The Significance of Capital Structure and Dividend in Determining Firm Profitability and Shareholder Value Added: Evidence from the Pharmaceutical Sector of India. * MeruguVenugopal, ** Dr. M Ravindar Reddy * Research Scholar, School of management, NIT Warangal ** Associate Professor, School of management, NIT Warangal Abstract To be more successful in the today s competitive world organizations need to incorporate innovative strategies to meet the most accepted goals of firm, increase in profitability and shareholder wealth maximization. The main aim of the paper is to examine the effect of capital structure and dividend on the profitability and shareholder value added of Indian pharmaceutical firms. We collected data on a sample of 27 firms listed on the Bombay stock exchange (BSE) from 2007 to 2014 and evaluated the data using OLS multiple regression. The results reveal that there is a significant positive relationship between profitability, shareholder value added and dividend. Whereas the capital structure measured as the debt equity ratio is negatively associated with profitability and shareholder value added. In addition size is positively associated with profitability and shareholder value added. Growth in assets has an insignificant negative association with profitability and shareholder value added. Keywords: Capital structure, return on assets, shareholder value added, OLS regression, innovative strategies. 1. INTRODUCTION It is now widely accepted that the elementary task of any business is value creation. Shareholder value maximization is one of the major goals of a company imposed by the investors (Pandey, 2001), which should be understood as a long-term concept. Since 1980 it s becoming popular, and is specifically associated with former CEO of General Electric, Jack Welch. Since then it has been a prominent aspect upon which perennial researches are performed and have evolved various yardsticks to measure and maximize the same. The true way that the business ought to generate wealth is by obtaining considerable economic returns to its owners. To obtain a coherent notion of the shareholder value, the business needs certain instruments that assist in measuring the same. These instruments may not be able to foretell, but could give hands so as to take certain pivotal decisions in the business. Amid these, few instruments are: Profitability, Size of the firm, Growth rate of sales, Capital structure, etc(r Azhagaiah, 2008) The Profitability of a company is recognized as a driver of corporate growth and value creation by many researchers. Also it has a great and profound impact on the shareholder's value. It can be measured by the terms Return on Total Assets (ROA), Return on Capital Employed (ROCE), Return on Investment (ROI), Return on Equity (ROE), Gross Operating Profit (GOP), and Profit margin on sales. Here we brought into the play ROA for the analysis. Shareholder wealth is represented in the market price of the company s common stock and dividend decisions.dividend decisions are recognized as centrally important because of the increasingly significant role of the finances in the firm s overall growth strategy.dividends can give an indication about the company s real worth to investors. The investor needs a return for his invested money and risk associated with it in the form of dividend or appreciation in the equity value of the firm and they are an important reflection of a company's value and will give a powerful message about future prospects and performance. The decisions related capital structure choice of a business plays a vital role because a poor decision can affect a firm s profitability and will destroyshareholders value(amponsah, Michael, & Hughes, 2013).The financial manager s goal is to maximize shareholder wealth, the decisions of him play a vital role in achieving this objective. On such decisions, capital structure is an important decision(sabir & Malik, 2012), for it could lead 245 MeruguVenugopal, Dr. M Ravindar Reddy
to an optimal financing mix which maximizes profitability and shareholder wealth. To meet these objectives various organizations have acknowledged the innovative strategies to be successful and ahead in the competitive world. However, it requires not only a plan, a systematic and continuous monitoring approachin the implementation of innovative strategies. When financial managers assess a potential investment in a project, they examine the risks and the potential benefits and costs. If the risk adjusted benefits do not outweigh the costs, they will not invest rather will shift their investment elsewhere. In order to support all the financial requirements firms earnings may not be sufficient. A firm can raise new capital either by borrowing or by selling additional ownership interests or both. The capital formed from some mix of debt, internally generated equity and new equity is called capital structure. Therefore In this paper, we are going to depict the influence of the major players in determining the firm s primary objectives i.e., Shareholder value maximization and profitability by drawing aid from the financial data of 27 odd Indian Pharmaceutical companies over a period of ten years (2007-2014) thrusting upon the capital structure and dividend. Hence, this is yet another study to contribute to the debate on capital structure and its application to a sector which has not been visited. 2. LITERATURE REVIEW Since a decade the relationship between capital structure choices and firm value has been broadly researched. Capital structure may affect the valuation of the firm, the higher the debt ratio, the greater the risk and will lead to increase in interest rate. The rising interest rates overwhelm the tax advantages of debt. If the firm fails to cover interest charges from its operating income, the firm may be forced into bankruptcy and too much debt can keep the company wipe out shareholders wealth in the process(ramachandran Azhagaiah, 2007),(Yinka & Oluwadetan, 2015),(Ogebe, Ogebe, & Kemi, 2013), (Balasundaram nimalathasan & Brabete, 2008) Studied capital structure and its effect on profitability of listed manufacturing companies in Sri Lanka. They discovered D/E ratio is positively and strongly related to profitability. Company profitability can be computed through various indicators. A generally used indicator is return on assets (ROA) It is measured by dividing earnings before interest and tax by book value of total assets(bevan & Danbolt, 2000), (Huang & Song, 2002), (Antoniou et al., 2008) and(rajan & Zingales, 1995)(Buferna & Hodgkinson, 2005). There is a significant and a negative relationship between leverage ratios and profitability of the firm. There are various determinants of shareholder value. Dividend policy is one such variable which affects firm s profitability measured by the return on assets. The results showed a positive and significant relationship between return on assets, growth in sales and dividend policy (Amidu, 2007). Similar results found in(ajanthan, 2013), (Adediran & Alade, 2013)and (Ouma & Murekefu, 2012)respective studies and managers ought to focus and devote adequate time in outlining a dividend policy that will enhance firm profitability and in this way shareholder value. (Raei, Moradi, & Eskandar, 2012)analyzed the impact of dividend policies of Iranian listed firms found a non-significant relationship between dividend policy and performance measured as return on assets.(sajid, Gul, Razzaq, Iqbal, & Khan, 2012) analyzed the impact of dividend policy on shareholder wealth of listed firms in Karachi Stock Exchange. Using multiple regression and stepwise regression, the result shows a significant impact of dividend policy on shareholder wealth. The size of the firm is measured by the natural logarithm of total assets. Companies with large total assets are capable of diversifying their investments and are less vulnerable to bankruptcy (Rajan & Zingales, 1995). It has been indicated by various studies that there is a positive relationship between a company size and leverage which, accordingly, ponders emphatically such company s profitability (sheridan titman, 1988),(Huang & Song, 2002), (Antoniou et al., 2008) and (Thippayana, 2014) According to (Ramalho & Vidigal, 2007), the issues of different size may have a different composition of capital structure determination. Small and medium scale firms more dependent on internally generated funds for investment in good opportunities. Moreover, they have limited access to external financing(coleman & Coleman, 2006)(Uyar & Guzelyurt, 2015), the study by (Al-najjar & Taylor, 2008)state that growth, firm size and profitability affect the composition of debt in the capital structure. (Chandrasekharan, 2012)analyses the 246 MeruguVenugopal, Dr. M Ravindar Reddy
determinants of capital structure in the Nigerian firms and He found that size, age, growth, profitability and tangibility are important determinants of capital structure. (Saeed, Munir, Lodhi, Riaz, & Iqbal, 2014) analyses the determinants of capital structure of Pakistan s pharmaceutical firms. They found profitability, growth and other independent variables are significantly dependent on capital structure. (Handoo & Sharma, 2014)examined the important determinants of capital structure of 870 listed Indian private sector companies and government companies. He concluded that the cost of debt, profitability, growth, asset tangibility, size, tax rate, and debt serving capacity are the most important determinants of capital structure. After studying various studies we have framed following objectives for this study a) To identify the relationship between profitability and the capital structure of debt to equity ratio in pharmaceutical firms. b) To identify the relationship between profitability and the dividend payout in pharmaceutical firms. c) To identify the relationship between shareholder value added and the capital structure of debt to equity ratio in pharmaceutical firms. d) To identify the relationship between shareholder value added and the dividend payout in pharmaceutical firms. Hypothesis framed The following null hypotheses were framed which need to be tested. H 0 1: There is no significant relation between the Debt equity ratio and Profitability of the firm. H 0 2: There is no significant relation between the Dividend payout and Profitability of the firm. H 0 3: There is no significant relation between the Debt equity ratio and Shareholder value added. H 0 4: There is no significant relation between the Dividend payout and Shareholder value added. Empirical model In order to achieve the main objectives of this study, we estimate the following OLS regression equations ROA it = β 0 + β 1 DERATIO it + β 2 SIZE it + GROWTH it + e it (1) ROA it = β 0 + β 1 DIVIDEND it + β 2 SIZE it + GROWTH it + e it (2) SVA it = β 0 + β 1 DERATIO it + β 2 SIZE it + GROWTH it + e it (3) SVA it = β 0 + β 1 DIVIDEND it + β 2 SIZE it + GROWTH it + e it (4) Where, the subscript i denotes firm s cross section dimensions ranging from 1 to 27, t denotes time series dimension year from 2007 to 2014 and e it represents an error component. ROA represents return on assets of firm i in time t, SVA is shareholder value added of firm i in time t, DERATIO is debt-equity ratio of firm i in time t, SIZE is the natural logarithm of assets of firm i in time t, and GROWTH is sales growth of firm i in time t. 3. RESEARCH METHODOLOGY Data and Variables In examining the effect of capital structure and dividend payout on the profitability and shareholder value added of pharmaceutical firms, panel data from 27 firms drawn from India is used. These 27 firms are purposely selected due to data availability and accessibility. Sample The data are annual in nature collected from the capitaline plus database and it covers the eight year period 2007 2014. The following set of data is captured to represent both the dependent and the independent variables. Dependent variables In order to analyze the effects of capital structure and dividend on the shareholder value added and profitability of firms in Pharmaceutical companies, profitability is measured by return on assets (ROA), which 247 MeruguVenugopal, Dr. M Ravindar Reddy
is defined as the ratio of earnings before interest and tax to total assets. ROA is used as a dependent variable. The return on assets is a better measure since it relates the profitability of the company to the asset base. The modern evaluation technique shareholder value added is considered as the one of the dependent variable in this study. The measure has been described by (Fernández, 2002), Shareholder value is calculated as follows: SVA = Increase of equity market value + Dividends paid during the year + other payments to shareholders (such as discounts on par value, share buybacks) Outlays for capital increases Conversion of convertible debentures. Independent variables The independent variables are debt-equity ratio (DERATIO) which represents the capital structure and dividend payout in the year. Only one of these independent variables will be used in the regression models.apart from these variables, the size of the firm, the growth in its sales were employed as control variables. Firm s size (SIZE) was measured as the natural logarithm of assets, and growth rate in sales (GROWTH) as (Sales 1 - Sales 0 )/Sales 0. 4. RESULT AND ANALYSIS Descriptive statistics The table 1 shows descriptive statistics about the variables used in the study. The mean value of return on assets is around 11.83 percent. It witnessed a high volatility range from 12.24 percent with the range of -28.08 and 105 percent. Which may be due to the inclusion of different scale and segment of firms in our sample. SVA is on average 1301.39 and showed a high volatility ranges from 4059.30 within the range of -8240.80 and 34314.59. The table further shows that the mean value of debt-equity ratio of all the firms taken together is 60.20 percent. This shows mostly pharmaceutical firms financing their activities through debt. The minimum, maximum, mean and standard deviation of the dividend is 0.00, 905.96, 60.86 and 106.86 respectively. This shows most of the pharmaceutical firms paying out dividends. The mean sales growth is 18 percent, with wide range spreads between -80.01 and 154.80 showing a high variation of firms growing policies during the study period. The minimum, maximum, mean and standard deviation of a firm s size is 1.20, 4.18, 2.86 and 0.69 respectively. Table 1: Descriptive Statistics SVA ROA DERATIO DIVIDEND SIZE GROWTH Mean 1301.3980 0.1183 0.6020 60.8625 2.8659 17.9994 Median 43.0450 0.1262 0.4450 18.0200 2.8692 17.3600 Maximum 34314.5900 1.0581 3.8500 905.9600 4.1847 154.8000 Minimum -8240.8000-0.2808 0.0000 0.0000 1.2038-80.0100 Std. Dev. 4059.3070 0.1224 0.6199 106.8658 0.6963 25.7145 Notes: ROA - return on assets; SVA - shareholder value added; DERATIO - debt-equity ratio; SIZE - natural logarith of assets; GROWTH - sales growth. Correlation analysis Table 2 contains the correlations among the dependent and independent variables considered for this study. Profitability of the firm (ROA) is negatively associated with a debt equity ratio and growth of the firm, this shows as the firm debt component increases profitability decreases. Whereas ROA is positively associated with Dividend and the size of the firm. Further, we can observe that shareholder value added is positively related to profitability, dividend and size of the firm. And negatively related to the debt equity ratio and growth of the firm. 248 MeruguVenugopal, Dr. M Ravindar Reddy
SVA 1 Table 2: Correlation matrix SVA ROA DERATIO DIVIDEND SIZE GROWTH ROA 0.0372 1 DERATIO -0.1805-0.5166 1 DIVIDEND 0.5239 0.2317-0.32 1 SIZE 0.3983 0.2016-0.2104 0.635 1 GROWTH -0.0196-0.0114 0.0788-0.0379-0.0352 1 Regression analysis To find more insights on the relation between the dependent variables and independent variables considered in this, we have carried OLS regression analysis. Table 3 to 6 present the results obtained after regression equation (1), (2), (3), and (4). In order to check the presence of autocorrelation, multicollinearity and heteroskedasticity in the data, Durbin Watson and Variance Inflation Factor (VIF) and Breusch-Pagan / Cook-Weisberg test for heteroskedasticity statistics were computed and it was found that the statistics are with the limit. Leading to the conclusion that there is no presence of autocorrelation, multicollinearity and heteroskedasticity in the data. Table 3 shows the results for model 1 which examined the relationship between ROA and capital structure. The results show that ROA has a significant negative association with a debt equity ratio. This depicts the increase in debt component in the capital structure choice adversely affects the profitability of the firm. Whereas the size of the firm and growth has insignificant positive association with ROA. Further, it can be concluded from the adjusted R squared value of 0.2667 that the independent variables together explain over 26.67% of the systematic variations in ROA during the period studied. The null hypothesis framed earlier is rejected as the p value if less than 0.05. Therefore, an alternative hypothesis is accepted that is there is a significant relation between the debt-equity ratio and profitability of the firm. Table 3: Summary of Pooled OLS Regression result of Equation (1) for the Period 2007-14 Variable Coefficient Std. Error t-statistic Prob. VIF DERATIO -0.0985 0.0118-8.3220 0.0000 1.05 SIZE 0.0172 0.0105 1.6375 0.1030 1.05 GROWTH 0.0001 0.0003 0.5338 0.5940 1.01 C 0.1256 0.0335 3.7481 0.0002 R-squared 0.2769 Adjusted R-squared 0.2667 F-statistic 27.0603 Prob(F-statistic) 0.0000 Durbin-Watson stat 1.4702 Table 4 shows the results for model 2 which examined the relationship between ROA and dividend payout. The results show that ROA has a significant positive association with a dividend payout to shareholders. This depicts the increase in profitability of the firm will lead to increase in dividend. Further, it can be concluded from the adjusted R squared value of 0.0454 that the independent variables together explain over 4.54% of the systematic variations in ROA during the period studied.the null hypothesis framed earlier is rejected as 249 MeruguVenugopal, Dr. M Ravindar Reddy
the p value if less than 0.05. Therefore, an alternative hypothesis is accepted that is there is a significant relation between the dividend and profitability of the firm. Table 4 Summary of Pooled OLS Regression result of Equation (2) for the Period 2007-14 Variable Coefficient Std. Error t-statistic Prob. VIF DIVIDEND 0.0002 0.0001 2.0142 0.0453 1.68 SIZE 0.0160 0.0152 1.0573 0.2915 1.68 GROWTH 0.0000 0.0003-0.0253 0.9798 1.00 C 0.0600 0.4125 1.4641 0.1446 R-squared 0.0587 Adjusted R-squared 0.0454 F-statistic 4.4059 Prob(F-statistic) 0.0050 Durbin-Watson stat 1.1144 Table 5 shows the results for model 3 which examined the relationship between SVA and capital structure. The results show that SVA has negative association with a debt equity ratio. But it is not significant. As the company has more debt, it has to repay its debt and interest associated with from all the earnings. This will leave less money to shareholders, sometimes it will be difficult for the firm to pay its shareholders. Whereas the size of the firm and growth has positive association with SVA. Further, it can be concluded from the adjusted R squared value of 0.1567 that the independent variables together explain over 15.67% of the systematic variations in SVA during the period studied.the null hypothesis framed earlier is accepted as the p value if greater than 0.05. Therefore, there is no significant relation between the debt-equity ratio and shareholder value added. Table 5 Summary of Pooled OLS Regression result of Equation (3) for the Period 2007-14 Variable Coefficient Std. Error t-statistic Prob. VIF DERATIO -663.3363 420.6080-1.5771 0.1163 1.05 SIZE 2198.5240 373.5210 5.8859 0.0000 1.05 GROWTH 0.2605 9.9191 0.0263 0.9791 1.01 C -4604.7400 1191.6100-3.8643 0.0001 R-squared 0.1685 Adjusted R-squared 0.1567 F-statistic 14.3205 Prob(F-statistic) 0.0000 Durbin-Watson stat 0.9487 Table 6 shows the results for model 4 which examined the relationship between SVA and dividend. The results show that SVA has a significant negative association with a dividend payout. This depicts as the company pays dividend periodically will increase shareholder value intern will lead to increase in market value of the firm. Further, it can be concluded from the adjusted R squared value of 0.2716 that the independent variables together explain over 27.16% of the systematic variations in SVA during the period studied.the null hypothesis framed earlier is rejected as the p value if less than 0.05. Therefore, an alternative hypothesis is accepted that is there is a significant relation between the SVA and dividend. 250 MeruguVenugopal, Dr. M Ravindar Reddy
Table 6 Summary of Pooled OLS Regression result of Equation (4) for the Period 2007-14 Variable Coefficient Std. Error t-statistic Prob. VIF DIVIDEND 17.2488 2.8628 6.0252 0.0000 1.68 SIZE 641.6760 439.3080 1.4607 0.1450 1.68 GROWTH 0.2309 9.1961 0.0251 0.9800 1.00 C -1591.5670 1194.6800-1.3322 0.1842 R-squared 0.2817 Adjusted R-squared 0.2716 F-statistic 27.7196 Prob(F-statistic) 0.0000 Durbin-Watson stat 1.1969 5. Conclusion This investigation has found that there is a significant positive relationship between profitability, shareholder value added and dividend. This is similar to the findings of (Amidu, 2007), (Ajanthan, 2013),(Adediran & Alade, 2013),(Ouma & Murekefu, 2012). Whereas the capital structure measured as the debt equity ratio is negatively associated with profitability and shareholder value added. This is similar to the findings of(r Azhagaiah, 2008),(Yinka & Oluwadetan, 2015), (Ogebe et al., 2013) and contradicts the result of (Balasundaram nimalathasan & Brabete, 2008). With addition size is positively associated with profitability and shareholder value added. Large firms tend to be more profitable and more profitable firms will increase shareholder value. Growth in assets has an insignificant negative association with profitability and shareholder value added. However, some limitations of the study are recognized. First, is the small sample size of 27 firms. Second and most significant is additional variables need to be added to the study would provide more insightful results. References Adediran, S. A., & Alade, S. O. (2013). AMERICAN JOURNAL OF SOCIAL AND MANAGEMENT SCIENCES Dividend Policy and Corporate Performance in Nigeria, (Samuel 1989), 71 77. http://doi.org/10.5251/ajsms.2013.4.2.71.77 Ajanthan, A. (2013). The Relationship between Dividend Payout and Firm Profitability : A Study of Listed Hotels and Restaurant Companies in Sri Lanka, 3(6), 1 6. Al-najjar, B., & Taylor, P. (2008). The relationship between capital structure and ownership structure New evidence from Jordanian panel data, 34(12), 919 933. http://doi.org/10.1108/03074350810915851 Amidu, M. (2007). Determinants of capital structure of banks in Ghana: an empirical approach. Baltic Journal of Management, 2(1), 67 79. http://doi.org/10.1108/17465260710720255 Amponsah, A., Michael, A., & Hughes, N. D. (2013). The Effects of Capital Structure on Profitability of Listed Firms in Ghana, 5(31), 215 230. Antoniou, A., Guney, Y., Paudyal, K., The, S., Analysis, Q., Mar, N., Paudyal, K. (2008). The Determinants of Capital Structure : Capital Market-Oriented versus Bank-Oriented Institutions Published by : Cambridge University Press on behalf of the University of Washington School of Business Administration Stable URL : http://www.jstor.org/stabl, 43(1), 59 92. Azhagaiah, R. (2007). The Impact of Capital Structure on Profitability, 9, 371 392. Azhagaiah, R. (2008). The Impact of Dividend Policy on Shareholders Wealth, 20(20). Balasundaram nimalathasan, & Brabete, V. (2008). capital structure and its impact on profitability: a study of listed manufacturing companies in sri lanka. Finances - Accounting. Bevan, A. A., & Danbolt, J. (2000). CAPITAL STRUCTURE AND ITS DETERMINANTS IN THE UNITED KINGDOM A DECOMPOSITIONAL ANALYSIS Alan A Bevan and Jo Danbolt Working Paper 2000 / 2 Capital 251 MeruguVenugopal, Dr. M Ravindar Reddy
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