The Ghana Stock Exchange

Published Date: 02 Nov 2017

Introduction

Through this analysis, an attempt to analyze the relationship between capital structure and profitability during 2008 to 2012 (05 years) financial year of the 42 listed companies on the Stock Exchange of Mauritius will be carried out.

The capital structure of a firm has long been a much debated issue for academic studies and in the corporate finance world. The relationship between capital structure and profitability cannot be ignored because the improvement in the profitability is necessary for the long-term survivability of the firm. Because interest payment on debt is tax deductible, the addition of debt in the capital structure will improve the profitability of the firm. Therefore, it is important to test the relationship between capital structure and the profitability of the firm to make sound capital structure decisions.

The question whether capital structure affects to the profitability of the firm or it is affected by profitability is a crucial one. Profitability and capital structure relationship is a two way relationship. On the one hand profitability of firm is an important determinant of the capital structure, the other hand changes in capital structure changes affect underlying profits and risk of the firm.

Several studies have been done on this area, but a comprehensive study has not yet been conducted, especially in Mauritius. Hence, this research proposal is an attempt to evaluate the relationship between capital structure and profitability of the listed companies on the SEM.

Aim of this Study

The main objective of this study is to scrutinise the relationship between the capital structure and profitability of the companies listed on the SEM and to ascertain whether capital structure has an impact on a firm’s profitability based on the empirical evidence generated.

Secondly, this study would attempt and investigate to determine if any optimal capital structure exist among the sample of 42 listed companies.

Thirdly, we want to find out whether relationship between capital structure and profitability is causal for the case of the firms listed on the SEM. This will be tested throughout by using econometrical analysis.

Literature Review

Capital Structure

The term capital structure can be defined as: "The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity." (Van Horne & Wachowicz, 2000, p.470)

It can as well be defined as "The mix of long-term sources of funds used by the firm. This is also called the firm’s "capitalization". The relative total (percentage) of each type of fund is emphasized." (Petty, Keown, Scott, and Martin, 2001, p.932)

One of the exhaustive and inclusive description was given by Masulis (1988, pl): ‘Capital structure encompasses a corporation’s publicly issued securities, private placements, bank debt, trade debt, leasing contracts, tax liabilities, pension liabilities, deferred compensation to management and employees, performance guarantees, product warranties, and other contingent liabilities. This list represents the major claims to a corporation’s assets. Increases or reductions in any of these claims represent a form of capital structure change."

However in this study, for the sake of simplicity, the capital structure will be analysed in term of debt and equity in line with other prominent capital structure studies and theories restricted to the debt equity mix.

Profitability

The term profitability is a very common term in the business world. It refers to an all round measurement and indicator for a firm’s success. Profitability can be defined as the ability of a firm to generate net income or profit on a consistent basis. It is often measured by price to earnings ratio. The accounting definition of profit can be given as the difference between the total revenue and the total costs incurred in bringing to market the product i.e. goods or service.

Hence, profitability had come to mean different things for different people. It can be defined and measured in several ways depending on the purpose. It is a generic name for variables such as net income, return on total assets, earnings per share, etc. though the simplest and common meaning of profitability is the net income.

Theories

The last century has witnessed a continuous developing of new theories on the optimal debt to equity ratio. Traditional theories of capital structure imply a consistent relationship between firm profitability and firm leverage. Empirical data, however, suggest that the relationship is not monotonic. In the cross-section of firms, non-profitable firms become significantly more leveraged as losses decrease; profitable firms become significantly less leveraged as profits increase until a point where the most profitable firms have again significantly greater leverage as profits increase.

According to Modigliani and Miller’s traditional trade-off model (1963), firms exchange the tax advantages of debt with the costs of financial distress (such as deadweight costs in the event of bankruptcy). Jensen and Mackling (1976) articulates an agency cost interpretation involving conflicts between shareholders and managers and between debt-holders and equity-holders. Myers and Majluf’s (1984) adds a pecking order theory based on information asymmetries between the firm and potential lenders. Other theories include those of corporate control, as in Harris and Raviv (1988) and Stulz (1988), and of competition in product markets, as in Brander and Lewis (1986) and Tittman (1984). Summaries appear in Ravid (1988), Harris and Raviv (1991), and Myers (2003).

The predictions of these theories vary but, in terms of firm profitability, trade-off models generally predict increasing leverage with increasing profitability (although Dotan and Ravid (1985) and Hennessy and Whited (2005) have conditions for the opposite prediction). Agency-cost models also often follow this prediction, while pecking-order models predict decreasing leverage with increasing profitability. A common characteristic is that these predictions are monotonic in profitability. A recent exception is the model in Alan and Gaur (2011) in which the relationship is non-monotonic. An earlier exception is in the relationship between long and short-term debt in the model in Diamond (1991), in which both the lowest and highest credit-rated firms use short-term debt while those in between use long-term debt.

Empirical studies have generally shown that the standard trade-off model prediction of increasing leverage with increasing profitability does not agree with empirical results. Examples include Fama and French (2002) and Rajan and Zingales (1995), which show a strong negative relationship using U.S. data. These results are so highly significant (up to 12.5 standard errors below zeroin Fama and French (2002)) that this trade-off theory prediction appears refuted.

Empirical Evidences

One of the earliest comprehensive researches into capital structure of business firms was done by Chudson Walter Alexander (1945) on a cross section of manufacturing, mining, trade, and construction companies in the US from the year 1931 to 1937. Although it has been more than two third of a century, that study is still relevant today. Chudson’s research showed there were undisputable relationships between corporate financial structure and the firm’s profitability.

Most of the studies had concluded that capital structure measured by debt/equity ratio had an inverse relationship with profitability measured by Return on Investment (ROI). Professor Myers of MIT had written in 1995 that "the strong negative correlation between profitability and financial leverage" is one of the ‘most striking facts about corporate financing" (p.303).

One significant research was conducted by Bradley, Jarrell and Rim (1984) using Ordinary Least Squares method to analyze the capital structure of 851 industrial firms over a period of 20 years (1962-81). They concluded that an optimal capital structure actually existed as proposed by finance theorists.

Bradley, Jarrell and Kim’s findings were supported by El-Khouri in 1989 who studied a sample of 1,040 Companies in US from 27 different industries covering a period of 19 years (1968-86). El-Khouri’s major findings were that there exists an optimal capital structure, and profitability was significantly but negatively related to capital structure.

Rajan and Zingales (1995), in their study of determinant of capital structure find that profitability is negatively or inversely related to gearing consistent with Toy et al. (1974), Kester (1986) and Titman and Wessles (1988). Given, however, that the analysis is effectively performed as an estimation of a reduced form, such a result masks the underlying demand and supply interaction which is likely to be taking place. More profitable firm will obviously need less borrowings, although on the supply-side such profitable firms would have better access to debt, and hence the demand for debt may be negatively related to profits.

Chiang et al., (2002) results show that profitability and capital structure are interrelated , the study sample includes 35 companies listed in Hong Kong. Raheman et al., (2007) find a significant capital structure effect on the profitability for non-financial firms listed on Islamabad Stock Exchange.

Mendell, et al., (2006) investigates financing practices across firms in the forest products industry by studying the relationship between debt and taxes hypothesized in finance theory. In testing the theoretical relationship between taxes and capital structure for 20 publicly traded forest industry firms for the years 1994-2003, the study find a negative relationship between profitability and debt, a positive relationship between non-debt tax shields and debt, and a negative relationship between firm size and debt.

Abor (2005) seeks to investigate the relationship between capital structure and profitability of listed firms on the Ghana Stock Exchange and find a significantly positive relation between the ratio of short-term debt to total assets and ROE and negative relationship between the ratio of long-term debt to total assets and ROE.

Gill, et al., (2011) seeks to extend Abor’s (2005) findings regarding the effect of capital structure on profitability by examining the effect of capital structure on profitability of the American service and manufacturing firms. A sample of 272 American firms listed on New York Stock Exchange for a period of 3 years from 2005 – 2007 was selected. The correlations and regression analyses were used to estimate the functions relating to profitability (measured by return on equity) with measures of capital structure. Empirical results show a positive relationship between short-term debt to total assets and profitability and between total debt to total assets and profitability in the service industry. The findings of this paper show also a positive relationship between short-term debt to total assets and profitability, long-term debt to total assets and profitability, and between total debt to total assets and profitability in the manufacturing industry.

the study made by Wolfgang Drobetz and Roger Fix (2003) documentedthat profitability is negatively correlated with leverage, both for book and marketleverage. Thus, result had reliably supports the predictions of the pecking order theory. Inaddition, to the statistical significance, the economic significance of profitability onleverage is also noteworthy. Due to that, this finding is consistent with the research made by Rataporn Deesomsak et. al (2004). Moreover, based on the study made by Murray Z.Frank and Vidhan K. Goyal (2004) had found that firms that have more profits tend tohave less leverage

The following sections will construe the proxies to be used, the test to be undertaken for analysis part, certain limitations to the model constructed and time allocated for the whole research.

Methodology

Proxies Used

Variables used for the analysis include profitability and leverage ratios. Profitability is

operationalized using a commonly used accounting-based measure: the ratio of

earnings before interest and taxes (EBIT) to equity. The leverage ratios used include:

. short-term debt to the total capital;

. long-term debt to total capital; and

. total debt to total capital.

Firm size and sales growth are also included as control variables.

II. Data Collection

Sample size taken for the analysis will be observations from 2007 to 2012 whereby the variables are measured quarterly.(time series test).

Data for ROE and leverage ratios are to be retrieved from the financial reports of the 42 companies.

III. Test to be performed

In this model, econometric software such as STATA and MICROFIT 5.0 will be used.

A. Tests for Stationarity

It is important to see whether the fundamental time series is stationary or not. If it is not, problems of autocorrelation, spurious regression would arise and forecasting would become futile. Therefore, tests of stationarity on the variables "economic growth", "financial development", "investment", "inflation" and also the "residuals" should precede tests of causality. Thus, the first tests to be performed are the DF, ADF and Phillips-Perron tests to test whether the series are stationary or not.

B. Tests for Cointegration

The implication that non-stationary variables can lead to spurious regression means that testing for cointegration is very important.

Cointegration occurs when two variables are individually non stationary but a linear combination of them is stationary. If a pair of variables satisfies the cointegration property it follows that they can be considered to be generated by what is known as the Error Correction Model (ECM). This was invented by the well-known econometrician Dennis Sargan and later it was popularized by Engle and Granger, and is known as the Engle-Granger two-step approach.

ROE i,t= β0 + β1DAi,t + β2SIZEi,t + β3SGi,t + uI,t

where:

. ROE i,t is EBIT divided by equity for firm i in time t;

. DAi,t is total debt divided by the total capital for firm i in time t;

. SIZEi,t is the log of sales for firm i in time t;

. SGi,t is sales growth for firm i in time t; and

. uI,t is the error term.