Optimal capital structure Titman and Wessels (1988) have advocated that the optimal capital structure of an organization refers to a framework, which maximizes revenue and reduces risks. In general, organizations prefer keeping a low level of debt and a high level of equity in their capital structure. Successful companies consider the cost of capital while planning a suitable capital structure. If a firm borrows capital at an interest rate of 7% for 10 years, considering a 3% inflation rate and can generate 15% returns by utilizing such capital, then the firm will be able to procure high level of debt. In this case, revenue generated is considerably high in order to cover the rate of interest earned by the firm. The revenue generation capability of a firm, therefore, plays a significant role in determining capital structure required to be adopted. The optimal capital structure is usually considered to be the one, which combines both equity and debt in suitable proportions. The level of equity capital is kept higher for minimizing the risk aspect in business. A low level of debt helps in bringing down the level of risks in business. Managerial knowledge and abilities also play a crucial role in determining the optimal capital structure for an organization. The cost of capital that is associated with debt capital is regarded low in comparison with the equity capital. In context of equity capital, the cost of issuance is higher. Even so, cost of procuring debt capital remains less compared to the high risk factors (Velnampy and Niresh, 2012). Welch (2004) has studied that firms may also consider developing the optimal capital structure on basis of the debt equity ratio. The ideal debt equity ratio is taken as 1.5 to 2 in most organizations. Shareholders are seen to prefer investing in those organizations, which have a low debt equity ratio. Debt equity ratio is also known as the financial leverage ratio. A high proportion of such a ratio indicates that organization is experiencing high leverage. Leverage is created in the organization when return generated from using assets is higher than investments made in the same. Having adequate leverage in the organization is essential, but high leverage ratios are undesirable as they signify that a major portion of the assets are obtained through borrowed sources, rather than own sources. Relationship between capital structure and profitability As per the studies conducted by Abor (2005), capital structure plays a crucial role in an organization’s performance and is seen to directly affect its profitability. Proper selection of the sources of capital is a vital aspect in framing financial strategies of a firm. In the previous segment of the research, ways in which high level of debt can lower the earnings available to shareholders were discussed. When a large portion of the revenue is lost in paying off interests and dividends, the firm is left with very little amount of retained earnings for the purpose of reinvesting in business. It is essential for a firm to have residual earnings after paying off all its dues so that investments can be made for expanding the business or initiating new projects and also for procuring raw materials for the next financial period. The profit available for such purposes is dependent upon two important aspects; firstly, ability of the firm to generate revenue and secondly, the payment of interest, dividends and other dues to providers of capital. Studies conducted by Titman and Wessel (1988) have revealed that there exists a negative relationship between profitability and debt equity ratio. In other words, it can be stated that as the debt-equity ratio of a firm increases, its profitability is reduced. Similarly, as the ratio falls, there is a rise in profitability. This theory is explained by the simple mechanism of debt inducing a reduction in the residual earnings of an organization. When firms have high debt equity ratio, it signifies that their borrowings are higher in comparison with the capital raised from own sources. This results in the payment of a large sum of revenue as interest at periodical intervals. Interests are required to be paid off before dividends are distributed amongst shareholders. When the level of interests paid to banks and other financial institutions are high, the level of earnings available to shareholders declines. Subsequently, the level of residual profit also falls. Hence, with rise in the level of debt in the capital structure of an organization, net profitability appears to slump (Aggarwal and Kyaw, 2010). Contrarily, the work of some authors has also proved the existence of a positive relationship between debt and profitability. The research by Taub (1975) on the listed companies of Thailand included regression analyses on four probability factors against debt equity ratio and recognised a positive relationship between debt and profitability. This implies that considering different factors and hypotheses related to return on capital, return on equity and net interest margin; influence on profitability may vary and may lead to positive results. Therefore, it becomes clear that the relationship existing between capital structure and profitability requires further empirical studies and is inconclusive. Relationship between capital structure, profitability and ROE The studies by Alti (2006) have pointed out Return on equity (ROE) as one of the most effective ways of assessing a firm’s profitability and growth. Firms with a high return on equity have little or no debt. This allows the owners to have excess cash reserves, which can be utilized for other purposes. A high return on equity also helps to significantly reduce the capital expenditures. High ROE values indicate that a firm is able to generate returns on its investments. ROE is generally calculated by dividing net income with the average stockholders’ equity. Net income refers to the income after payment of taxes. Although ROE is an effective measure of profitability of a firm, it cannot be solely relied upon. It is possible to inflate ROE by increasing the proportion of debt and reducing share capital. With increase in net income of a firm, the value of ROE also rises (Athanasoglou, Brissimis and Delis, 2008). Net income of a firm can only be maximized by way of reducing its expenses and interests. ROE is highly affected by the level of leverage existing in an organization. It is seen that with presence of leverage or debt capital in the organization, the ROE increases considerably. ROE is calculated in most firms by using the DuPont model. The DuPont model incorporates three important variables; firm’s profit margin, asset turnover and the equity multiplier. The model helps in establishing a relationship between the net income and the equity. It can, thus, be observed that a firm’s profitability is affected by operating efficiency or financial leverage. In addition, organizations with a high level of sales revenue can also rely upon the usage of leverage or debt capital in the organizational structure (Baker and Wurgler, 2002). Studies by Banchuenvijit (2011) have also shown that wealth maximization objective of a firm plays an important role in its profit earning capacity. The wealth maximization theory of an organization appears to be influenced by market structure. Based upon the market structure, a firm formulates different types of strategies, which influence the sources of capital chosen. Under favourable market conditions, in an oligopolistic market, it is seen that a firm maximizes output in order to increase the net revenue. In similar scenarios, it is witnessed that organizations reduce their production and profitability. The shareholders of an organization enjoy high returns during favourable economic periods, whereas when the economy is down, shareholders enjoy fewer returns. This aspect is ignored by shareholders as the loss is generally transferred on to the lenders. The returns payable to the lenders get considerably delayed. This is primarily due to limited liability status of the organisation’s shareholders. As a result, in an oligopolistic market, firms can acquire higher levels of debts and increase profitability. In a competitive market, however, firms are risk sensitive and adhere to lower levels of debt (Banchuenvijit, 2011). Campello (2003) has stated that profitability is the ability of a firm to continue earning profits. Ratios are used for assessing performance of an organization. Ratios help in judging the profit position of a firm, when a large amount of data is obtained by summarizing the information. Profitability and leverage ratios help in determining the role played by capital structure in generating adequate profits and analyzing the relationship between net returns and sources of capital. From the above discussion, it is evident that one of the most crucial decisions that firms must make is related to capital structure. The structure adopted by a firm for financing the business is generally long-term in nature and cannot be changed frequently. Such long-term decision should be taken only after careful scrutiny of market conditions, firm’s abilities and economic policies established by the regulatory authorities. Evidence from Thai companies Studies conducted on the Thai listed companies by Chen (2004) reveal a strong inter-relationship existing between the capital structures, profitability and the cost of capital. This ultimately influences the earnings available to equity shareholders. Profitability firms are considered as better prospects for lending by the financial institutions. Organizations are required to carefully plan their capital structures so that profitability motives are achieved. The profit generating capacity of a firm is taken into account by shareholders. Shareholders also check the level of debt existing therein. If the proportion of debt is very high, residual earnings available to the shareholders will be low. Such organizations will pay off a large portion of their profits as interest on debt. Nevertheless, not all firms encounter such an issue. For organizations that incur a very high level of profits, it is seen that investors are not too concerned about the existing level of debt (Cassar and Holmes, 2003). The profits of such firms are usually so high that earnings available to the shareholders will be a large sum. Many organizations are found to opt for debt capital in their capital structure as this helps to achieve tax shield. Due to presence of debt capital, the interest paid by a firm gets deducted from the net taxable revenue. As a result, firms pay a lower amount of tax to the government. To obtain such tax related advantages, many organizations obtain debt capital and maintain the same in their capital structure (Chen, 2004). The studies by Abor (2005) have indicated presence of a positive relationship between short-term debt and profitability. The studies have also proved that long-term debt and profitability share a negative relationship. In case of short-term debt, the interest payable is not a lump sum amount. Net profits are affected less by the short-term loans. Moreover, such loans bring adequate revenues and liquidity to the firm. Consequently, profits are seen to positively increase, simultaneously with short-term debts. The scenario, however, gets reversed in case of long-term debts. The amount payable as interest on such debts is high. These debts are mainly used for investment in fixed assets or in long-term projects. The profit earned from such investments is not instant and involves a long period of time (Desai, Foley and Hines, 2004). As a result, even after procuring such loans, net profits of the organization do not increase. The profits are seen to improve only after high revenues are generated from break even sales. For such reasons, there is a negative relationship between the profits and long-term debt capital. Dongzhi (2003) has stated that even though long-term debt has a negative impact upon firm’s profitability in the short run, it is observed that profits gradually increase in long run. Small and new firms find it difficult to issue shares and procure investments through shareholders. A portion of the share capital is provided by business owners and the additional capital requirements are fulfilled by procuring loans. Small firms also hugely rely upon debt capital for their expansion and diversification related plans. As profitability and revenues increase, firms replace a significant portion of the debt by equity capital. Equity capital is regarded as an internal source of capital as shareholders are owners of the business. There is a greater sense of security when a business is financed by its internal sources. Debt capital heightens the level of risks as it is primarily an external source of finance. The analysis of listed companies of Thailand conducted by Banchuenvijit (2011) suggests that majority of the profitable firms issue less debt and relies more upon internal sources of capital. Raising capital through the issue of equity is more commonly practiced. Thai companies were studied from three important perspectives in relation to usage of debt. Companies incurring high profits had low debt in their capital structure. Based on size, it has been noticed that large sized firms have a higher level of debt capital. The negative relationship shared by debt and tangibility reveals that organizations with a higher level of fixed assets have a lower proportion of debt (Eslava, et al., 2004). Taub (1975) has stated in his studies that in a globalized economy, a company is required to operate in highly uncertain economic situations. Capital structure decision is one of the most difficult decisions for firms. Hence, the debt equity ratio can considerably affect the value of an organization and consequently the returns available. Banks and other financial institutions provide debt capital only after analyzing creditability and financial strength. Firms with a high credit rating can procure borrowed capitals at very low rates of interests as their revenue generation capacity is high (Chaing, Chan and Hui, 2002). Financial institutions are less confident in providing capital to firms that are rated low and have less revenue earning capability. Such firms are exposed to the risk of becoming solvent, which is why banks charge a very high rate of interest from them. Having a high level of borrowed capital also influences the level of earnings available to shareholders (Raheman, Zulfiqar and Mustafar, 2007). Also, if a firm becomes bankrupt, then shareholders are the last to be paid off with the dues, while debt providers are the first to receive reimbursements. For such reasons, most firms maintain a low level of debt capital in their capital structure. Unlike shareholders, providers of debt capital are not considered to be owners of the business. Legally, firms are required to pay off interests entirely before payment of dividends. Although presence of a high proportion of debt in the capital structure increases overall risk position of an organization, it is not advisable to ignore debt capital completely. Presence of suitable amounts of debt capital increases the leverage aspect of a firm. In Thai listed companies, it has been observed that the debt proportion is similar in both private and public sector businesses. Even so, the debt proportion was seen to be high for small and medium sized firms, while the proportion was low in big firms. It has been observed that firms, irrespective of their size, gradually lessen the proportion of debt in their capital structure. The initial high debt proportion generally caters towards meeting the preliminary needs of investment in assets and setting up of the business. Studies by Shubita and Alsawalhah (2012) reveal that when a firm generates suitable amounts of revenue, retained earnings increase. These retained earnings are reinvested in business in the form of capital. The reinvestment is made by reducing the proportion of debt. Expansion plans and investment in different projects are made from such retained earnings and excess profits of the firm. Such a strategy helps an organization to stabilize its risk position. A lower risk position helps to attract further investment and increase the owner’s equity proportion. Effect of profitability on EPS and DPS From the studies conducted by Baral (2004), it can be effectively understood that a positive correlation exists between short-term debt and profitability, while there is a negative relationship between long-term debts and profitability. Profitability and size of a firm also appears to have a negative relation with the long-term debt. Hence, firms prefer to have a lower level of debt for long-term profitability. The primary objective of an organization is to maximize wealth for its shareholders. The EPS and the DPS can only be increased, when the residual earnings of a firm after paying off all expenses are maximized (Baral, 2004). It is generally not possible to lower expenses of an organization as this directly affects the profitability and productivity. Thus, firms try to reduce the interest payable on debt. It has been observed that organizations that procure a high debt in the long run are required to generate very high revenues. This is done in order to provide adequate returns to the shareholders as well as generate retained earnings for reinvesting in business. This creates immense pressure upon the company to achieve high sales and consequently, high revenues. Firms prefer to pay dividends, instead of interests, on loan (Udomsirikul, Jumreornvong and Jiraporn, 2011). Lack of empirical literature One of the primary issues faced while conducting the research upon Thai listed companies was that very little efforts have been taken by researchers to identify the relationship existing between profitability and capital structure. As a result, the impact of capital structure upon ROE and profitability of Thai firms become ambiguous and lack empirical evidence. Adequate measures are required to be taken by regulatory authorities and financial institutions so as to conduct research upon the subject matter. It is essential to study the financial aspects of numerous listed private and public firms for reaching suitable conclusions regarding the subject matter as well as obtaining evidences based on which policies and regulations can be developed. This helps to maintain stability in the economic operations in future. Theory of capital structure M&M Theory The capital structure theory by Modigliani and Miller (M&M), as explained by Faulkender and Petersen (2006), is based upon the concept that in a perfect market scenario, capital structure of an organization has fewer roles to play in overall performance. In other words, the theory suggests that there is no relationship between the cost of capital and capital structure. A firm’s value is determined by that of its underlying assets and earning capacity. The M&M theory stands on grounds of the following assumptions. It is considered that there are no taxes, transaction costs and bankruptcy costs existing in the market. The cost of borrowing is equal for both companies and for investors. Similar market information is available to all companies and investors. It is also assumed that there is no effect of debt on firm’s earnings before taxes and interests. In the real world, these assumptions are considered as irrelevant as there are taxes, transactional costs, cost of bankruptcy, dissimilarity in market information and borrowing costs and considerable effects of debt capital on earnings (Frank and Goyal, 2003). The M&M theory tries to achieve a simplified view by assuming that there are no taxes and bankruptcy costs. Under such circumstances, the weighted average cost of capital remains constant even with changes in the capital structure. As there are no changes in the cost of capital due to rise or fall in debt, it is observed that organisation’s stock price remains unaffected. The capital structure, therefore, remains unrelated to the stock prices (Garrison, 2002). The trade-off theory of leverage assumes that capital structure of a firm benefits from leverage until the optimal structure is reached. The leverage arises from the aspect that interest on debt capital is tax deductible. The tax liability of a firm effectively gets reduced by issuance of bonds. Then again, this feature is not applicable for equity share capital. Due to the tax deductions available to companies, net interests to be paid on bonds issued becomes lower (Gaud, et al., 2005). Hall, Hutchinson and Michaelas (2004) have pointed out that difference between the trade-off theory and the M&M theory arises from effects of debt capital upon the capital structure. In the M&M theory, it is assumed that there are no taxes, which render the benefits arising from presence of debt capital unrecognized. On the other hand, in the M&M theory with corporate taxes, the benefits emerging out of debt capital is recognized. As a result, firms with higher proportion of debt are considered to be of greater value under this theory as they can enjoy tax shield. The M&M theory without corporate taxes states that equity and debt proportion are irrelevant factors. Harvey, Lins and Roper (2004) have opined that under M&M theory, when the proportion of debt in a company increases, the returns available to shareholders improve too. The presence of debt in a company’s capital structure makes it more prone to risk. Higher risk premium is demanded by shareholders. Since the theory considers that the debt equity changes have no influence upon capital structure, the weighted average cost of capital remains constant. Only the returns available to shareholders are increased. On the contrary, when the M&M theory identifies corporate taxes, it is seen that by increasing the value of debt, the weighted average cost of capital is reduced (Harvey, Lins and Roper, 2004). Considering the research conducted by Hayek (2007), the M&M theory can be judged from two view points. In the first view point, it is believed that a company does not give any recognition to corporate taxes. As a consequence, the existence of debt has no impact upon capital structure. From this view point, having debt capital increases net expenses of a firm, given that it requires paying fixed amount of interests, irrespective of the amount of profits earned. The amount paid as dividends to shareholders, however, fluctuates as per firm’s revenue and profits. As a consequence, equity is a more secure and beneficial source of capital from the first view point of study (Hayek, 2007). The second view point of the M&M theory recognizes corporate taxes. It is assumed here that companies are required to pay taxes. Consequently, organizations gain tax advantages through debt proportion in their capital structure. The leverage advantages of debt capital would help organizations to reduce tax liabilities (Margaritis and Psillaki, 2010). Although presence of debt capital implies that firms need to pay interests, reduction of taxes ultimately entails significant gains. From this view point of the M&M theory, it can be said that having debt capital in the organization helps in gaining leverage, thereby reducing the cost of capital. The reduction in cost of capital should be equal to or higher than the interests paid. If the interest paid are relatively higher than reduction in taxes, the benefits available from debt capital becomes irrelevant (A. Hovakimian, G. Hovakimian, and Tehranian, 2004). On the contrary, Huang and Song (2006) in their studies have indicated that apart from the M&M theory, net income theory, net operating income theory and traditional theory are also considered to important. The net income theory is developed upon the aspect of maximizing market value of an organization. It states that by lowering overall cost of capital, it is possible for organizations to increase the market value. Debt is considered to be a cheaper source of finance as compared with equity (Obrien, 2003). As a result, the cost of capital incurred by a firm falls owing to the fact that there are lower taxes to pay. Higher proportion of debt increases market value of a firm. High debt capital in the capital structure allows organizations to obtain financial leverage. This theory mainly suggests that it is beneficial for an organization to have a higher proportion of debt (Huang and Song, 2006). Jamal (2013) has advocated that under net operating income theory, structure of capital has no relation with its costs. The market value of a firm is seen to remain the same, regardless of changes made in the structure of capital. This theory is quite similar to the M&M theory without corporate taxes. The net operating income theory mainly mentions that value of a firm is dependent on its ability to generate revenue. Firms experiencing high revenue subsequently have higher profits and retained earnings, which in turn raise market value of these firms. As a consequence, profitability of an organization is more dependent on its revenue compared to capital structure (Jamal, 2013). The traditional theory of capital structure, as suggested by Lemmon, Roberts and Zender (2008), is a mixture of both net income and net operating theories. The traditional theory involves three phases. In the first phase, a firm is required to acquire more debt in its capital structure. It is observed that organizations, which are in their start up phase, have a higher proportion of debt. Debt capital helps to obtain higher leverage, which is considered important in this phase. In the second stage, it is assumed that a firm has reached the optimum capital position (Ozkan, 2001). The weighted cost of capital is the lowest at this stage. The market value of the organization is maximized. The company after attaining this stage should not consider increasing its debt capital. 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