CHAPTER II LITERATURE STUDIES

CHAPTER II LITERATURE STUDIES 2.1 Capital Structure Theory The discussion on capital structure began with the suggestions proclaimed by Modigliani and Miller (MM) in the late 1950s. The basic assumptions of MM were the three following things: no taxes, no transaction costs and individuals and firms borrow at the same rate. According to MM, the value of levered firm is the same as the value of unlevered firm. The firm s financing strategies which implemented in its capital structure may not affect its value. MM also suggested that the movement of the firm s cost of equity is alligned with its level of leverage. Higher level of leverage may increase the cost of equity as well. The element of debt in its capital structure leads to higher risk that need to be borne by the shareholders. In 1963, MM included the element of corporate taxes into their propositions. They concluded that the value of levered firm is higher compare to unlevered firm. The levered firm may receive a benefit of tax shields. Interest payment on corporate debt is tax deductible. The existence of deductible expense may result in lower amount of corporate taxes to be paid by firm. Therefore, the net income of levered firm may be higher than unlevered firm. 6

7 2.2 Optimal Capital Structure Firm s optimal or target capital structure is the appropriate proportion of debt and equity that maximizes the market value of the firm s equity and minimizing its cost of capital (Hawawini and Viallet 2007). In order to reach the optimal capital structure, there are five steps that firm does follow and repeated (Brigham and Ehrhardt 2005): 1. Estimating the cost of debt 2. Estimating the cost of equity 3. Estimating the weigthed average cost of capital (WACC) 4. Estimating the firm s value 5. Estimating shareholder wealth and stock price 2.3 Leverage 2.3.1Type of Leverage Leverage in a firm can be defined as the use of assets or debts in order to generate return. There are two types of leverage with reference to the firm s income statement: operating leverage and financing leverage. The firm s income statement divided into two parts to illustrate better understanding on the leverage (Gitman, 2009). The upper part focuses on the revenue minus both fixed and variable cost which results earnings before interest and taxes (EBIT). As for the lower part of the

8 firm s income begins with EBIT all the way to earnings available for common shareholders. Operating leverage uses the upper part of the firm s income statement. Operating leverage determines the relationship between the revenue and EBIT. Other factors held constant the small change in revenue may caused in large change in EBIT (Brigham and Ehrhardt, 2005). Break- even point (BEP) is an important measurement. BEP is the level of sales at which total revenues and expenses are equal and operating income is zero (Laux, 2010). Operating leverage uses fixed operating cost to generate higher level of revenue then it results in higher EBIT. The determination of the size of fixed operating cost may be affected by the firm s future planning. 2.3.2 Financial Leverage Financial leverage uses fixed financial cost to magnify the effect of changes in firm s earning before tax (EBIT) on its earnings per share. Fixed financial cost is the interest charges on borrowed fund that the firm needs to pay regardless on the amount of EBIT available. Financial leverage may cause positive and negative impact. Leverage is positive when the return of the investment is higher than the cost of borrowed fund and vice versa. Positive financial leverage may result in the increase of EPS (Khan and Jain, 2007). Increase in financial leverage will increase the firm s risk which may force it to generate higher EBIT (Syamsudin, 1995, cited in Bhirawa, 2000).

9 Three important suggestions on financial leverage according to Brigham and Ehrhardt (2005): 1. The presence of debt in firm s capital structure may bring benefit to its shareholders. They may continue to manage the firm without having to incerease their investment. Creditors consideration is limited to the firm s ability to payback the funds that have been given to the firm in term of debts. Shareholders have the control in managing their funds. 2. The shareholders return may be maginified or leveraged when the cost of borrowed funds are lower than the return of the investments. The higher the level of debt of a firm, it may also increase the risks. 3. Creditors may bear with risk when they decide to give loans to a firm. Therefore, they need to know their margin of safety. Margin of safety can be obtained by analysing the firm s ability to repay its loans through the equity. Financial leverage describes how a firm finances its activities. The ability of a firm to meet all of the obligations can be examined by the financial leverage ratio. The following formulas are the approaches to measure this ratio: According to Ross, et al., (2008), leverage ratio can be measure using the below formula: Debt-equity ratio (DER) = Total debt / Total equity

10 The data to support the measurement can be obtained from the firm s balance sheet. Total debt is the sum of all of the obligations that a firm have. This ratio describes the proportion of the firm s capital structure to finance its assets. DER may also indicate the level of debt which a firm safely borrowed for a period of time. This ratio is carefully examined by the creditors in making its decision on approving a loan to a firm. Creditors may prefer firm with lower DER, because higher DER indicates a higher loan risk. Loan risk is the tendency of the loan not being repaid. Shareholders on the other side may prefer a higher DER, because they expected to increase their earnings. DER may also be useful to analyze a firm s condition compare to its competitors. Looking at the industry where the firm operates is needed in measuring this ratio. The situation of an industry may not be the same with the other industry. Capital intensive industry such as infrastructure may have higher debt ratio compare to a restaurant. Degree of financial leverage (DFL) with income statement as the base of measurement (Gitman, 2009) 1. DFL = % change in EPS / % change in EBIT Financial leverage observed the relationship between earnings before interests and taxes (EBIT) and earnings per share (EPS) of a firm. Financial leverage explains the changes in EBIT resulted in changes in firm s EPS. Financial leverage exists whenever the DFL is greater than

11 1. It means that the changes in EPS must be greater than the changes in EBIT. 2. DFL = EBIT / EBIT I (PD x (1/(1-T)) Where I = interest PD = preferred stock dividend T = tax In a condition when there is no payment of preferred stock dividend, the formula may be written as below: DFL = EBIT / EBT The difference between DER and DFL are as follows: Debt to equity ratio only determine the proportion of firm s capital structure (the proportionate level of debt and equity) DFL measures the impact of fixed financing cost on the firm s financial structure (Gitman, 2009). The effects of financial leverage may depend on firm s EBIT (Ross, et al., 2008).

12 2.4 Cost of Capital Cost of capital is also a key factor in choosing the mixture of debt and equity used to finance the firm (Brigham and Ehrhardt, 2005). Cost of capital describes as an overall cost that is required for a firm to finance its investments or projects. Cost of capital consists of cost of debt and cost of equity. Cost of debt refers to the interest rate that the creditors charged to the firm. Cost of equity capital identifies as the minimum required rate of return expected by the investors for the amount invested in the firm s shares. Firm may decide to use debt on its capital structure because of the benefit from interest expense which is tax deductible. However, when leverage exists the shareholders earning may become volatile. Leverage is attached with financial risk. The shareholders may required higher rate of return which will result in higher cost of equity. The benefit of tax may be offset by the increase in cost of equity. Highly leverage firm which caused by the continuation of the firm to borrow funds, may increase the bankruptcy risk (Maugham, 2000). Weighted average cost of capital is the minimum rate of return that a firm required to achieve in order to satsify the investors who provide the capital. Weighted average cost of capital (WACC) after tax is evaluated using the following formula (Ross, et al., 2008): WACC= R s x S / (S + B) + R b x (1 t c) x S/ (S + B) Where: S = firm s equity

13 R s = cost of equity T = tax rate for the firm B = firm s debt R b = cost of debt Cost of Equity Capital Cost of equity capital identifies as the minimum required rate of return expected by the investors for the amount invested in the firm s shares. The return may be derived from dividend or an increase in the market value of shares which is known as capital gain. There are two models to calculate cost of equity capital: constantgrowth model (dividend discount model) and capital asset pricing model (CAPM) Hawawini and Viallet (2007), the formula of Constant-growth model (dividend discount model): The value of common stock describes as the total present value of the future dividens. The growth of dividends is assumed to be at constant rate in perpetuity. There is a given dividend per share that is expected to be paid within one year. P 0 = D / (k g) k = (D / P 0 ) + g where

14 P 0 = stock value D = expected dividend per share at the end of year 1 g = growth in dividend (perpetuity) Damodaran (2002), the formula of Capital Asset Pricing Model (CAPM) is as follow: R j = R f + β x (R m R f ) where R j = stock returns R f = risk-free rate of returns R m = market returns β = beta Comparisson between Gordon model and CAPM model: CAPM model includes a risk factor on the measurement. The risk is reflected as beta. Beta describes the tendency of the stock of a security to act in response of the movement in the market. Formula to estimate firm s beta (Ross, et al., 2008) β = Cov (R i, R m ) / Var (R m )

15 Cost of debt capital Cost of debt refers to the interest rate that the creditors charged to the firm. The formula to calculate the firm s cost of debt has been presented above. There are three elements included in the measurement, such as portion of debt, cost of debt and tax rate. The following are the formulas to calculate these three elements: Portion of debt = BV IBD / (BV IBD + BV Total equity) where BV IBD = book value of interest bearing debt Cost of debt = Interest expense / Average interest bearing debt Tax rate (%) = Tax expense / Profit before tax 2.5 Price Earning Ratio PER is a financial ratio which describes how much do investors willing to pay for a share per its earnings. PER can be used to analyze whether the price of a stock is too high or too low compare to its own historical price and its industry s price. PER will be use best when it is compare to its own industry rate as a guideline. Financial leverage is attached to investment decisions which affect the firm s profitability. Leverage firm uses borrowed funds to make investments. The investment funds are used to develop the firm s future planning. The increase in firm s profit may increase the shareholder s wealth. The increase in profit may

16 increase the value of EPS. The market value of shares may also increase when the value of EPS increases (Bhayani, 2009). High financial leverage indicates that firm uses more debt on its capital structure. High financial leverage results in high fixed financial charges and thus financial risk. Financial risk is the risk when the firm doesn t have sufficient funds to cover its fixed financial charges. Firms with high growth rates in earnings may have high PER, while firm with high level of financial leverage may have lower PER to reflect the higher risk profile of such companies (Correia, et al., 2007). Leverage has negative relationship with price earning ratio. Investors may use leverage which represented by debt to equity ratio to determine the financial condition of a firm. Highly leverage firm may have higher financial risk because it will need to pay the fixed financial cost. This condition may decrease the price earning ratio of firm (Lukas, 1994, cited in Daulata, 2004). PER is assumed as indicator of firm s ability to generate earnings. Firm with high growth rate of earnings may give positive signal to investors to invest in its firm. Profitable firm may tend to use internal financing over debt. In conclussion, financial leverage has negative relationship with price earning ratio (Servaes, 1995 & Handayani, 2005, cited in Yohanna, 2005). 2.6 Value of Firm Value of firm can be determined through the sum of its value of debt and equity or. The firm s value of debt and equity can be seen in its balance sheet. The

17 values of the accounts presented in firm s balance sheet are stated at the accountingbased book values. Accounting-based book values reflect the historical or original costs. In order to provide information which may reflect the current condition, the value of firm can also be determined through the sum of its market value of debt and equity. Market values reflect the current values of firm. Berk, et al. (2009) describes the formula to calculate market-value balance sheet as follow: Market value of assets = Market value of equity + Market value of debt Market value of equity also refers to market capitalization. Market capitalization equals to market price per share times the number of outstanding shares. Market value of debt equals to interest bearing debt. Interest bearing debt is the sum of firm s obligations (short-term and long-term) which have the element of interest. 2.7 Hypothesis Development 2.7.1 Relationship between Financial Leverage and Cost of Capital Dhankar and Boora (1996) performed a study about cost of capital, optimal capital structure, and value of Indian firms listed in Bombay Stock Exchange. They determined to identify whether the changes in capital structure may result changes in cost of capital. The result showed that the relationship between capital structure and cost of capital are negative and insignificant. It means that the changes in the capital

18 structure may not be followed by a proportional changes in the cost of capital. According to Dhankar and Boora, cost of debt is cheaper than cost of equity. There is a tax benefit for interest payment. Cost of capital is not the only determinant of capital structure, so that the exact relationship cannot be measured. There is no specific formula to calculate cost of capital in Indian companies. Each company may have different formula to calculate cost of capital. Khadka (2006) conducted a study to investigate the relationship between leverage and cost of capital in Nepalese firms. The aims of the study were to test whether an increase in leverage may cause a decline in overall cost of capital and cost of equity. He used a simple regression analysis to test the relationship between variables. The result showed that there is insignificant relationship between leverage and cost of capital. However, the coefficient is negative. Negative sign indicates that increase in leverage may cause a decline in cost of capital. MM s (Modigliani and Miller) suggested that cost of capital decline with the increase of leverage because of the tax benefit of the interest charges. The result showed insignifficant relationship between cost of equity and leverage. The coefficient is negative which indicate increase in leverage result in decrease in cost of equity. He also found that cost of capital may also decline when he eliminates the tax benefit on interest charges. The result opposed the MM s suggestion. Bhayani (2009) conducted a study in Indian cement industry within 2000 2008 periods. Firm may need to construct its capital structure to obtain the level that may bring an increase in the investment. The cost of capital may be varying between

19 cheap and expensive funds. He then investigated the correlation between financial leverage and cost of capital. The result shows that there is no correlation between financial leverage and cost of capital. Based on the previous studies about the relationship between financial leverage and cost of capital, the author determines the hypothesis of the study as: There is a correlation between financial leverage and cost of capital 2.7.2 Relationship between Financial Leverage and Price Earning Ratio Bhirawa (2000) studied that financial leverage has negative relationship with price earning ratio. The study used LQ45 firms whitin 1995 1997 periods. The result opposed MM s proposition, but alligned with previous study by Rizqoni in 1995 (cited in Birawa, 2000). Investors that wish to invest in firm s stock price may consider the firm s level of debt. Firm with high level of debt have high financial risk which may result in firm s difficulty on fixed financial cost payment. This situation may affect the amount of profit available for shareholders. Yohanna (2005) studied that financial leverage has a negative relationship with price earning ratio. The study used manufacture and trade & services firms listed in JSX within 2004 2007 periods. Higher price earning ratio may result in lower financial leverage. It is because high price earning ratio may indicate good firm s capital that result in lower debt financing.

20 Daulata (2004) studied that debt to equity ratio has a positive relationship with price earning ratio. The study used 22 Indonesian firms listed in JSX within 2002 2003 periods. The criterias of the samples are firms that never do activities such as stock split, right isssue and dividend shares activities within the choosen periods. Daulata stated that the result of the study contradicts the theory. Higher portion of debt in firm s capital structure may result in increase of risks that need to be borne by the firm. In this situation, firm may increase the required rate of return in valuing its stock. As the result, price earning ratio may decline. He suggested extending the sample periods to obtain more accurate results. Novianti (2005) examined the relationship between capital structure and earning per share in Indonesian listed pharmacy firms for 2003 2004 periods. The result showed that capital structure has a positive and strong relationship with earning per share. The increase in capital structure may cause the increase in earning per share as much as the coefficient regression. Kholid (2006) examined the determinants of price earnings ratio on firms listed in Jakarta Stock Exchange (JSX) for 2001 2003 periods. He only used firms that pay dividend within 2001 2003 periods as the sample. The result showed that debt to equity ratio (leverage) has no significant influence on price earning ratio. The theory of high debt to equity ratio which may result in decrease of price earning ratio is not proven in this study. The author stated that high debt to equity ratio describes that the firm uses debts more over equities. High level of debt may indicate low firm s solvability which may result in lower ability of firm to repay its debts. Lower

21 solvability indicates high firm s financial risk. High risk may cause a decline in firm s stock price which may result in lower price earning ratio. The result of the study opposed this theory. He concluded that debt to equity ratio may not be used as a variable to analyse the value of price earning ratio. Kusumaputra (2006) studied the factors that affect firm s price earning ratio. The sample of firms used in the study was LQ45 within 2002 2004 periods. She found that financial leverage has no significant relationship on price earning ratio. The result of the study opposed the theory of financial leverage as a proxy of risk. Firms with high level of debt may have higher risk because debt may raise commitment. Commitment refers to interest payment to the creditors. Payments to creditors would take precedence over shareholders. By looking at the financial leverage as a proxy of risk, the higher the financial leverage then the investors preference on the stock price may decline which result in decline of price earning ratio. The explanation of the contradicted result was the possibility of the investors view on high risk high return. Regardless to the risk of high level of debt, firms may still have potential to generate an increase in shareholders value. Nugroho (2006) investigated the factors that influence firm s capital structure. The data used in the study was the listed property firms in JSX for 1994 2004 periods. The result showed that price earning ratio has a positive and significant influence on debt to equity ratio. He stated that the firm may need to maintain the firm s financial performance in order to attract investors. Price of earning ratio will

22 be high when investors convinced with the firm. In this condition, firm may not be difficult to find creditors. Mugiharta (2007) studied the determinants of debt to equity ratio on firms listed in JSX for 2000 2002 periods. He found that price earning ratio has a positive and significant impact on firm s capital structure. Investors indicated the increase in price earnings ratio as a signal of firm s positive prospect. Therefore, creditors will not hesitate to provide loans for the firm. Bhayani (2009) conducted a study in Indian cement industry within 2000 2008 periods. Debt is cheaper fund compare to equity. In condition where the cost of borrowed funds is lower than the return of investments, it may increase the firm s earnings. He then investigated the correlation between financial leverage and price earning ratio. The result shows that there is no correlation between financial leverage and price earning ratio. Based on the previous studies about the relationship between financial leverage and price earning ratio, the author determines the hypothesis of the study as: There is a correlation between financial leverage and price earning ratio 2.7.3 Relationship between Financial Leverage and Value of Firm Dhankar and Boora (1996) studied the influence of capital structure on value of firm. They used 26 companies from different industries in India as the sample.

23 They tested the two variables for both micro and macro level. In micro level, the result showed that there is no significant relationship between capital structure and value of firm. The authors explained that capital structure is not the only factor that affects value of firm. Market price of the firm s stock is not the only indicators of firm s performance. There are qualitative factors which may affect the value of firm. That is why the exact relationship between capital structure and value of firm cannot be measured. While the result from macro level showed that there is a highly positive and significant relationship between capital structure and value of firm. The author explained that the positive and negative effects of qualitative factors on the indivudual stock price may offset one another. That is why the correlation between capital structure and value of firm is positive because more real value of the stock price can be measured. The result showed that leverage may bring benefit to increase value of firm. Dhankaar and Boora confirmed with the companies on qualitative factors which may affect the value of firm. Based on their discussion, the qualitative factors are operating results, business risk, economic conditions, promoters, tax rates and structures, and political conditions. Sharma (2006) studied the influence of financial leverage on firm s value. The study focused on selected manufacturing sector firms in India. The variables used by the author were DER, return on investment (ROI), ROE, and EPS. The result demonstrates that capital structure of most of the firms has exhibited a direct correlation between the financial leverage and firm s value where the capitalization

24 was optimum. At the level of optimum capitalization the condition of the firms were as follows: DER (2:1) was close to the industry standard in India ROI, ROE and EPS showed an upward trends Safrida (2008) studied the impact of firm s capital structure on its value. Debt to equity ratio is used as the measurement of the firm s capital structure. The value of firm was measured by market to book value ratio. The data used in the study was the listed manufacture firms in Jakarta stock exchange for 2004-2006 periods. The result showed that capital structure has a negative and significant impact on the value of firm. Decrease in the firm s level of debt may bring effect to the increase in value of firm. She concluded that the firm tend to use debt for its financing therefore it brings influence to the decreasing value of a firm. Rayan (2008) studied that financial leverage has a negative correlation with value of firm. The study used listed South African firms within 1997 2007 periods. This result indicates that an increase in financial leverage may result a decrease in value of firm. MM s theory explaines that the cost of equity may increase aligned with the increase of the level of debt. Optimal capital sucture suggests that the value of firm may be maximized when the cost of capital is at minimim level. The author suggested that the result of the study may be explained by the possibility of firms are not on their optimal level of debt. However, the calculation done on the sample firms did not verified whether they move closer to the optimal level of debt. The other

25 additional explanation was firms may employ higher level of debt because of the existence of tax benefit. However, profitable firms may not choose to rely on high debt because they have good capacity on their internal funds. Sarpi (2009) studied the relationship between the capital structure and value of firm. The study used listed Indonesian firms within 2006 2007 periods. The result showed that capital structure has a negative and significant relationship with value of firm. The increase in the firm s level of debt may indicate that the firm s is facing a dificulty in cashflows. Therefore, the increase in the firm s level of debt may increase the risk of bankruptcy. This situation decreases the value of firm. Bharasa (2009) studied the influence of debt to equity ratio on value of firm (Market value of equity). The study focused on banking firms for 2005 2007 periods. In partial, debt to equity ratio does not affect firm value. However, simultaneously debt to equity ratio and debt to assets ratio have a positive and significant influence on value of firm. Bhayani (2009) conducted a study in Indian cement industry within 2000 2008 periods. The purpose of the study is to test MM s proposition on value of levered firm is higher than value of unlevered firm. The result shows that there is no correlation between financial leverage and value of firm. The result opposed MM s proposition.

26 Based on the previous studies about the relationship between financial leverage and value of firm, the author determines the hypothesis of the study as: There is a correlation between financial leverage and value of firm