Impact of Capital Structure on Profitability
Rakesh M1, Dr. Janet Jyothi D Souza2
1Research Scholar and Asst. Professor, Department of MBA Vivekananda College of Engineering and Technology, Nehru Nagar, Puttur D.K
2Associate Professor, Department of Management Studies, Ballari Institute of Technology, Ballari, Karnataka, India
*Corresponding Author E-mail: rakeshhebbar.m@gmail.com, janetjyothidsouza@gmail.com
ABSTRACT:
Capital structure decision is a very significant area of financial decision making due to its impact on other financial decision variables. Studies have proven the impact of capital structure decision on financial performance. Present study aims at establishing the relationship between capital structure and profitability. Financial variable ROCE is considered as a dependent variable against Debt equity and Debt to market cap ratio being independent. Nifty50 companies over a period of five years (2013-2017) are considered for the purpose of analysis. The data generated is cross sectional time series (Panel Data) in nature. The study employed Panel Data Regression analysis through panel econometric techniques. The results of the study revealed that capital structure is not very significant in determining the profitability of the firm. However there exists a weak negative relationship between capital structure and profitability. The study would definitely contribute towards the conceptual innovations in finance and finance literature.
KEYWORDS: Capital structure, profitability, value of the firm, financial and non-financial companies.
1. INTRODUCTION:
Profit is the primary objective of any business undertaking. The success or failure of any strategic corporate decision is evaluated mainly based on its impact on profitability. Any decision which a negative impact on profitability will have has to be abandoned. Profitability has been given considerable importance in finance related research. The firm can finance its assets either through debt or equity. But the mix of both would be the best choice. Capital structure is the composition of Debt and Equity capital. Capital structure is one of the most complex areas of financial decision making due to its impact on various financial decision variables.
Capital structure decision is one of the important factors affecting the profitability of the firm. (Sivathaasan 2013). Capital structure decisions will have an impact on the Earnings Per Share (EPS) and wealth of shareholders also. It is one of the very crucial decisions to be taken in the business undertaking due to its impact on the future of business. (Sekar, Gowri, and Ramya, 2014). The seminal work by Modigliani and Miller 1958 on capital structure presented the basis for the development of various research theories in capital structure. The relationship between capital structure and the profitability of the firm has been proved in many studies.(Bernard, 1992; Chen, 2002; Abor, 2007; Seppa, 2008; El‐Sayed Ebaid, 2009; Propagation, David, and Franzoni, 2012;Maina, 2013; Rajesh, 2013; Chisti, Ali, and Sangmi, 2013; Handoo and Sharma, 2014; Thippayana, 2014; Serghiescu and Văidean, 2014; Sorana, 2015; Alipour, Mohammadi, and Derakhshan, 2015; Chadha and Sharma, 2015; Harris, 2015; Mittal, 2015; Oziomobo and Zahiruddin, 2016; Aff and Nassar, 2016; Jouida, 2017; Phuong, Le, Phan, and Bich, 2017). The present study is undertaken to analyze the impact of capital structure on profitability in Indian context by incorporating the nifty 50 companies listed in NSE. Nifty 50 represents the diversified best fifty most performing stocks in the market. Therefore the results of the study would definitely contribute to the new dimension of financial literature.
2. LITERATURE REVIEW:
The impact of capital structure on profitability always draws the attention of researchers because of its conflicting results/outcomes across various studies. A three tier summary of article review is presented below. The first phase discusses the negative impact of Capital structure on profitability. The second phase shows the positive effect of Capital structure on profitability and the third phase discusses about the relevance of capital structure decision.
Many studies have proven the negative impact of capital structure on profitability. Zeitun and Gary (2007) investigated and examined the effect which capital structure has had on corporate performance using a panel data sample representing of 167 Jordanian companies during 1989-2003. Study revealed negative relationship between capital structure and profitability. Zeitun and Tian (2007) investigated the impact of capital structure on corporate performance of 167 Jordanian companies during 1989-2003. The study revealed the significant negative relationship between Capital structure and profitability of the firms. The results showed that a firm’s capital structure had a significantly negative impact on the firm’s performance measures. Salawu (2009) investigated the impact of capital structure on profitability of 50 non-financial companies listed in Nigerian Stock Exchange over a period from 1990-2004. The results revealed that the profitability is negatively related to long term debt and positively related to short term debt. Ali et al (2012) analysed the impact of capital structure on profitability of 28 chemical and automobile companies listed in Pakistan stock exchange. The data is spread over a period of seven years from 2005-2011. The study revealed that both positive and negative relationships are existing between variables. Shubita and Jordan (2012) examined the impact of capital structure on profitability of 39 Jordanian Industrial companies listed in Amman Stock Exchange during a six year period from 2004-2009. The results of the study revealed the significant negative relationship between capital structure and profitability. Mohammadzadeh (2013) examined the impact of capital structure on profitability of 30 Iranian pharmaceutical companies over a period of 10 years from 2001 to 2010. The study revealed the negative relationship between capital structure and profitability. Amponsah et al (2013) analysed the relationship that is existing between capital structure and profitability of 34 companies listed in Ghana stock exchange for a period of 5 years from 2005 to 2009. The results of the study showed the negative relationship between capital structure and profitability. Maina (2013) investigated the impact of capital structure on financial performance of selected commercial banks in Ethiopia over a period of 5 years from 2011 to 2015. The study revealed that there is a significant negative relationship between capital structure and profitability of the firm. Tailab (2014) analysed the impact of capital structure on financial performance of 30 Energy American Firms for a period of 9 years from 2005-2013. Return on Asset (ROA) and Return on Equity (ROE) are considered as the representatives of financial performance. The study proved the negative impact of capital structure on profitability. Tarek Al-Kayed et al (2014) examined the impact of capital structure on performance of 85 Islamic Banks (IBs) in 19 countries. Results of the study proved that IBs’ performance improves with increase in equity. This study shows the negative impact of capital structure on profitability Abeywardhana (2015) analysed the impact of capital structure on profitability of non-financial SMEs of UK for a period of 1998-2008. The study revealed the existence of significant negative relationship between capital structure and profitability. Aff and Nassar (2016) examined the impact of capital structure on financial performance of the firm. A total of 136 companies listed in Instanbul stock exchange are chosen as samples. 8 years data from 2005 to 2012 has been chosen for the study. ROA, ROE and EPS were the dependent variable against the debt equity ratio being independent. The results of the study revealed the negative relationship between the capital structure and firm performance Oziomobo and Zahiruddin (2016) examined the impact of capital structure on firm performance at Nigeria. A total of 100 non-financial firms listed in Nigerian Stock Exchange for a period of 2010 to 2014 have been considered. Through Panel data analysis approach it was found that there is a negative relationship between capital structure and profitability. Singh and Singh (2016) examined the impact of capital structure on profitability of top 10 BSE listed cement companies over a period of 5 years from 2010 to 2015. Through co-efficient of correlation analysis the negative relationship between capital structure and profitability are proven. Muraleetharan (2016) proved the negative relationship between capital structure and profitability. Colombo Stock Exchange listed Sri Lankan tobacco food and beverages companies have been considered for the study. A reference period of 7 years from 2008 to 2014 has been considered. Muhammad et al (2016) examined the impact of capital structure on profitability of 19 Karachi Stock Exchange listed companies of Pakistan. A reference period of 12 years from 2006-2012 has been considered. The study proved the negative relationship between capital structure and profitability.
Couple of studies have proven positive impact of Capital structure on profitability. Kyereboah-coleman (2007) examines the impact of capital structure on firm performance of 52 Micro finance institutions of Ghana over a period of 10 years from 1995-2004. Results of the study proved that the highly leveraged micro finance firms performed better. Jamal (2010) investigated and examined how profitability of firms, in the automobile sector of Pakistan, was influenced by working capital management and capital structure of the firms. The current ratio was taken as representative of the result of working capital management policy and financial leverage as the bench mark for capital structure. An econometric model has been developed in the analysis. The results of the study revealed that financial leverage has a significant positive impact on profitability of the firms. Nasimi (2016) examined the impact of capital structure on profitability through multiple regression model. A total of 30 firms from FTSE 100 index of London Stock Exchange has been considered. Reference period is from 2005 to 2014. The results of the study proved the positive relationship between capital structure and profitability. Gill et al (2016) examined the impact of capital structure on profitability of 272 listed service and manufacturing firms in New York Stock Exchange for a period of 3 years from 2005-2007. The results of the study showed a positive relationship between capital structure and profitability. Venugopal and Reddy (2016) investigated the impact of capital structure on profitability and shareholders wealth. A total of 18 Indian cement companies listed in BSE and NSE are considered for a period from 2007-2014.The study revealed the positive impact of capital structure on profitability and wealth with low level of significance. Phuong et al (2017) examined the impact of capital structure on performance of the companies in Vietnam. The study has considered all the non-financial listed firms form the period 2007-2012. The results of the study revealed that there exists a positive relationship between capital structure and profitability.
The studies have proven the significance of capital structure on profitability of the company. Chen (2002) examined the impact of capital structure on firm performance at Egypt. All publicly traded non-financial firms from 1997 to 2005 have been considered. The study revealed that capital structure has no or weak impact on the performance of the firm. Kaifeng (2002) empirically tested the influence of the debt structure on the company value, by considering sample companies incorporated in Netherlands. It was well accepted that the market value of any firm is independent on its capital structure, given the assumptions of capital markets are "perfect". Kong et al (2002) examined the interrelationship between profitability, cost of capital and capital structure of the property and construction companies of Hong Cong. 18 Developers and 17 contractor firms have been considered over a period of seven years from 1994-2000. The results of the study proved that profitability, cost of capital and capital structure are interrelated to each other. Ahmad et al (2012) investigated the impact of capital structure on firm performance of 58 Malaysian firms listed in the equity market for a period of six years from 2005-2010. The study revealed the significant relationship between capital structure and profitability. The findings have highlighted the effects of capital structure on the firm performance. Chisti et al (2013) examined the impact of capital structure profitability. 10 companies in the automobile industry were chosen from India. A reference period of 5 years from 2007 to 2012 has been selected for the study. The profitability ratios have been considered as dependent variable against capital structure ratios being dependent. The results of the study revealed the significant relationship which is existing between capital structure and profitability. Rajendran and P (2013) examined the relationship between capital structure and firm performance in listed manufacturing firms in Sri Lanka. The study was initiated on “capital structure and firm performance with the samples of 25 manufacturing companies using the data representing the periods of 2008-2012. Ahmed and Munir (2013) made an attempt to explore the relationship between the capital structure and the profitability of the petrochemical industry firms in the Kingdom of Saudi Arabia, and the direction of this relation for the targeted firms during the period 2008-2011. The study revealed that the profitability performance of the petrochemical industry firms in Kingdom of Saudi Arabia has no significant relationship with capital structure decision. Kajananthan and Nimalthasan (2013) examines the impact of capital structure on firm performance of 25 Sri Lankan manufacturing companies for a period from 2008-2012. The study proved the significant relationship between capital structure and firm performance. Pirzada et al (2015) examined the relationship between institutional stock holding and firm performance. Firm performance is measured by ROA, ROE, PE and EPS. The stusy used data of 30 Malaysian firms listed in main board of BURSA over a period of 2001 to 2005. Results of the study proved the significant relationship between stock holding and firm performance.
Above studies proved that the impact of capital structure decision on firm performance or profitability are different across the studies. The impact of capital structure decision on firm performance varies across the industries and countries as well. The present study undertaken makes an attempt to analyse the impact of capital structure exclusively on the profitability of the company and not on the overall firm performance.
3. DATA AND METHODOLOGY:
The study used cross sectional time series (panel) data compiled from the financial statements of Nifty 50 companies for each year from 2013 to 2017. The coverage of the data from the year 2013 to 2017 is due to its availability. The data is collected from the website ‘www.arcadiastock.com’.
3.1 Hypotheses of the study:
The study focuses on analysing the impact of capital structure on profitability. In this regard the following hypotheses have been developed.
H0: There is a significant relationship between profit and capital structure.
H1: There is no significant relationship between profit and capital structure
3.2 Specification of the Model:
The study uses debt to equity ratio and debt to market cap ratio as independent variable against ROCE being dependent. ‘Debt to equity ratio’ and ‘Debt to Market Cap ratio’ represents the capital structure and ‘Return On Capital Employed’ (ROCE) represents the profitability of the companies. The linear relationship between the independent and dependent variable is developed. The following panel data regression equation symbolizes this.
Y = a + b1*X1 + b2*X2+e
Where,
“Y” represents ROCE
“X1” represents value of Debt to Equity ratio,
“X2” represents the value of Debt to market ratio,
“b1” represents the beta co-efficient of Debt to equity ratio,
“b2” represents the beta co-efficient of Debt to Market Cap ratio and
“a” represents the alpha intercept of the equation.
“e” represents the error term.
3.3 Data analysis technique:
Panel data regression analysis is employed in the study. Panel data regression considers the individual heterogeneity of various samples where as time series and cross sectional analysis do not. There are three models in Panel Data regression. They are,
1. Pooled OLS Regression Model
2. Fixed Effect Model
3. Random Effect model
Pooled regression Model does not consider the heterogeneity or individuality of data samples. It considers that all the companies are alike in terms of its data characteristics. Since the sample companies in this study are spread across various industries, the data characteristic is heterogeneous in nature. Therefore Pooled OLS cannot be employed. This model believes that the co-efficients are same for all the samples.
Fixed Effect (FE) Model allows for heterogeneity or individuality among the sample data. It also believes that intercept may differ across companies, but intercept does not vary over time.
Random Effect (RE) Model also allows for heterogeneity. It assumes that the data being analysed are drawn from a hierarchy of different populations whose differences relate to that hierarchy.
In this study since the sample is spread across various industries, it is believed that sample is heterogeneous in nature. Therefore either the FE or the RE model should be employed. The choice is made between FE or RE model by using the Hausman’s Test.
4. ANALYSIS AND INTERPRETATIONS:
The following table 4.1 shows the results of FE and RE Model. Table 4.2 shows the summary of Hausman’s Test. Table 4.3 is the correlation matrix between variable. And Table 4.4 shows the values of Descriptive Statistics.
4.1. Test summary of Fixed Effect and Random Effect Model
Variables |
FE Model |
RE Model |
||
Probability |
t-statistics |
Probability |
t-statistics |
|
ROCE |
0 |
12.20681 |
0 |
7.398424 |
Debt to Market Cap ratio |
0.3908*** |
-0.860086 |
0.2593*** |
-1.1306 |
Debt equity ratio |
0.1799*** |
-1.345733 |
0.0938*** |
-1.68194 |
R2 |
0.909.3 |
0.022584 |
*** Not significant at 5% level of significance
4.2 Hausman’s Test
Hausman's Test Summary |
Chi-Sq. Statistic |
Chi-Sq. d.f. |
Prob. |
Cross-section random |
2.503529 |
2 |
0.286*** |
*** Random Effect Model is most appropriate. (0.286>0.05)
4.3 Correlation
Variables |
Total DEBT to MCAP |
DEBT EQUITY |
ROCE |
TOTAL DEBT TO MCAP |
1 |
0.733135 |
-0.26413 |
DEBTEQUITY |
0.733135457 |
1 |
-0.20131 |
ROCE |
-0.264134296 |
-0.20131 |
1 |
4.4 Summary of Descriptive statistics
Variables |
ROCE |
Total DEBT to MCAP |
DEBT EQUITY |
Mean |
24.02879 |
0.25144 |
0.56676 |
Median |
15.715 |
0.01 |
0.07 |
Maximum |
177.25 |
4.37 |
7.06 |
Minimum |
-31.53 |
0 |
0 |
Std. Dev. |
25.87825 |
0.509337 |
1.330383 |
Skewness |
2.899388 |
3.558924 |
3.884667 |
Kurtosis |
14.97506 |
21.70781 |
17.85825 |
Jarque-Bera |
1844.04 |
4173.395 |
2928.439 |
Probability |
0 |
0 |
0 |
Sum |
6007.198 |
62.86 |
141.69 |
Sum Sq. Dev. |
166751.3 |
64.59668 |
440.7099 |
Observations |
250 |
250 |
250 |
5. RESULTS AND FINDINGS:
The study believes that the data sample in heterogeneous in nature. Therefore the choice between FE and RE Model is necessary. Hausman’s test helps in the Choosing between FE or RE Model. If the ‘p’ value of Hausman’s test is less than 0.05, then FE model will be appropriate for the study. On the other hand, if Hausman’s test value is more than 0.05, RE Model will be appropriate. In this study the ‘p’ value of Hausman’s test is 0.2860 which is more than 0.05. Therefore RE Model should be employed to analyse the data (p>0.05).
The results of RE Model is expressed in table 4.1. If the probability value of independent variable is less than 0.05 or 5%, then it is interpreted that the independent variable is significant in determining the value of dependent variable. In this study the independent variables are ‘Debt to equity ratio’ and ‘Total Debt to market cap ratio’ against the ‘ROCE’ being dependent. The probability value of Debt to equity ratio and Total Debt to market cap ratio are 0.0938 and 0.2593 respectively. The probability values of both the variables are more than 0.05. Therefore the null hypothesis is rejected at 5% level of significance and alternate hypothesis is accepted. Hence the impact of capital structure on profitability is not very significant. However the coefficient values -3.77 and -2.53 respectively of Debt to equity ratio and Total debt to market cap ratio indicates the negative relationship between the independent variable and the dependent variable.
6. CONCLUSION:
The present study could prove the significant impact of capital structure decision on profitability. The study analysed the impact of capital structure decision on the profitability of the firm. With the limited data of 50 listed Indian companies spread over a period of 5years, panel data is developed and analysed. The result of Hausman’s test proved that the Random Effect Model (RE) is appropriate for this study. The results of empirical study through RE Model found that there is no significant relationship between capital structure and profitability. However the weak negative impact of capital structure on profitability is evidenced with R2 value being 0.022584. The study can be further improved by incorporating more companies with large time series.
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Received on 25.03.2018 Modified on 10.04.2018
Accepted on 29.04.2018 ©A&V Publications All right reserved
Asian Journal of Management. 2018; 9(3):1067-1072.
DOI: 10.5958/2321-5763.2018.00169.5