The Effec of Corporae Finance on Profiabiliy The Case of Lised Companies in Fiji Asha Singh School of Accouning and Finance Universiy of he Souh Pacific Suva, Fiji laa_a@usp.ac.fj Absrac This paper empirically examines he effec of corporae finance on he profiabiliy of firms ha are lised on he Souh Pacific Sock Exchange in Fiji. The sudy finds ha over he years 2000-2007, he 16 companies ha are lised on he sock exchange relied largely on equiy finance. Using panel daa analysis, he sudy also finds ha all he hree measures of leverage are inversely relaed wih profiabiliy. Alhough shor-erm and long-erm debs are saisically insignifican, oal deb is highly significan. Keywords: corporae finance, profiabiliy, leverage, Souh Pacific Sock Exchange.
I. Inroducion All ypes of businesses need o make financial decisions in order o maximise firm value. One such decision is he choice of corporae finance. Invesmen opporuniies can be financed using wo major caegories of securiies being equiy and deb. Wihin hese wo caegories here are counless combinaions. For insance, a business can be financed using a mixure of bonds, commercial bank loans, commercial noes, leases, reained earnings and shares, o name a few. The choice of corporae finance was iniially explained by he seminal work of Modigliani and Miller (1958). They proposed ha he choice of finance had no influence on firm value. However, heir heory was framed in a highly simplified environmen by making several unrealisic assumpions, such as perfec capial marke, homogenous expecaions, no axes and no ransacion coss. Afer heir iniial proposiion ha capial srucure is irrelevan, Modigliani and Miller revised heir argumen in 1963 by incorporaing he influence of axes. In his new dimension, hey argue ha firms should use as much deb as possible because of he ax savings on ineres paymens. Ineres is a ax-deducible expense which means ha if a firm pays more ineres, hey will pay lower ax. However, as a firm coninues o use more deb he poenial bankrupcy-relaed coss increases. Bankrupcy coss are incurred when here is probabiliy ha a firm will defaul on he loan repaymens and he paymen of ineres. Therefore, he choice of corporae finance involves a radeoff beween ineres-ax savings and bankrupcy coss. This is known as he saic rade-off model. 2
In addiion o his, he pecking order heory can also be used o explain he choice of capial srucure and is effecs of profiabiliy. This heory suggess he order in which a firm will finance is invesmen opporuniies. I suggess ha a firm will iniially rely on inernally generaed funds, ha is, reained earnings. This is because reained earnings are he cheapes of all sources of finance. Afer using reaining earnings, he firm will hem move o use deb finance and finally will issue equiy. The implicaion of he pecking order heory is ha if a firm is profiable i is expeced o uses less deb compared o firm ha do no generae high profis. There are sudies carried ou o examine he impac of corporae finance on firm profiabiliy. However hese sudies mainly examine he lised companies of he developed counries. There are also no sudies underaken in Fiji o empirically examine his relaionship. Therefore, his paper seeks o provide an insigh ino he capial srucure of lised firms in Fiji and o examine how his capial srucure impacs on is performance. The Souh Pacific Sock Exchange is he only licensed sock exchange in Fiji. I commenced operaions as a rading pos in 1979 and coninued rading in his manner unil 1996 when a call marke session was esablished. The exchange provides a primary marke o companies o raise equiy finance as well as secondary marke o provide improved liquidiy. Apar from he lised company s shares oher securiies ha are raded on he exchange are Governmen bonds, sauory auhoriy bonds, Governmen reasury bills, sauory auhoriy promissory noes, cenral bank noes and radable erm deposis. The res of he paper is srucured as follows: secion wo provides a review of he lieraure, secion hree discusses mehodology and daa, secion four discusses empirical resuls and secion five provides concluding commens. 3
II. Review of relaed sudies There are several sudies ha have been carried ou o examine he relaionship beween corporae finance and profiabiliy. Some have been carried ou using single counry daa while ohers have made inernaional comparisons. However, hese sudies have produced conflicing resuls. Rajan and Zingales (1995) is one of a few sudies ha have used cross-counry comparison of capial srucure heories. They use four key independen variables o analyse he deerminans of capial srucure of he public companies in he G-7 counries 1. These variables were angibiliy of asses, marke-o-book raio, log of sales (as a proxy for size) and a measure of profiabiliy. Given ha mos of he sudies on capial srucure are based on US daa, hey waned o es if he deerminans of capial srucure choice in he US are similar in oher counries. Rajan and Zingales find ha he facors ha deermine he choice of capial srucure in he US are similar for oher G-7 counries. In addiion o his, hey find a significanly negaive correlaion beween profiabiliy and leverage. A similar sudy is underaken by Booh e al. (2001) whereby hey analyse capial srucure choices of 10 developing counries 2 o find if he variables ha explain such choices in he developed counries are also relevan for he developing counries. They examine his behavior over he period 1980 o 1991. Booh e al. exend Rajan and Zingales (1995) model by incorporaing ax and business risk. They use panel daa echnique o esimae he hree measures of deb agains firm s ax rae, sandard deviaion of ROA (as a proxy for business risk), asse 1 These are The Unied Saes, Germany, Canada, Ialy, France, Japan and Unied Kingdom. 2 These were India, Pakisan, Thailand, Malaysia, Turkey, Zimbabwe, Mexico, Brazil, Jordan and Korea. 4
angibiliy, log of sales (as a proxy for size), ROA, marke o book raio. They find ha in boh developed and developing counries, similar variables explain capial srucure choices. This holds despie insiuional differences beween hese wo economies. One of he sronges resuls ha hey found was ha for all counries in he sample (excep Zimbabwe) profiabiliy was consisenly negaive and significan wih all measures of deb. Their hree measures of deb were oal book-deb raio, long erm book-deb raio and long erm marke deb raio. In anoher cross-counry sudy, Raha e al. (2003) also finds similar evidence whereby profiabiliy declined as firms increased heir use of leverage. They analyse he financial srucures and performance of corporaions in he developing counries. Amongs various oher hings, hey examine he relaionship beween inernaional finance and firm profis in he emerging markes of Eas Asia and Pacific 3, Europe and Cenral Asia and Lain America and he Caribbean. Using US daa, Friend and Lang (1988) esimae several mulivariae relaionships of he deb raios using ordinary leas squares. Amongs oher hings, hey find ha he deb raios of he closely held corporaions and publicly held corporaions are srongly negaively relaed o profiabiliy. Similar conclusion is also reached by Graham (2000), who carried ou research o find if he ax benefis of deb affec a firm s corporae financing decisions. He finds ha a ypical would could double is ax benefis by using deb unil he marginal benefis begin o fall. He infers a firm s use of deb by examining he shape of is ax benefi funcion. 3 Noe ha Fiji was no included in his sudy. 5
Kyereboah-Coleman (2007) also aemp o he find he impac of capial srucure on profis bu in a differen environmen seing. Using panel daa analysis over he period 1995-2004, he analyses he performance of microfinance insiuions in Ghana. Mos of he sudies examining he effec of capial srucure have been carried ou in he developed economies on large and lised firms. These insiuions provide credi and financial services o small and micro enerprises. As a measure of performance of he microfinance insiuions, he uses a unique daa of Oureach and Defaul rae. These variables capure and he success and susainabiliy of he insiuions. As measures of leverage, he uses shor-erm deb, long-erm deb and oal debs as a raio of oal asses. For conrol variables, he uses firm size, risk level and firm age. Firm size is measured as he los of asses, risk level is measured as he deviaion from mean profiabiliy while age is he number of years he firm has been in operaion and his is measured as log of age. His sudy shows ha highly leveraged microfinance insiuions perform beer han hose which use less leverage. Abor (2005) invesigae he relaionship beween capial srucure and profiabiliy of he 22 firms lised on he Ghana Sock Exchange over he period 1998-2002. Using panel daa mehodology, he esimaed hree models, one each for shor erm, long erm and oal debs. He used ROE as a measure of profiabiliy and sales growh and log of sales (as a proxy for firm size) as conrol variables. In all he hree equaions he finds significanly posiive effec of he conrol variables on profiabiliy. He finds a significanly posiive relaionship for shor-erm and oal deb wih and profiabiliy. On he oher hand, he finds a significanly negaive relaionship beween long-erm deb and profiabiliy. Baker (1973) also finds ha a significanly posiive 6
relaionship using indusry daa. He came o his conclusion by conrolling for risk and marke srucure variables. III. Mehodology This paper included all he firms ha are lised on he SPSE over he period 2000-2007, which resuled in 110 observaions. The variables analysed are profiabiliy and leverage raios. Profiabiliy is operaionalised using earnings before ineres, ax and depreciaion and amorizaion (EBITDA) over oal asses. The leverage raios include shor-erm deb o asses, long-erm debs o asses and oal debs o asses. The leverage raios were also analysed in hese caegories in Kyereboah-Coleman (2007) and Abor (2005). In order o accuraely capure he effec of leverage on profiabiliy, oher variables ha affeced profiabiliy were conrolled. There variables were firm size and risk. In ligh of he panel characer of he daa, panel daa mehodology is applied. Therefore he relaionship beween financial leverage and profiabiliy is esimaed using he following regression models: ROA i, = β 0+ β1sdai, + β2sizei, + β3riski, + ε i, (1) ROA i, = β 0+ β1ldai, + β2sizei, + β3riski, + ε i, (2) ROA i, = β 0+ β1dai, + β2sizei, + β3riski, + ε i, (3) Where: ROA i, is earnings before ineres, ax and depreciaion and amorizaion divided by oal asses for firm i in ime ; 7
SDA i, is shor-erm deb divided by oal asses for firm i in ime ; LDA i, is long-erm deb divided by oal asses for firm i in ime ; DA i, is oal-erm deb divided by oal asses for firm i in ime ; SIZE i, is he log of asses for firm i in ime ; RISK i, is he deviaion from he mean ROA for firm i in ime ; IV. Empirical resuls Table 1 provides a summary of he descripive saisics of he dependen and independen variables. This shows he average indicaors of he annual daa compued from he financial saemens of he lised companies. The profiabiliy rae measured by ROA reveals an average of 14.91% wih a median of 16.40%. This suggess ha he firms performed moderaely during he 2000-2007 period. As a measure of profi, ROA indicaes managemen's efficiency in using business asses o generae ne income. The variable SDA measures he raio of shor-erm deb o oal asses. The average value of his is 27.09% wih median of 24.24%. This suggess ha on average 27% of he asses are financed using shor-erm debs. The raio of long-erm deb o oal asses averages 10.29% wih a median of 7.42% while oal debs o asses averages 37.69% wih a median of 39.45%. These saisics indicae ha firms lised on he SPSE over he sudy period largely rely on equiy financing given ha deb financing is only around 38%. Furhermore, of he deb financing used, around hree-quarers are in he form of shor-erm. 8
Table 1 Descripive Saisics Variable Mean Sd. Dev. Min Median Max ROA 0.1491 0.1199-0.5821 0.1640 0.4075 SDA 0.2709 0.1419 0.0172 0.2424 0.7364 LDA 0.1059 0.1083 0 0.0742 0.4341 DA 0.3769 0.1589 0.0172 0.3945 0.7364 SIZE 7.3824 0.65914 6.3188 7.1569 8.6280 AGE 1.2051 0.3701 0 1.3010 1.7782 RISK 0.0003 0.0807-0.1709-0.0033 0.5808 Panel daa analysis is used o invesigae he relaionship beween corporae finance and profiabiliy. Ordinary leas squares regression resuls are presened in Table 2. The resuls from he regression models (1), (2) and (3) denoe ha he independen variables explain he deb raio deerminaions of he firm a 78.00%, 78.14% and 78.69%, respecively. The F-saisics prove he validiy of he esimaed models. The resuls in regression (1) reveal a negaive relaionship beween shor-erm deb and profiabiliy. However, his relaionship is no significan. Similar resul is also obained for longerm deb in regression (2). The hird regression model reveals a significanly negaive relaionship beween oal debs and profiabiliy. This implies ha ha an increase in oal debs is associaed wih a decline in profis. The conrol variables, firm size and risk, were highly significan in all he hree models. The measures of firm size and risk were adoped from Kyereboah-Coleman (2007) sudy. An addiional conrol variable, firm age was also esed. Age represened he number of years a firm was in operaion and was measured as log of age. In ligh of he poliical insabiliy in he counry over he sudy period, he effec of he coup variable was 9
also esed as a dummy. Alhough, hese wo variables refleced he correc sign, hey were removed from he final regressions as heir effecs were highly insignifican. Table 2 Regression Resuls Profiabiliy Variable 1 2 3 SIZE 0.02280(9.29) * 0.0219(13.30) * 0.0260(8.73) * RISK -0.9959(-9.36) * -0.9799(-9.17) * -0.9719 (-9.19) * SDA -0.0746(-1.25) [0.213] LDA -0.1225(-1.51) [0.133] DA -0.1162 (-2.15) ** Adj R2 0.7800 0.7814 0.7860 SE 0.0896 0.08931 0.08837 Prob (F) 0.0000 0.0000 0.0000 * Significan a 1% level ** Significan a 5 % level P values are included in square brackes V. Conclusions The choice of corporae finance is one of he crucial decisions ha a firm underakes as his will affec he value of he firm. This paper examines he financing paerns of he firms ha are lised on he SPSE over he period 2000-2007. Furhermore, he paper also examines he effecs of corporae financing choice of he firm on is profiabiliy. The resuls reveal ha over he sudy 10
period, lised companies largely relied on equiy financing as deb finance only consiued 38%. Of he amoun of deb finance used, majoriy was hrough shor-erm funds. The sudy also finds ha all he hree caegories of corporae finance are negaively relaed o profiabiliy. Alhough shor and long-erm debs have an insignifican relaionship, oal debs are significanly relaed. This implies ha lised companies are no concerned abou he mauriy and he resulan cos of deb finance. Insead, hey are more concerned wih he availabiliy of funds. Finally he negaive relaionship beween leverage and profiabiliy is consisen wih he pecking order heory. Bibliography Abor, J. 2005. The effec of capial srucure on profiabiliy: an empirical analysis of lised firms in Ghana. The Journal of Risk finance. Vol. 6(5), pp. 438-445. Baker, S. Risk, leverage and profiabiliy: an indusry analysis. The review of economics and saisics. Vol. 55(4), pp. 503-507. Beal, D. and Goyen, M. 2005. Inroducing corporae finance. John Wiley & Sons Ausralia, Ld., Ausralia. Booh, L., Aivazian, V., Deimirguc-Kun, A. and Maksimovc, V. 2001. Capial srucures in developing counries. The Journal of Finance. Vol. 56(1), pp. 87-130. Fama, E. and French, K. 1998. Taxes, financing decisions and firm value. The Journal of Finance. Vol. 53(3), pp. 819-843. 11
Friend, I. and Lang, L. 1988. An empirical es of he impac of managerial self-ineres on corporae capial srucure. The Journal of Finance. Vol. 43(2), pp. 271-281. Graham, J. 2000. How big are he ax benefis of deb? The Journal of Finance. Vol. 55(5), pp. 1901-1941. Kyereboah-Coleman, A. 2007. The impac of capial srucure on performance of microfinance insiuions. The Journal of Risk finance. Vol. 8(1), pp. 56-71. Modigliani, F. and Miller, M. 1963. Corporae income axes and he cos of capial: a correcion. The American Economic Review. Vol. 53(3), pp. 433-443. Modigliani, F. and Miller, M. 1958. The cos of capial, corporaion finance and he heory of invesmen. The American Economic Review. Vol. 48(3), pp. 261-297. Rajan, R. and Zingales, L. 1995. Wha do we know abou capial srucure? Some evidence from inernaional daa. The Journal of Finance. Vol. 50(5), pp. 1421-1460. Raha, D., Mohapra, S. and Sule, P. 2003. Corporae Financial Srucures and Performance in Developing Counries in Global Developmen Finance. World Bank. www.spse.com.fj 12