Research Project Topic: CapitalStructure and Firm’s Profitability  Objectives of the study: 1.

      Toidentify and analyze the capital structure of the selected companies.2.      Toidentify and analyze the profitability of the selected companies.3.      Toanalyze the relationship between the capital structure and profitability. Scope of Research:We cannot ignore the relationship betweenprofitability and capital structure.

The long-term survivability of the firmdepends upon the improvement in the profitability. Interest payment on debt istax deductible; hence, the addition of debt in the capital structure willimprove the profitability of the firm. So, it becomes important to find out therelationship between capital structure and the profitability of the firm inorder to make appropriate capital structure decisions.The lack of a consensus about what would qualify asoptimal capital structure in the food processing industries in India hasmotivated me to conduct this research.

This study requires knowledge about thecapital structure and the profitability indicators of the firm. Hypothesis:H0: There is no significant relationship between thecapital structure and profitability of selected firms.H1: There is significant relationship between thecapital structure and profitability of selected firms.

     Introduction Thecapital structure is defined as the mix of debt and equity that the firm usesin its operation. The capital structure of a firm is a mixture of differentsecurities. In general, firms can choose among many alternative capitalstructures.

For example, firms can arrange lease financing, use warrants, issueconvertible bonds, sign forward contracts or trade bond swaps. Firms can alsoissue various distinct securities in different combinations to maximize overallmarket value. The present era is the era of intensecompetition and survival of the fittest is the slogan of the corporate world.

In such a scenario decision making has emerged as one of the toughest tasks asit decides the fate of every firm. Therefore, managers have to take intoconsideration the cause effect relationship while making a particular decision.The managers of present corporate world have to follow systems approach intheir decision making because a decision taken in isolation can bring a firm tothe verge of a disaster.  In today’s competitive and dynamicbusiness world, financial decision plays a fundamental role in the firm’s dayto day performance and operations. Firm’s financial decision affects almost allactivities within the company. In the field of corporate finance, capitalstructure decision is the most debatable issue for academicians andpractitioners of corporate finance starting from a seminar work of Modiglianiand Miller in 1958. Modigliani and Miller (1958) stated that the firm’s value isindependent from their capital structure decision, by assuming unrealisticassumptions on the real world; such as no corporate taxes, no transaction cost,and perfect capital market.

However, Modigliani and Miller (1963) incorporatedcorporate taxes into their earlier assumption and they stated that optimalcapital structure can be attained from 100 per cent debt financing throughgetting tax saving advantage of using debt. However, the second propositionalso not considered the disadvantages of using more debts, such as bankruptcycost and default risk. After the work of Modigliani and Miller(1958 & 1963) a number of theories have been developed to explain optimalcapital structure of the firms. Agency cost theory, static trade-off theory,and pecking order theory are the most popular theories of capital structure.However, both debt and equity finance have their own merits and demerits. Themerits of debt financing are tax-shield, disciplinary tool and cheapest sourcesof finance, while bankruptcy cost and default risks are its disadvantage. Inthe case of equity share, its advantage is there is a low probability ofbankruptcy cost, while no tax advantage, costly and difficulty of controllingfree cash flow are its disadvantages.  Of all the aspects of capital investmentdecision, capital structure decision is the vital one, since the profitabilityof an enterprise is directly affected by such decision.

Hence, proper care andattention need to be given while making the capital structure decision. There couldbe hundreds of options but to decide which option is best in firm’s interest ina particular scenario needs to have deep insight in the field of finance as useof more proportion of Debt in capital structure can be effective as it is lesscostly than equity but it also has some limitations because after a certainlimit it affects company’s leverage. Therefore, a balance needs to bemaintained. There are two main benefits of debt fora company. The first one is the tax shield: interest payments usually are nottaxable; hence the debt can increase the value of the firm. Another benefit isthat debt disciplines managers. Managers use free cash flows of the company toinvest in projects, to pay dividends, or to hold on cash balance. But if thefirm is not dedicated to some permanent payments such as interest expenses,managers could have incentives to “waste” extra free cash flows.

That is themain reason, in order to discipline managers, shareholders attract debt. Also,it is a standard practice in debt agreements between banks and debtors tointroduce some financial covenants for firms (nominal level of the free cashflow, debt-to-EBITDA ratio, EBITDA-to-interest expenses ratio etc.). Managerscannot break these covenants, and hence are bound to be more effective. Inaddition, the law usually guarantees a right of partial information disclosureto the company’s debt holders, which serves as additional managers’ supervisiontool.

As a result, actions of managers become more transparent, and they havemore incentives to create higher value for the owners. Understanding the relationship betweenthe company debt and value could provide useful insights for investors for tworeasons. Firstly, shareholders would be able to target optimal debt-to-equityratios, which may improve discipline of the managers, but does not overburden afirm with extraneous interest payments.

Secondly, debt holders would have atool in hand to identify overleveraged and underleveraged firms. This may helpthem allocate their funds more effectively.            Reviewof Literature  Empirical Evidence Modigliani and Miller (1958) theory of”capital structure irrelevance” states that financial leverage does not affectthe firm’s market value with certain assumptions. These assumptions related tohomogenous expectations, perfect capital markets and no taxes. In order to find the relationshipbetween the capital structure and the profitability of a firm, a lot of researchhas been undertaken by various researchers all over the world. The review ofsome of the major studies has been undertaken so as to develop a clearunderstanding about the relationship between capital structure andprofitability. The review of such major studies is as follows: Sarkar and Zapatero (2003) found apositive relationship between leverage and profitability. Myers and Majluf(1984) concluded that firms that use less debt capital comparing with equityare profitable and generate high earnings than those that use more debt capital.

 Sheel (1994) showed that all leveragedeterminants factors that were studied, except firm size, are important toexplain debt behavior variations. Gleason, et al., (2000) using data fromretailers in 14 European countries, which are grouped into 4 cultural clusters,it is shown that capital structures for retailers vary by cultural clusters.This result holds in the presence of control variables. Using both operational andfinancial measures of performance, it is shown that capital structure influencesfinancial performance, although not exclusively. A negative relationshipbetween capital structure and performance suggests that agency issues may leadto use of higher than appropriate levels of debt in the capital structure,thereby producing lower performance. Graham (2000) integrates underfirm-specific benefit functions to estimate that the capitalized tax benefit ofdebt equals 9.7 percent of firm value.

The typical firm could double taxbenefits by issuing debt until the marginal tax benefit begins to decline. Chiang et al., (2002) undertake a studyand the findings of the study put forth that profitability and capitalstructure are interrelated; the study sample includes 35 companies listed in HongKong Stock Exchange. Abor (2005) investigates the relationship between capitalstructure and profitability of listed firms on the Ghana Stock Exchange andfind a significantly positive relation between the ratio of short-term debt tototal assets and ROE and negative relationship between the ratio of long-termdebt to total assets and ROE.   Mendell, (2006) examines financingpractices in firms in the forest products industry by studying the relationshipbetween taxes and debt hypothesized in finance theory. In analyzing thetheoretical association between capital structure and taxes for 20 tradedforest industry firms for the years 1994-2003, the study discover a negativerelationship between debt and profitability, a positive relationship betweennon-debt tax shields and debt, and a negative relationship between firm sizeand debt.

 Gill, (2011) seeks to elongate Abor’s(2005) findings regarding the effect of capital structure on profitability by observingthe effect of capital structure on profitability of the American service andmanufacturing firms. The Empirical results of the study show a positive relationshipbetween short-term debt to total assets and profitability and between totaldebt to total assets and profitability in the service industry. The findings ofthis paper also show a positive relationship between short-term debt to totalassets and profitability, long-term debt to total assets and profitability, andbetween total debt to total assets and profitability in the manufacturing industry. The other major studies undertaken byMesquita and Lara (2003), Philips and sipahioglu(2004), Haldlock and james (2002),Arbabiyan and Safari (2009), Chakraborty (2010), Huang and Song (2006), Pandey(2004) came up with the findings which were conflicting in nature as some studiesconfirm positive relationship between capital structure and profitability whileother studies confirm positive relationship between the variables.  Theoretical Studies One of the first works about the role ofdebt is Modigliani and Miller (1958). They claim that owners of the firms areindifferent about its capital structure, because the value of the firm does notdepend on debt-to-equity ratio. Authors consider “an ideal world” without taxesand any transaction costs.

Later Modigliani and Miller (1963) introduce taxes intotheir model and show that the value of a firm increases with more debt due tothe tax shield. Modigliani and Miller’s work initiatedfurther discussions about optimal capital structure. Since their theorypredicts 100% debt financing (due to substantial corporate tax benefit), whichis not observed in practice1, there should be some trade-off costs against thetax shield. The actual level of debt is determined by tax advantage and thesecosts. Economists consider bankruptcy costs, personal tax, agency costs,asymmetric information and corporate control considerations as possibletrade-off options against tax shield. This is the essence of the trade-offtheory, according to which higher profitability is related to higher leveragedue to the tax shield, but is not at the level of 100% of assets due totrade-off costs. Myers and Majluf (1984) developed a”pecking order” theory of capital structure, according to which firms initiallyuse internal funds, then debt, and, if a project requires more funding, equity.

Therefore, firms which are very profitable and generate sufficient cash flowswill use less debt. Studies of the relationship between firmperformance and leverage can be divided into two groups. The first one is basedon the information asymmetries and signaling. Ross (1977) came up with a modelthat explained the choice of debt-to-equity ratio by a willingness of a firm tosend signals about its quality.

The core idea of Ross (1977) is that it is toocostly for a low-quality firm to abuse the market and signal about its highquality by issuing more debt. As a result, low quality firms have low amount ofdebt, and the leverage increases with the value of a firm. A similar model wasdeveloped by Leland and Pyle (1977): the higher is the quality of the projectmanager wants to invest in, the higher is the willingness of the manager toattract financing. That is why a risky firm will end up with lower debt. The second group of studies describesthe connection between capital structure and firm performance through theagency costs theory, developed by Jensen and Meckling (1976) and Myers (1977).Agency costs are related to conflicts of interest between different groups ofagents (managers, creditors, stockholders).

There could be two types of agencyproblems.   Asimilar idea, but from a slightly different point of view, was suggested byGrossman and Hart (1982). Firms, which are mostly equity financed, have verylow risk of bankruptcy. Managers of such firms are not penalized in case of lowprofits and have no incentives to be more effective. Besides, bankruptcyimplies some personal costs for managers, such as loss of reputation etc. Tosum up, a rise of leverage is followed by improved corporate performance accordingto this type of agency problem. Alternativetheory about managers acting in their own interests was suggested by Harris andRaviv (1988).

They describe higher leverage as an antitakeover instrument: –firms with a large amount of debt will be less likely to become a target foracquisition. That is why managers, who are afraid to lose their job aftertakeover, may be willing to accumulate higher than necessary amount of debt. ·        An agency problem between stockholdersand debt holders. This type of a problem is rooted in the conceptual differencebetween stockholders and debt holders. The former take more risks and demandhigher return, whereas the latter take less risk and agree with lower return.Hence, shareholders may want to take projects with higher risk than debtholders would prefer. In the case of success of these projects stockholderswill earn extra return, while in the case of failure all losses will be betweendebt holders and stockholders (Jensen and Meckling, 1976). As a consequence, moreindebted firms take lower-risk projects.

On the other side, Myers (1977) showedthat discrepancies in goals between debt holders and shareholders could lead tounderinvestment. Thus, higher leverage might as well lead to lower corporateperformance.  Summary of all capital structuretheories is shown in Table 1:  Table 1. Summary of capital structuretheories. Theory Relationship Causality Modigliani and Miller (1963) Positive Performance affects debt Trade-off Positive Performance affects debt Pecking-Order Negative Performance affects debt Free-cash-flow Positive Debt affects performance Signaling Positive Performance affects debt Agency problem Negative Debt affects performance    It is against this background that the presentstudy has been undertaken so as to facilitate the existing literature. 

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