The Oxygen Of An Organization

Published Date: 02 Nov 2017

Cash is the oxygen of an organization, without which all vital parts of a business would have died. A lump occurs when cash fails to flow properly, and this affects adversely the organization. Failure to find remedy to that may leave the business in a serious condition.

Nowadays, one of the major dilemmas of many firms is lack of cash. This source of finance is used for payment of wages, administration costs, advertising, interest on loan and other expenses of the business. When a firm is growing, its principal problem is the financing of its growth. Generally, the requirement of funds is bigger than the generation of funds at particular points of time in a business. Thus, few companies can finance their own developments and growth entirely from their own operating activities, that is, from the profits they make. A qualified financier said" if the money is available, and looks cheap, borrow it even if you don’t need it immediately." As the past years have been hit by inflation, this advice is really helpful for growing companies. Failure to find cash for finance before it is required highlights bad management.

Companies need finance for indoor and outdoor activities, to invest in fixed assets or manage their working capital. However, internal sources may still prove insufficient for firms to finance capital intensive projects. Since firms aim at better performance, growth and expansion, there is a need for a solid financial base that is external sources of finance where companies may opt for long term loans, new equity issues and leases.

The aim of every firm is to maximize shareholder’s wealth. In order to improve the value of the shareholder’s stake in the firm, any investment or financing decision is justified based on the above mentioned objective of every company. Capital structure which is an important managerial instrument, represent the proportionate relationship between debt and equity. The financing decision influences the return and risk of the shareholder’s and also affects the market value of the share as well as the cost of capital.

AIMS AND OBJECTIVES

The objectives of this analysis are:

To find out the connection that exists between capital structure and performance of the firm.

To scrutinize on the influence of capital structure and leverage on dependent variables.

To find out if an optimal capital structure decision can help firms to increase their value and thus their performance.

PROPOSED METHODOLOGY

Out of 21 non-financial listed firms, only 16 firms from Commerce, Industries, Sugar, Hotel, Leisure and Transport have been taken into consideration. The appropriate data were collected from the financial statement of the firms for a period of 6 years’. In addition, the relationship of the organizational variables between leverage ratio and debt ratio were evaluated through an annual trend over the time period of 6 years’.

ORGANISATION OF THE STUDY

Chapter 1 provides a summary of the analysis, general aims and objectives and the proposed methodology.

Chapter 2

2.1: Theoretical review which gives a broad meaning of capital structure and its impact on the return and risk of shareholder. The section also includes capital structure theories illustrating on the relationships on the mixture of debt and equity, and its effect on firms’ value.

2.1: Empirical Review presents empirical evidence found by well-known researchers based on the relationships of capital structure and firm performance.

Chapter 3 deals with an overview of the Mauritian economy, the evolution of Stock Exchange in Mauritius and the sources of finance used in the non-financial companies.

Chapter 4 is based on the proposed methodology used for the analysis, that is, organizational variables such as ROE, ROA, EPS, TOBIN’S Q and MBVR will be analyzed by using regression from the STATA software. The second part of this chapter indicates the empirical results.

Chapter5 will summarize the findings and will justify on the possible reasons behind these outcomes.

WHAT IS CAPITAL STRUCTURE?

In corporate finance, it is very crucial to study the financing performance of corporations which is revealed by their capital structure. Capital structure refers to the way a corporation finances its activities and maximizes its total market value through the combination of long term sources of funds and equity shares. One major issue that a corporation confronts is the choice of a proper external source of finance between debt and equity.

Debt refers to the money that is borrowed through the form of loans and overdraft facilities and repaid by a business over time. Debt can be either short term or long term. However, the firm must have sufficient cash flow to be able to repay back the debt otherwise it loses the control of the business.

Equity in the capital structure of a firm refers to the money which is owned by the holder of the firms in the form of shares. If a firm is wholly financed by ordinary share then the cash flows are owned by ordinary share holders. Alternatively, when the firm has debt and equity capital then the firm obtains the remaining cash flows after payments are made to debt holders.

Debt and equity financing are both fundamental in providing firms capital to finance their businesses. The decision which sources of finance use depends on the long term objectives of the firm. Therefore firms use the debt to equity ratio which is applied to verify whether managers are controlling a business in a rational approach.

The Process of the Financing Decision

Capital decision budgeting

Need to raise funds Internal funds

Debt

Financing decision External equity

Desired debt-equity mix

Existing capital structure

Retention policy

Effect on risk

Effect on EPS

Effect on cost of capital

Optimum capital structure

Performance of the firm

Figure 1

Customized from I.M Pandey (1999)

EFFECT OF FINANCIAL LEVERAGE

Financial leverage is described by I.M Pandey as "the use of fixed charges sources of funds, such as debt and preference capital as well as the owner’s equity in the capital structure" [1] . Financial leverage of a company is expected to earn more on the fixed charges funds than their costs. Therefore, the surplus will boost the ROE which is levered higher than the ROA. On the contrary, a deficit in financial leverage may reduce the ROE which will be levered below the ROA. Hence, financial leverage is a double-edged sword where the surplus will boost the rate of return on the shareholder’s equity along with causing the risk of loss to them.

SHAREHOLDER’S RETURN

The principal aim of a firm in using financial leverage is to increase the earnings of equity owners under beneficial financial situations. In order to realize this objective, the firm should be able to acquire fixed charges funds at lower cost than the rate of return on the firm’s net assets (ROA). Earnings per share (EPS) and return on equity (ROE) inflates if equity holders obtain the remaining between the return produced by assets sponsored by the fixed-charges funds and costs of these funds. Nevertheless, if fixed-charges funds are achieved at higher cost than the return on assets, EPS and ROE will collapse. This shows that EPS, ROE and ROA are vital figures for analyzing the impact of capital structure on firm’s performance.

Two situations are described to illustrate the effect of leverage on EPS and ROE where in the first instance financial plans are analyzed by assuming that that EBIT is constant. In the second case the effect of capital structure on EPS and ROE is shown under varying EBIT.

Constant EBIT

Let’s assume that the newly formed firm is expecting a before-tax rate of return of 24% on the estimated total investment of Rs 500,000.

EBIT= Rs 500,000 x 24% = Rs 120,000

The new firm has two alternative financial plans to consider:

To raise the entire funds by issuing common shares. ( i.e. 50,000 share at Rs10 each)

To raise half of the funds by issuing common shares (i.e. 25,000 shares at Rs10 each) and borrow the other half. (i.e. Rs250,000 at 15% interest)

The tax rate is 50%.

Financial Plan

All-Equity (Rs)

Debt-Equity (Rs)

EBIT

120,000

120,000

Less: interest (INT)

0

37,500

Profit before taxes

120,000

82,500

Less: taxes

60,000

41,250

Profit after taxes (PAT)

60,000

41,250

Total earnings of investors ( PAT+ INT)

60,000

78,750

Number of common shares

50,000

25,000

EPS (PAT/number of shares)

1.20

1.65

ROE (PAT/equity)

12.0%

16.5%

Source: I.M Pandey (1999)

From the table the impact of financial leverage is quite significant as 50% of debt is used to finance the investment. The EPS and ROS are better in the debt-equity plan than the all-equity plan for two reasons:

The firm is able to borrow half of its funds requirements at a cost lower than its ROA. Consequently the firm is able to pay 15% interest on its debt and earns a return of 24% when investing only Rs2, 50,000. The remaining difference goes to the owners of the firm without any equivalent investment.

Under the debt to equity plan, the firm has only 25,000 shares compared to the all-equity plan. Therefore, the EPS is raised from Rs1.20 to Rs1.65.

The interest tax shield

The effect of debt is also explained by analyzing the impact of interest charges on the firm’s tax liability. The use of debt in capital structure is favorable to the firm as interest charges which are tax deductible provide tax shield and this raises the shareholder’s earnings. The impact of financial leverage is favorable on EPS and ROE if firm’s rate of return is more than the cost of debt. If ROA equates to the cost of debt then there is no impact of financial leverage on the shareholder’s earnings. It is the fact of the tax deductibility of interest charges which makes the use of the debt in the capital structure beneficial to a firm. [2] 

Varying EBIT

In practice, EBIT is constrained to several impacts; for instance, instability in the financial situations may make EBIT change. The variability of EBIT causes EPS to fluctuate within wider ranges with debt in the capital structure. With more debt, EPS increases and decreases faster than the rise and fall in EBIT. Financial leverage not only magnifies EPS but also increases its variability.

However, the adverse impact on EPS and ROE is harsher with more debt in the capital structure when EBIT is negative. This is due to the relationship between the ROA and cost of debt. EPS and ROE will reduce with more leverage if ROA is less than the cost of debt.

SHAREHOLDER’S RISK

Operating risk and financial risk are the two types of risk related with variability of EBIT and EPS. Operating risk is an unavoidable risk which is determined by the environment (internal/external) in which the firms operates. Financial risk, on the other hand, includes the variability of EPS caused by the use of financial leverage. Firm experiences financial risk when it uses debt as in the presence of debt, the inconsistency of shareholder’s earnings will increase. Thus financial risk can be avoidable if firm does not use debt in its financial structure. A firm is considered as risky if its debt- equity ratio surpasses the firm’s standard.

CAPITAL STRUCTURE THEORIES

Since the aim of a firm is to maximize its value, the financing decision should be observed from the point of its effect on the firm’s value. If financing decision can affect the firm’s value then a firm would have a capital structure which raises the market value of the firm. The firm’s value can get affected either by variation in the estimated earnings or cost of capital. Consequently, the effect of leverage on the cost of capital and value of the firm would lead to an optimum capital structure where at the debt-equity mix the firm’s total value will boost and the WACC will lessen.

There are three schools of thoughts that explain the effect of leverage on WACC and firm’s value:

Extreme views: The Net Income Approach

The Net Operating Income Approach

Intermediate views: The Traditional Approach

NET INCOME APRROACH

Under this view, it is assumed that the cost of equity and cost of debt does not depend on capital structure. By altering the proportion of debt in the financing structure, a firm can raise/reduce its value and reduce/raise the cost of capital. The assumptions [3] to this approach are as follows:

Cost of equity (Kе) and cost of debt (Kd) are not affected by changes in leverage.

Kd is less than Ke.

There is no corporate income tax.

Cost of capitalAs Ke and Kd are constant and Ke is greater than Kd, a rise in the use of debt in capital structure would cause a reduction in the WACC (Ko) and a rise in the firm value. Hence, the optimal capital structure would happen when the firm will maximize its value and minimize its WACC. This can only occur when the firm is hundred percent debt-financed. A clear illustration of this approach is shown below.

Ke

Kd

Ko

Leverage

Figure 2: leverage and cost of capital under NI approach

Source: I.M Pandey (1999)

NET OPERATING INCOME APPROACH

Under the NOI approach, the market value of the firm and the WACC remain constant despite the changes in the capital structure of the firm. The assumptions [4] to this approach are:

The separation between debt and equity is not significant since the market capitalizes the firm value as a whole

Kd remain unchanged

There is no corporate income tax

Ko is constant and depends on business risk but not on financial mix

The use of less costly debt funds increases Ke.

The diagram below represents the NOI approach which states that the cost of capital does not change with the level of debt and thus there is no optimal capital structure. Consequently, all capital structures are optimal and the value of the firm is not affected by a change in gearing.

Cost of capital

Ke

Ko

Kd

Leverage

Figure 3: leverage and cost of capital under NOI approach

Source: I.M Pandey (1999)

THE TRADITIONAL APPROACH

The similar to the NI approach, the traditional approach does not assume that cost of equity is constant with financial leverage. Under this approach, the firm value can rise by a prudent mix of debt and equity. Obviously this will decrease the WACC up to a certain level of debt. WACC decreases with moderate level of leverage since equity capital is more expensive than debt capital. Hence, an optimal leverage ratio is obtained only when value of firm is maximized and cost of capital is minimized.

According to the traditional approach, the relationship between the cost of capital and capital structure is divided into three stages. In the initial level, that is increasing value, Ke either remains unchanged or increases slightly with debt. Therefore, the advantage of using low cost debt is greater than the cost of equity. Since the market perceives the use of debt as a rational policy, Kd is invariable. An increase in leverage will raise the value of the firm and shareholder’s wealth but will reduce the WACC.

In the second stage, which is the optimum value, a rise in leverage will have slight impact on WACC and the firm value once the firm reached a certain level of leverage. Consequently, this will result into a disadvantage as the equity capitalization rate will be greater than the low cost of debt. An optimum value will obtained as the WACC will fall and firm value will rise.

The last stage is the stage of declining value. With a high level of leverage, the value of the firm falls and WACC increases. The company is perceived as risky because investors notice a high level of financial risk and claim a higher return for this additional risk which will increase Kd.

Cost of capital

Ke

Ko

Stage II

Kd

Kd

Stage III

Stage I

Leverage

Figure 4: leverage and cost of capital under the traditional view

Source: I.M Pandey (1999)

MODIGLIANI-MILLER THEORY

The MM theory propositions are based on assumptions which are related to a perfect market capital where there is:

no taxes and transaction cost

no asymmetric information

homogeneous expectations by investors

no effect on investment outcomes by financing decisions

investors care only about their wealth

Based on these assumptions, Miller and Modigliani divided their hypotheses into three propositions.

Proposition 1

The proposition 1 which is the irrelevant proposition argues that "the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate P appropriate to its class" [5] . To prove the indifference proposition, Modigliani and Miller used the notion of absence of arbitrage.

The arguments of M&M are, therefore, that identical firms will have identical valuation except for their capital structure. If the contrary happens, that is, if identical firms have different market values, arbitrage will take place and this will allow equity holders to make a capital gain.

Proposition 2

The M&M proposition 2 focuses on the cost of equity. The second proposition states that the firm value depends on the required rate of return in the firm’s assets, the cost of debt of the firm and debt/equity ratio of the firm. The M&M argues that the return requested by equity holders fluctuates directly with the amount of debt. The debt/equity ratio will boost because a company will borrow more debt. As a consequence the required rate of return will also increase.

Hence, if proposition 1 holds, "the expected return on levered shares will be a linear increasing function of leverage" [6] . Therefore, the average cost of capital will remain unchanged and the firm value will not be affected.

Proposition 3

The last proposition argues on how personal taxation affects the Modigliani and Miller analysis with corporate taxation. The required rate of return increases with the financial leverage. Here, Miller and Modigliani assumed that bankruptcy cost is zero. The cost of capital, which is considered as the minimum required rate of return of a project, is an asset of the project and its risk property, and is independent of the securities used to finance the project [7] .

THE PECKING ORDER THEORY

The pecking order theory is based on the fact that managers have more information on their company than investors. The pecking order theory developed by Myers-Majluf implies that capital structure decisions do affect firm values and performance. According to this theory there is no optimal capital structure for a firm. The presence of asymmetric information between managers and investors implies that market can misprice the firm’s equity and thus can lead to distortions in investments. In order to underestimate information asymmetries, corporations prefer to rely on internally generated funds which are retained earnings. According to the pecking order hypothesis firms that generate high earnings are required to use less debt capital. When internal funds are used up, debt is issued but when it becomes irrational to use more debt the firm will issue equity Myers and Majluf (1984).

THE STATIC TRADE-OFF THEORY

The static trade-off theory assumes that there is the existence of an optimal target financial debt ratio which maximizes a firm’s wealth. According to this theory, the optimal capital structure can be attained by conducting an offset between benefits (interest tax shield) and the cost of financial distress (bankruptcy and agency cost) of debts. The theory estimates that the company is invariant in terms of its assets and operations but there may be possible alteration in the leverage ratio. The theory is also consistent that the firms with low business risk borrow more than those with high volatile cash flows.

The cost of financial distress will arise when a company uses excessive debt and is unable to meet the interest and principle payments. Brigham and Gapenski (1996) argue that managers of the corporations should be able to find out when the optimal target is attained and aim at maintaining it at that level. Therefore, the cost of capital (WACC) and financial cost will decrease and firms will be able to increase its value and performance.

AGENCY THEORY

Jensen & Meckling (1976) initiated researches based on agency relationship and agency cost to illustrate the existence of optimal financial structure at the firm level. In most corporations, ownership and control are separated, where the owners of a corporation assign the daily running of the business to the managers. In theory, shareholders are only the owners of a firm and the role of its directors is to maximize the shareholder’s utility. This separation result in conflicts of interest between agents and costs to the firm known as the agency cost of equity.

The outside equity holders gain more form the manager’s increasing efforts and bear no costs. Consequently the conflict between shareholders and managers arises because managers hold less than hundred percent of the residual claim [8] . Jensen and Meckling observed that managers prefer to pursue their own interest by using the free cash flow available instead of maximizing shareholder’s wealth. As a result, the increased in the agency cost and proportion of equity held by outsiders will minimize the firm value and performance. As argued by Lubatkin and Chatterjee (1994), in order to make managers run the business more efficiently and in the firm’s interest, shareholders have to raise their debt to equity ratio.

The introduction of debt mitigates the agency cost and conflicts that exists between the managers and the shareholders. The agency cost of debt ensures that managers will return the free cash flow to investors instead of investing it in a negative NPV projects. Firms would prefer to increase leverage as the debt level can be used to monitor the managers. Thus, high leverage would result in a reduction in the agency cost and inefficiency. This would force managers to concentrate only on necessary activities which would lead to improve the firm’s performance.

Nevertheless, the firm should be careful when issuing an increasing amount of debts as the conflict between the shareholders and the debt holders will worsen if the company keeps on borrowing from its creditors. Therefore firms financed by debt are better than those financed by equity as they give managers less decision powers. However, transaction costs such as cost of capital and bankruptcy cost may force firms to stop its profitable projects which will thus reduce the firm value and profitability.

Consequently by combining the two agency costs, the agency cost of equity will reduce in leverage while agency cost of debt will rise with leverage. Hence, this will lead to the maximization of firm value and minimization of total agency cost resulting to the optimal leverage ratio.

Cost

Agency cost of debt

Total cost

Cmin

Agency cost of equity

D/E*

D/E

Figure 5

EMPIRICAL EVIDENCE

Researchers have done some analyses to find out the impact of capital structure choices on the performance of firms. Consequently, empirical studies have been carried out and created mixed outcomes.

Abor (2005) analyzed the relationship between capital structure and corporate profitability of listed firms in Ghana during the period 1998-2002. His measures included short term debt ratio, long term debt ratio, and total debt ratio. The results revealed that the short term debt ratio and total debt ratio are positively related with the company’s profitability, that is, ROE. He argued that a low priced short term debt lead to a growth in the level of profits. When the total debt increases, profitability will also be higher. On the other hand, long term debt ratio is negatively related with the company’s profitability. This means that a high priced in long term debt is correlated with a decline in profitability. This shows that the Ghanaian firms depend more on debts as their main financing option and short term debt is a significant factor as it represents 85 percent of the total debt financing. Berger and Bonaccorsi di Patti (2006) obtained similar conclusion. The results are also consistent with the findings of Hadlock and James (2002) where profitable firms use more debt (loan) financing to expect high return.

Saedi and Mahmoodi (2011) used a sample of 320 listed firms of the Tehran Stock Exchange during the period of 2002 to 2009 to analyze the relationship between capital structure and firm’s performance. They used the four performance measures (ROA, ROE, EPS and Tobin’s Q). The investigation showed that there is a positive sign between capital structure and the two performance measures that is EPS and Tobin’s Q. Capital structure is negatively correlated to ROA but there is no significant association between capital structure and ROE.

Opler and Titman (1997) analyses the significance of debt to equity choice by comparing firms in Unites States during the period of 1976-1993. They found out an adverse relationship between the market-to-book ratios and the debt to equity ratio. This is because the probability, if issuing debt to equity choice, weakens with the company’s market-to-book ratio. As a consequence, firms having a high market-to-book value will obtain a high target ratio. They also found that companies use more debt to finance assets and more equity to finance growth opportunities. They also found out that the two capital structure theories, that is, static trade-off and pecking order theory could be used to explain the firm’s behavior in the choice of capital structure. Titman (2001) came across the fact that corporations having low leverage and high level of returns will issue more debts which harmonize the static trade-off model.

Another study investigated by Nour Abu-Rub (2012), about the effect of capital structure and firm performance. The five performance measures such as ROE, ROA, MVBR, EPS and TOBIN’S Q was used as dependent variables and capital structure measures including SDA, LDA, TDA, and TDE as independent variables. The analysis used a sample of 28 listed companies of the Palestinian Stock Exchange (PSE) over the period of 2006- 2010. The results showed that capital structure had a positive effect on the firm’s performance measures. Consequently, both the accounting and market measures are statistically significant with TDA .The independent variables are extremely related with ROE based on the Adjusted R-square value (81%). The result also reported that the market measures are better than the accounting measure in Palestinian companies.

Kinsman and Newman (1998) analysis showed that firms having high levels of debt have low performance while firms having low debt experience high value. Consequently the result suggested that debt and firm performance are inversely correlated. Majumdar and Chibber (1999) also found that debt-equity ratio is negatively and significantly related with performance.

Frank and Goyal (2003), in their study of the pecking order theory of capital structure in the publicly traded American companies found a positive relationship between firm leverage and performance. Debt financing does not dominate equity financing. The information found in the financing deficit may be relevant in the case where large companies amend their leverage.

Ahmad, Abdullah & Roslan (2012) In this study the impact of financing decision on firm performance was analyzed in the consumer and industrials sectors of the Malaysian market where a sample of 58 firms were taken for the period 2005-2010. The study used ROE, ROA, SDA, LDA and total debt as variables. The results showed that SDA and TDA were significantly related to ROE while SDA and TDA were found to be significantly related to ROA. The analysis for lagged values also shows that LDA is positively correlated to ROE, thus it is concluded that leverage has an impact on shareholder’s return. Myers and Majluf’s (1984) theory also proves similar result where there is a positive relationship between LDA and firm’s profitability.

The impact of capital structure on performance of firms in Egypt analyzed by Ebaid (2009) showed the relationship that exists between ROA and ROE with the independent variables. The analyst was inspired by the paper of Jensen and Meckling (1976) which suggest that the conflict that exist between managers and shareholders does not affect the firm’s level of debt as managers are encouraged act more in the shareholders’ interest. Ebaid (2009) proved an adverse and significant correlation between ROA and SDA and TDA while no relationship exist between ROA and LDA. The variable ROE has on its part no significant link with the independent variables, that is, short term debt, long term debt and total debt.

Zeitun and Tian(2007) in their analysis done by using 167 Jordanian companies for the period of 1989 to 2003, found out that there is a negative relationship between leverage and performance of firm by using both the accounting and market measure. The result shows that SDA is negatively correlated to ROA. Consequently, SDA exposed firms to the risk of refinance as it has a negative impact on the accounting performance measure ROA. However, SDA has a positive and significant effect on Tobin’s Q which indicates that the relationship between high levels of SDA in the capital structure and high Tobin’s Q leads to high growth rate and high performance. The TDA ratio is found to be significant and negatively correlated to the market performance measure Tobin’s Q while LDA and TDE are found to be insignificant and negatively related to Tobin’s Q. TDA and LDA are found to be positively but insignificantly related with MBVR while SDA has a negative and insignificant influence on MBVR. TDE is positively and significantly correlated with MBVR indicating higher levels of debt to equity in the capital structure are associated with a higher level of market performance.

The observation of the different features of theoretical and empirical literature has facilitated the way to explore the relationship between capital structure and performance of the listed firms in the Mauritian Stock Exchange companies. The literature has enabled us to choose the suitable methodology which will be applicable in analyzing capital structure in the Mauritian firms.

OVERVIEW OF THE MAURITIAN ECONOMY

Since Mauritius relied only on Sugarcane during the independence, the growth rate in Mauritius was very slow. Therefore, the economy of Mauritius started from an inward looking strategy to an outward looking strategy where the textile industry started to flourish during the 1980’s.This diversification strategy was due to the three main pillars of its economy which are agriculture, textile and tourism.

However, the economy was vulnerable to external shocks and climatic conditions. Consequently, there was a need to increase the resilience of the economy. The expansion of a vibrant financial sector became a vital part in the development of Mauritius which commenced in the 1980’s.

It was necessary to develop and expand the economic structure of Mauritius and offer it with a contemporary financial infrastructure and suitable platform to carry out business more effectively. It is in this manner that the Stock Exchange of Mauritius was established. Consequently, at present Mauritius is also concentrating on information & communication technologies sector which is helping in boosting the economy.

In Mauritius, both the public and private sector are involved in providing services and pricing policies in health sectors, education, property development, banking and insurance sectors. The public sector provide business facilitation services and bear small profit margin whereas the private sector yield greater profit margins in sectors such as commercial, tourism, industry and financial services sectors.

STOCK EXCHANGE OF MAURITIUS

History of SEM

In 1988 the Stock Exchange Act established a small but profitable exchange run by a private limited company known as Stock Exchange of Mauritius (SEM) ltd. The Act also created the Stock Exchange Commission which controls and supervises stock exchange activities. SEM manages and encourages the efficiency of the regulated stock market in Mauritius. In October 2008, the SEM became a public company and is now recognized as one of the leading exchanges in Africa and also a member of the WFE.

In 1994, the stock market became accessible to foreign investors with the aim of eliminating exchange controls. Due to this openness foreign investors gained from several reasons such as repatriation of profits on sale of shares at no cost, no tax on dividends and capital gains. In 1997, the successful implementation of the Central Depository System (CDS) ensured the proficient clearing settlement of trades and simultaneously decreased some basic risk in the process.

SEM also launched the Automated Trading System (SEMATS) in 2001 which ended the traditional trading system which personified the SEM since its foundation. More developments which occurred on the SEM are the introduction of the trading of treasury bills where the government securities were being traded on the Exchange.

Since 2010, SEM deals with equity and debts products in EURO and GBP. In June 2011, SEM was recognized as the initial Exchange in Africa to list, trade and settle equity products in USD. Due to this innovative factor, SEM was well positioned globally and now contributes to the internalization of the Exchange. In 2011, SEM introduced in its Listing Rules provision for the listing of Global Business corporations and specialist debt instruments. Hence, SEM moved from a domestic-equity-focused Exchange to a multi-product-internationally-focused Exchange.

Evolution of SEM

The Official Market (SEM 2012a) and the Development & Enterprise Market (DEM) are the two markets which are run by the Stock Exchange of Mauritius. The official market started operating with five listed corporations in 1989 with a market capitalization of nearly USD 92 million. At present 43 corporations are enrolled on the Official Market with a market capitalization of almost US$ 5.7 billion since end of December 2012. The DEM, on the other hand, which is a market designed for SME’s started operations on 4th August 2006 and has now 47 listed firms on the market representing a market capitalization of nearly US$ 1.4 billion since the end of December 2012.

Propagation of market information

Market information and significant data are published by SEM with the aim to help its members and potential shareholders. Under this perspective, at present there are three indices formed by the SEM. These are known as known as SEMDEX, SEMTRI and SEM-7where day-to-day information are published to illustrate the market progress and trends.

The SEMDEX is an index of prices of all listed shares and each stock is evaluated to its share in the overall market capitalization accordingly. Only ordinary shares are included in this index and the shares must be listed on the official market. SEMTRI is a Total Return Index which offers local and foreign investors an excellent performance measurement of the domestic market. The SEM-7 consists of the seven leading and qualified shares of the record.

Objectives of the SEM under the SEA:

To operate and sustain the Stock Exchange

To offer facilities for trading and dealing in securities in the Stock Exchange

To retain to the agreement of the commission and provide sufficient and the right equipped premises for the control of its business.

To establish a clearing system under the Securities Act 1996

HISTORICAL DATA

Official Market

Number of listed firms

Market Cap in US:$ (End of period) 

P/E Ratio (End of period)

Dividend yield (End of period) %

No. of trading sessions:

SEMDEX (End of period)

SEM-7

SEMTRI Rs (End of period)

 

 

 

 

 

1989

6

 93,256,603 

6.56

5.42

26

117.34

-

118.95

1990

13

 254,716,404 

6.26

4.17

51

171.23

-

183.3

1991

19

309,514,683

6.12

5.11

50

154.17

-

173.11

1992

21

 423,547,897 

8.72

4.29

99

183.18

-

217.41

1993

29

 842,218,132 

13.64

30.9

97

302.63

-

375.45

1994

34

1,578,321,657

20.11

2.08

147

476.1

-

608.24

1995

39

1,562,795,282

10.85

3.2

149

344.44

-

454.97

1996

42

1,693,391,217

11.3

3.28

148

353.46

-

485.32

1997

42

1,754,626,096

12.86

3.62

160

391.12

-

557.28

1998

42

1,849,913,465

11.56

3.88

548

465.6

111.7

691.29

1999

43

1,643,314,579

8.98

5.03

250

435.69

105.16

680.04

2000

42

1,335,553,901

6.4

6.73

247

390.1

94.68

650.71

2001

40

1,061,846,545

5.91

8.3

246

340.92

74.65

626.75

2002

40

1,324,231,440

5.33

9.83

248

399.26

88.45

812.56

2003

39

1,953,476,852

7.43

5.74

252

549.58

119.39

1,194.85

2004

40

2,395,779,949

9.93

4.85

254

710.77

149.67

1,619.92

2005

41

 2,645,899,713 

7.98

4.64

249

804.03

175.43

1,951.83

2006

41

3,540,600,633

11.95

3.66

251

1204.46

264.41

3,060.71

2007

41

6,035,377,908

13.26

2.8

250

1,852.21

477.40

4,868.61

2008

40

3,343,389,240

6.17

5.14

248

1,182.74

267.22

3,233.74

2009

40

4,815,679,265

10.74

3.5

250

1,660.87

360.75

4,712.70

2010

37

5,679,519,988

14.05

2.5

252

1,967.45

373.22

5747.82

2011

43

5,721,771,159

11.29

3.04

249

1,888.38

 349.86

5,673.68

2012

43

5,669,064,037

11.3

3.39

247

1732.06

 349.86

5364.29

Table 1

Source: Stock Exchange of Mauritius

SOURCES OF FINANCE IN MAURITIUS

Equity finance

Firms generally seek to obtain money for their business through equity financing.

Equity finance can be raised through ordinary shares to shareholders/stakeholders who represent an ownership position of the firm through SEM. They are the official holder and are able to apply some degree of control over the organization of the firm.

Ordinary shares

The stakeholders are entitled to dividends only after all claims have been paid. Only the board of directors gives the approval of the rate of dividend since it is variable. Consequently, they bear high risk but also benefit from the maximum return in the form of greater dividend or capital gains. In case of liquidation, they are the last to be repaid. The two types of ordinary shares are right issue and bonus issue.

Retained earnings

Retained earnings are considered as an internal source of finance where after a successful trading year and after paying all the costs from the profit obtained, the company can use some of the profit to finance future activities. This source of finance has no risk and no obligation towards others. However, retained earnings can be utilized only when the firm is making tremendous profit and this may occur once a while and not frequently.

Debt financing

Preference shares

Preference shares are similar to ordinary shares where they carry a certain degree of risk but less to ordinary shares. In case of profit, dividends are paid to them. However, preference shares have a fixed dividend rate and get a claim on the assets before the ordinary shares but after the debenture holders.

Loans from financial institution

An alternative way to debt finance is to borrow money from financial institution, where money is given to the borrower in terms of loan. The bank keeps record of the principal and repayment during the maturity of the loan. The rate of interest on loan is either fixed or floating. The floating rate will always depend upon the creditworthiness of the borrower. For instance, HSBC offers loan at floating rate of interest and recommend loans for long term investments and capital expenditure. Firms such as Omnicane Ltd, Sun Resort Ltd, Phoenix Beverages Ltd and Harel Mallac Ltd borrow both at long-term and short-term.

Leasing companies

Leasing is a process by which a firm can finance the use of capital equipment without having to buy it. It is a medium term source of finance under which the firm is bound legally to make payments over the leased period. The two types of lease agreement are operating lease and finance lease.

Finance lease

This type of lease transfers all types of risks and rewards of ownership of an asset to the lessee. For instance in Mauritius Leasing Company Ltd, the client remains the beneficial owner and enjoys possession of the leased asset. When the contract terminates, the client can either buy the asset instead of paying the residual value which is usually set at 1%. Leases in ENL Land Ltd are grouped as finance leases where the conditions of the lease move all the risks and returns of ownership to the leaseholder. Plant and equipment acquired by ENL Land Ltd are classified under finance lease.

Operating lease

Operating lease is a short term financing and the lease period is less than the useful economic life of the asset. Under the operating lease there is no residual value but the monthly rental is based on the expected market value. When the contract gets over, the client can either return the equipment to the lessor or may buy the equipment at a negotiated price. Consequently, a new lease may be entered into with similar lessee or the latter may sell the asset to a third party. Gamma Civic Ltd uses both types of leasing where under finance leases, fixed assets are depreciated over their estimated useful life. While other leases such as leases of land are classified under operating lease.

Issue of debentures

Issue of debentures refers to the issue of an official document by the firm which acknowledges debt taken by the firm. The procedure of issuing debentures is similar to that of issue of shares. Mortgage debentures are secured by a price on the firm’s asset. Firms can recuperate their principal with the owing amount of interest on such debentures out of the assets mortgaged by the business.

Foreign sources

New projects of the firms are financed from foreign financial organizations such as the European Union and United Nations Conference on Trade and Development.

Graph 1: sources of finance on SEM

Source: Stock Exchange of Mauritius

As mentioned earlier firms can obtain funds from retained earnings, debt or equity in order to finance their activities. The graph shows the quantity of each of the three sources of finance used over time from 2006 to 2011 for all the listed firms on SEM. The study proves that firms in Mauritius prefer to use debt as a source of funding. From 2007 to 2009 debts have been dominating as shown in the graph. This means that firms prefer debt financing to retained earnings since the use of retained earnings has been constantly low during the 6 years. Equity issued by firms shows a rapid rise in 2010 and 2011. Hence, this shows that the pecking order theory is not applicable in the listed firm since they rely more on external sources than internal sources in order to finance their activities.

Data Sources

The collection of data can be done in two ways: primary and secondary data. The primary data are publicly unavailable and can be collected through ways of surveys and interviews. Secondary data, on the contrary, can be collected from internal sources that are formed within the organizations itself, for example, through its internal reports and accounts. It can also be collected through newspapers, magazines, articles and reports. Consequently, the analysis will be conducted by using secondary data extracted from the annual reports of the listed firms on SEM.

Research Objectives

The objectives of this analysis as previously mentioned in the chapter 1 are:

To find out the relationship between capital structure and performance of the firm.

To investigate on the impact of capital structure and leverage on organizational variables.

To find out if an optimal capital structure decision can help firms to increase their value and thus their performance.

Sample Selection

The study uses data for the period of 2006-2011 from the handbook published yearly by SEM. The handbook provides detailed reports of the financial statement of all Mauritian listed companies. The sample will consist of accounting data only from non-financial firms on the official market of SEM. Therefore, the following sectors will be considered: industry; commerce; transport; leisure and hotels; and sugar. Consequently, banking and insurance; investment sector and property development will be excluded. Out of the 21 non-financial firms only 16 will be analyzed.

Limitations

Data for the year 2012 has not been included given that the financial statements figures for these two years are not yet audited.

Four non-financial firms were excluded due to lack of data.

Ratios are based on financial statements which contain a degree of biasness.

The aim of this masterpiece is to analyze the relationship between capital structure decisions and firm performance. Hence, accounting and market measures will be used to measure the performance of firms and leverage ratio for capital structure as illustrated in the diagram below.

Dependent variables

Accounting Measures

Independent variables

EPS

MBVR

ROA

Tobin’s Q

Market Measures

TDE

TDA

LDA

SDA

Capital structure

ROE

Firm Performance

Figure 6

Source: Own

DEPENDENT VARIABLES

Return on Equity (ROE)

ROE measures the profits earned for each rupee invested in the firm’s stock. A low ROE means a poor management performance while a high ROE means a good management performance and firm is undercapitalized.

Return on Asset (ROA)

ROA indicates how much each rupee of assets earns on an after-tax income basis for a given time. A low ROA means ineffective management while a high ROA means effective management.

Earnings per Share (EPS)

It states a firm’s profits on a per share basis. It helps for comparison to the market stock price.EPS is used to determine how efficiently firms generate income per share of stock.

Market to Book Value Ratio (MBVR)

It is an investment valuation ratio which is used by investors to compare market value of a firm’s shares to its book value. The ratio indicates how much shareholders are contributing for a firm’s net assets. A low ratio signifies a good sign for the firm.

Tobin’s Q

Tobin’s Q, introduced by James Tobin, is the ratio of the market value of a firm’s to its total asset value. If the Tobin’s Q ratio is greater than 1, then the firm’s market value is higher than the total asset value. Thus this shows that the firm is performing well with its investment decisions and the profits made would surpass the cost of the assets. However, if the ratio lies between 0 and 1, it means that the stock is undervalued as the value of the firm’s assets is greater than the value of its stock. The perfect condition would be then the ratio is more or less equivalent to 1 which indicates that the firm is in stability.

INDEPENDENT VARIABLES

Short Term Debt Ratio (SDA)

The ratio will indicate if a firm will be able to satisfy its immediate financial obligations. A high short term debt ratio indicates a lack of liquidity as most of the corporate debt will have to be met in the current year.

Long Term Debt Ratio (LDA)

The ratio measures the percentage of a firm’s assets that are financed with loans and other financial obligation for more than one year. A low long term debt ratio means that the firm is less dependent on debts for their business needs. A high long term debt ratio means that the firm must have positive revenue and steady cash flow.

Total Debt Ratio (TDA)

It measures the portion of a firm’s capital that is provided by borrowing. Total debt is used in investing to find out the level of risk in a firm. A low debt ratio means the business has less total debt than asset. Problems may arise when a firm tries to borrow more money as the firm may be unable to repay back the debt to the lenders. Consequently, a high debt ratio means there is insolvency risk or bankruptcy risk in the business as the firm does not have sufficient assets on hand to settle up all debt instantly.

Total debt to Equity Ratio (TDE)

It indicates the ratio of debt on a firm’s financial statement to the amount of funds provided by owners. A low debt to equity ratio means a company is safe despite of excessive caution. In general it should be between 50% -80% of equity.

Below is the measuring index of both the dependent and independent variables:

VARIABLES

MEASURING INDEX