International Journal of Multidisciplinary Consortium

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1 Impact of Capital Structure on Firm Performance: Analysis of Food Sector Listed on Karachi Stock Exchange By Amara, Lecturer Finance, Management Sciences Department, Virtual University of Pakistan, ABSTRACT P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 1 & Dr. Bilal Aziz, Associate Professor Finance, GC University, Faisalabad, Pakistan, biiilal@live.com This study has been conducted to mainly analyze the relationship of capital structure and its effect on company s performance. Sample included 33 listed companies from food sector of Pakistan. Debt ratios including debt to equity, short term debt to total assets and long term debt to total assets have been used as explanatory variables while return on assets and earnings per share have been used as proxy of performance. Assumption of multicollinearity, heteroskedasticity, contemporaneous correlation and auto correlation have been tested and based upon the results PCSE along with Prais-Winsten regression has been used. Results of regression analysis revealed negative relation of capital structure ratios with performance while among these, only debt to equity ratio has significant effect on company s performance. Negative relation of capital structure ratios lead to the conclusion that food sector is not properly utilizing debt in its capital structure and financial analysis need to find an optimal mix of debt and equity for maximization of company s profits. KEYWORDS: Capital Structure, Fixed & Random effects, Panel corrected standard errors. INTRODUCTION Capital structure is the blend of internal and external sources of funds used by the firms to finance their assets. Firms have the choice either to use debt or equity to finance their assets but the best is to use mix of both. In this regard, theories related to capital structure have always remained an area of interest finance scholars. Relationship of the capital structure and firm performance has been highlighted by different theories. In this regard, capital structure theory given by Professors Franco Modigliani and Merton Miller (MM) in 1958 under restrictive set of assumptions like efficient capital markets, investors homogeneous expectation, no taxes, no transaction cost etc. and they approved that value of a firm is not affected by its capital structure. They argued that any benefit of using increased proportion of debt as cheap source of financing is offset by increased cost of equity. Later on Modigliani and Miller presented capital structure theory by removing the assumption of no taxes because under tax code of most countries, interest payments are tax deductible. Removal of this assumption changed the

2 result of capital irrelevancy theory and MM proved that firm s value increases by increasing the level of debt in capital structure and optimal capital structure is 100% debt. However, probability of financial distress also increases by increasing the amount of leverage in capital structure. Static tradeoff theory proposed to balance the cost of financial distress and tax shield benefit by using debt. This theory suggests optimal capital structure that is achieved by using an optimal level of leverage where the benefits of debt in form of tax shield obtained becomes almost equal to the cost of financial distress incurred by using debt. Liaison of capital structure with firm performance has been examined by many researchers like Muritala (2012), Khan (2012), Skopljak (2012) and Ebrati, Emadi, Balasang and Safari (2013). It has been empirically proved in these research studies that the performance of a firm is affected by its capital structure. Aim of this research is to analyze effect of capital structure on firm performance in context of Pakistan. For this paper, sector analysis has been conducted to analyze the effect of financing choices on firm performance by selecting one of the leading sectors of food producer. OBJECTIVES 1. Aim of this study is to investigate the capital structure influence on firm performance by conducting an empirical study on selected sector of Karachi Stock Exchange. 2. To determine the dependency of firm performance on capital structure 3. To determine positive/ negative relationship of capital structure with firm performance and extent of this relationship in context of selected sector Literature Review Ebrati et al (2013) conducted a study to explore the relationship between capital structure and firm performance on the non-financial listed companies of Theran stock exchange for the period of Explanatory variables of his study were short term, long term and total debt to total asset while return on equity (ROE), return on assets (ROA), market to book value ratio (MBVR), earning per share (EPS) and Tobin s Q were used as proxy of accounting and market measures of firm performance. Results obtained by using Multiple Regression Analysis and indicate that capital structure is negatively related with EPS and ROA while it has positive significant relation with ROE, MBVR and Tobin s Q. Saeed et al (2013) studied the impact of capital structure on performance of listed banks of Karachi stock exchange in Pakistan for the period of Independent variable of the study included ratios of short term, long term and total debt to capital while Return on Equity (ROE), Return on Asset (ROA) and earnings per share (EPS) have been used as depended variables and as proxy of firm performance. Multiple regression analysis has been used and results of the study indicate that short term debt and total debt to capital ratios have strong positive relation while the long term debt to capital ratio has negative relation with performance of banking industry in Pakistan. Skopljak (2012) investigated effect of capital structure on firm performance of financial sector by using 15 Authorized Deposit-taking Institutions (ADIs) of Australia over the period of Dependent variables are profit efficiency measure and return on equity while explanatory variables include equity to total assets, standard deviation of return on equity, %age of directors ownership and size of the firm. Findings of the study P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 2

3 show significant and quadratic relationship between capital structure and performance of banks in Australia. These findings support theory of agency Cost that capital structure has significant relation with firm Performance. Results indicate that at relatively low level of leverage if the banks increase the amount of debt in capital structure, it leads to increase the profit efficiency and ultimately the bank s performance. Relationship between capital structure decisions and firm performance on engineering sector of Pakistan was found significant in the study conducted by Khan (2012). Pooled Ordinary Least Square regression was used to analyze the data of 36 selected companies over the period of Results of study indicate that independent variables of short term and long term debt to total asset have significant negative relation with firm performance which measured by return on equity, return on asset and Tobin s Q. Firm size measured by taking natural log of total assets has been used as control variable in the study and its affect has also been studied on firm performance and it is found that firm size has insignificant relation with firm performance measured by return on asset. Muritala (2012) examined the effect of capital structure on firm performance by selecting 10 listed non-financial firms in Nigeria over the period of Explanatory variables include Debt ratio, investment in tangible assets and growth opportunities while return on asset and return on equity are used as measures of firm performance. Firm size and age are introduced as control variables in the study to analyze their effect on firm performance. Panel Least Square (PLS) is used to analyze the data and results of the study confirm those of asset turnover, size and age are positively related to firm s performance. Results of the study confirm negative relation between debt ratio and firm performance and further reveal a significant but negative relationship between asset tangibility and ROA used as a measure of firm performance in the study. Antwi, Mills, and Zhao (2012) studied the effect of capital structure on company s value by taking all 34 listed companies of Ghana stock exchange (GSE). Simple regression analysis was used to study this effect. Major two components of capital structure, total equity and long term debt, have been used as independent variable to analyze their effect on firm value. Results of the study indicate that both the components of capital structure are positively and significantly related with firm value but use of long term debt maximizes firm value more than the equity. Overall results of the study suggest for using perfect combination of debt and equity for maximizing shareholders wealth. Saeed et al. (2013) studied the impact of capital structure on performance of listed banks of Karachi stock exchange in Pakistan for the period of Independent variables of the study included ratios of short term debt to capital, long term debt to capital and total debt to capital. On the other hand, return on equity (ROE), return on asset (ROA) and earnings per share (EPS) have been used as dependent variables and as proxy of companies value. Multiple regression analysis has been used and results of the study indicate that short term debt and total debt to capital ratios have strong positive relation while the long term debt to capital ratio has negative relation with performance of banking industry in Pakistan. Pratheepkanth (2011) studied the impact of capital structure on firm performance for the period of 2005 to For this purpose, 30 business firms listed on Colombo stock P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 3

4 exchange have been selected and regression analysis has been adopted for analysis of the data. Gross profit, net profit, return on asset and return on investments have been used as dependent variables while debt to equity ratio has been used as explanatory variable. Results of regression analysis revealed that capital structure measure of debt to equity and value s measures included in this study have insignificant relation. Further, correlation analysis, showed that only the gross profit has positive but weak relation with capital structure measure while other performance measures of net profit, return on assets and return on investments have negative association with debt to equity ratio. Niresh and Velnampy (2012) analyzed the direct influence of capital structure on profitability for which banking sector has been selected. Sample of 10 listed Sri Lankan banks have been selected and the data gathered from 2002 to Dependent variables include net profit, return on capital employed, return on equity and net interest margin while the independent variables of the study were ratios of debt to equity and debt to total funds. Descriptive statistics and correlation analysis had been used for analysis of the data and results of the study depicted that capital structure measures used in the study are negatively correlated with profitability measures but only debt to equity ratio is positively linked with ratio of return on equity. Methodology Purpose of this study is to empirically analyze the effect of financing choices of debt and equity on firm performance. The study has been conducted on food sector which is among the leading sectors of Pakistan listed on Karachi Stock Exchange. Out of total 54 listed companies, 33 had been finalized for the study based upon availability of data for consecutive seven years from Proxy Variables and Proposed Empirical Model Variables that have been used as proxies are given as follows: Dependent variables of company s performance that have been used for this study are return on assets and earnings per share while independent variables of capital structure included debt / equity ratio, long term debt to total assets ratio and short term debt to total assets ratio. Along with these, firm size measured by total assets has been used as control variable in the study which has also been used by other scholars in their studies Empirical Model (ROA) it = α i + β 1 (STDTA) it + β 2 (LTDTA) it + β 3 (DE) it + β 4 (TA) it + u it Equation 1 (EPS) it = α i + β 1 (STDTA) it + β 2 (LTDTA) it + β 3 (DE) it + β 4 (TA) it + u it Equation 2 Here ROA = Return on Assets EPS = Earnings per share (Earnings after tax / no. of ordinary shares) STDTA = short term debt to total assets LTDTA = Long term debt to total assets DE = Debt to equity ratio = Error term u it Theoretical Frame Work P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 4

5 Different theories have been presented on capital structure and its relevancy with firm performance. Franco Modigliani and Merton Miller (MM) first proposed capital irrelevancy theory in 1958 under restrictive set of assumptions including perfect capital market and no taxes. They argued that any blend of debt and equity is irrelevant to firm value. Any benefit received by using additional amount of debt is compensated by increase in cost of equity. Later on, they removed the assumption of no taxes and proved that firm s value increases by increasing the level of debt in capital structure. Hence optimal capital structure is 100% debt at which firm value is maximized. On other hand, extremely increased leverage level in capital structure leads towards financial distress. Hence another theory of capital structure named static Tradeoff Theory, seeks to balance cost of financial distress with tax shield benefits of using debt. This theory suggests to find out an optimal level of debt and equity at which the cost of financial distress becomes equal to the tax shield benefits of using debt and this optimal level leads to maximize the value of a firm. Data Collection Sources and Data Analysis Financial Statement Analysis of non-financial listed companies published on official website of State Bank of Pakistan from is the major source of data for this study. Panel data of this study has been analyzed by using technique of panel corrected standard errors (PCSE) along with Prais-Winsten regression because of the presence of hetero, contemporaneous and auto correlation issues in the data. However, there is not multicollinearity found in the balanced panel data used for the study. Hypothesis H0: There is no significant influence of all capital structure measures selected for this study on company s performance Purpose of this hypothesis is to test the effect of capital structure measures on company s performance means to test whether models selected for this study are significant or not. Following are the null and alternate hypotheses: Analysis and Discussion This section has been divided in to two sections, one is based upon descriptive and the other one is based upon empirical analysis. Descriptive analysis ROA EPS DE STDTA LTDTA Mean Median Maximum Minimum Std. Dev Sum Sq. Dev Observations Table 1: Descriptive statistics P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 5

6 Maximum value of return on asset is almost 78% with mean value of 9% only. Similarly, earning per share maximum value is almost Rs. 413 but means value is only Rs This shows that companies operating in food producer sector are under performing. Short term debt ratio has been observed 62% on average while long term debt ratio is 24% on average shows that food producer sector rely more on short term debt as compared to long term debt. It is evident form debt to equity ratio that debt proportion used by this sector is two times higher than equity proportion and shows minimum deviation (standard deviation is only of 5.19) from its mean value while highest deviation from mean value has been observed in short term debt ratio. Empirical Analysis Panel data effect has been tested by using Hausman test and output has been shown in Table 2 that has been provided in appendix. Result depicts that panel data used is the study has fixed effect instead of random effect. Table 3 to Table 11 that have been provided in appendix for both equations show output of tests used to analyze the different assumptions. Stationarity of data has been analyzed by using Levin, Lin & Chu unit root test and found that all variables are stationary at level. Variance inflation factor has been used to analyze the multi collinearity in the data and found that there is not multi issue. However, heteroskedasticity analyzed by Modified Wald test, contemporaneous correlation analyzed by Pesaran's test and auto correlation analyzed by using Wooldridge test exist in the data. In the presence of hetero, contemporaneous and auto correlation, simple OLS could not be applied that is why, technique of PCSE along with Prais-Winsten regression have been used to test the hypothesis. Table 12 that has been provided in appendix represents the regression result for equation 1. According to the result, equation 1 is significant at α=5%. Further analysis depicts that all the three independent variables are negatively influencing return on asset but among these, only ratio of debt to equity has been found significant while short term and long term debt ratio have insignificant relation with return on asset. Table 13 that has been provided in appendix represents the regression result for equation 2. These results are same as we have observed in equitation 1 means all independent variables are negatively affecting earnings per share but among these, only the ratio of debt to equity has significant negative effect on performance. Negative relation of independent variables shows that company s performance decreases by increasing the amount of debt in capital structure. CONCLUSION This study has been conducted to empirically analyze the relation of capital structure with performance. Results of the study depict that food sector in Pakistan is not using an optimal mix of debt and equity which is evident form negative relation of debt ratios with performance. All three capital structure measures used in the study have negative relation with performance but only the relation of debt to equity ratio has been found significant. Negative relation of debt ratios is consistent with static trade off theory that states, financial analysts need to find an optimal mix of debt and equity for maximization of company s profits. Increased amount of debt from optimal level leads the company towards financial distress and badly affect its profits. P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 6

7 REFERENCES International Journal of Multidisciplinary Consortium Antwi, S., Mills, E. F. E. A., & Zhao, X. (2012). Capital Structure and Firm Value: Empirical Evidence from Ghana. International Journal of Business and Social Science, 3(22), Ebrati, M. R., Emadi, F., Balasang, R. S., & Safari, G. (2013).The Impact of Capital Structure on FirmPerformance: Evidence from Tehran Stock Exchange. Australian Journal of Basic and Applied Sciences, 7(4), 1-8. Khan, A. G. (2012). The relationship of capital structure decisions with firm performance: A study of the engineering sector of Pakistan. International Journal of Accounting and Financial Reporting. 2(1), Levin, A., Lin, C.-F., & James Chu, C.-S. (2002). Unit root tests in panel data: asymptotic and finite-sample properties. Journal of econometrics, 108(1), List of Companies listed at Karachi Stock Exchange. (n.d.). Retrieved September , from KSE Stocks: Modigliani, F., & Miller, M. H. (1959). The cost of capital, corporation finance, and the theory of investment: Reply. The American Economic Review, 49(4), Muritala, T. A. (2012). An Empirical Analysis of Capital Structure on Firms Performance in Nigeria. International Journal of Advances in Management and Economics. 1(5), Niresh, J. A., & Velnampy, T. (2012). The Relationship between Capital Structure and Profitability. Global Journal of Management And Business Research, 12(13), Podestà, F. (2002). Recent developments in quantitative comparative methodology: The case of pooled time series cross-section analysis. DSS Papers Soc, Pratheepkanth, P. (2011). Capital structure and financial performance: evidence from selected business companies in Colombo stock exchange Sri Lanka. International Refereed Research Journal, 2(2), Saeed, M. M., Gull, A. A., & Rasheed, M. Y. (2013). Impact of Capital Structure on Banking. Performance (A Case Study of Pakistan). Interdisciplinary Journal of Contemporary Research in Business, 4(10), Skopljak, V. (2012). Capital Structure and Firm Performance in the Financial Sector: Evidence from Australia. Asian Journal of Finance & Accounting, 4(1), Saeed, M. M., Gull, A. A., & Rasheed, M. Y. (2013). Impact of Capital Structure on Banking Performance (A Case Study of Pakistan). Interdisciplinary Journal of Contemporary Research in Business, 4(10), P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 7

8 Appendix International Journal of Multidisciplinary Consortium Unit Root Test Variable Test T.stat. P value Stationary DE Levin, Lin and Chu test* P= On level STDTA Levin, Lin and Chu test* P= On level LDTA Levin, Lin and Chu test* Table 2: Output of Unit Root Test Testing of Assumptions: Equation 1 Testing the Correlate s Random Effect Equation: ROA with de, stdta, ltdta Test cross-section random effects P= On level Test Summary Chi-Sq. Statistic Chi-Sq. d.f. Prob. Cross-section random Table 3: Output of Hausman test Variance Inflation Factor-VIF Date: 12/17/13 Time: 13:05, Sample: , Observations: 231 Variables Coef. Variance Un-centered VIF Centered VIF DE STDTA LTDTA C NA Table 4: Output of Multi-collinearity Modified Wald test for groupwise heteroskedasticity in fixed effect regression model H0: sigma(i)^2 = sigma^2 for all i chi2 (33) = Prob>chi2 = P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 8

9 Table 5: Output of Hetero International Journal of Multidisciplinary Consortium. xtserial roa de stdta ltdta Wooldridge test for autocorrelation in panel data H0: no first-order autocorrelation F( 1, 32) = Prob > F = Table 6: Output of Auto Correlation test. xtcsd, pesaran abs Pesaran's test of cross sectional independence = 3.610, Pr = Average absolute value of the off-diagonal elements = Table 7: Output of Cont. Correlation test Testing of Assumptions: Equation 2 Variance Inflation Factor-VIF Date: 12/17/13 Time: 13:12, Sample: , Total observations: 231 Coefficient Un-centered Centered Variables Variance VIF VIF DE LTDTA STDTA C NA Table 8: Output of Multi-collinearity Modified Wald test for groupwise heteroskedasticity in fixed effect regression model H0: sigma(i)^2 = sigma^2 for all i chi2 (33) = 9.9e+06 Prob>chi2 = Table 9: Output of Hetero Wooldridge test for autocorrelation in panel data H0: no first-order autocorrelation F( 1, 32) = Prob > F = P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 9

10 Table 10: Output of Auto Correlation test Pesaran's test of cross sectional independence = 4.011, Pr = Average absolute value of the off-diagonal elements = Table 11: Output of Cont. Correlation test. xtpcse roa de stdta ltdta i.time, correlation(ar1) (note: estimates of rho outside [-1,1] bounded to be in the range [-1,1]) Output of Regression Analysis: Prais-Winsten regression, correlated panels corrected standard errors (PCSEs) Group variable: entity Number of obs = 231 Time variable: time Number of groups = 33 Panels: correlated (balanced) Obs per group: min = 7 Autocorrelation: common AR(1) avg = 7 max = 7 Estimated covariances = 561 R-squared = Estimated autocorrelations = 1 Wald chi2(3) = 6.65 Estimated coefficients = 10 Prob > chi2 = Panel-corrected roa Coef. Std. Err. z P> z [95% Conf. Interval] de stdta ltdta time _cons rho Table 12: Regression analysis result (Eq. 1) P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 10

11 Prais-Winsten regression, correlated panels corrected standard errors (PCSEs) Group variable: entity Number of obs = 231 Time variable: time Number of groups = 33 Panels: correlated (balanced) Obs per group: min = 7 Autocorrelation: common AR(1) avg = 7 max = 7 Estimated covariances = 561 R-squared = Estimated autocorrelations = 1 Wald chi2(3) = Estimated coefficients = 10 Prob > chi2 = Panel-corrected eps Coef. Std. Err. z P> z [95% Conf. Interval] de stdta ltdta time _cons rho Table 13: Regression analysis result (Eq. 2) P u b l i s h e d b y : M o d e r n R o h i n i E d u c a t i o n S o c i e t y P a p e r I d : Page 11

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