LONDON SCHOOL OF BUSINESS & FINANCE In Collaboration With
UNIVERSITY OF WALES MSc in Finance Dissertation Proposal A Study on Capital Structure and Profitability Relationship For UK Firms Prepared by: XXXXXXX October 21, 2010
Program Module Tutor Name Student ID Word limit Word Count Proposal Topic
MSc in Finance (Risk Management) Research Methodology …………. ………… ………… 3500 - 4000 Words 3600 Words A Study on Capital Structure and Profitability Relationship for UK Firms
RESEARCH PROPOSAL For
A STUDY ON CAPITAL STRUCTURE AND PROFITABILITY RELATIONSHIP FOR UK FIRMS For the partial fulfillment of the requirement for the degree of
Master of Science (Finance)
By Sajid Ghumra (M1002222)
Submitted to LSBF Manchester
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Contents Page
Chapter 1
Chapter 2
Contents Page
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Introduction
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1.1 Context and Relevance of the Study 1.2 Research Objectives 1.3 Research Questions and Hypotheses 1.4 Scope and Limitations of the Study
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Background and Literature Review
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2.1 Early Study on Capital Structure by W A Chudson 2.2 M & M Propositions 2.3 Profitability and Leverage theories
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2.3.1 Pecking Order Theory 2.3.2 Agency Costs Theory 2.3.3 The Trade off theory
Chapter 3
Chapter 4
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2.4 Capital Structure Studies in UK 2.5 Conclusion: Various Studies on Capital Structure
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Research Framework
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3.1 The Research Model and Methodology 3.2 Data Sample 3.3 Variables
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Research Plan and Implementation
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4.1 Research Schedule 4.2 Resources
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References
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CHAPTER 1 INTRODUCTION The subject of capital structure is a widely discussed topic in academic circles and in the corporate finance world. The question whether capital structure that a firm employs to finance its assets, affects to the profitability of the firm or it is affected by profitability is 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 affect underlying profits and risk of the firm that is reflected in the value of the firm. Traditional view is that an optimum level of capital structure exists up to that level increasing debt will increase the value of firm. Hence it improves profitability up to that level, beyond that it will reduce profitability. Chudson (1945) carried out an extensive study that implies the possibility of a relationship between the capital structures of a firm with its profitability. Merton Miller and Franco Modigliani (1958) in their famous Miller-Modigliani (MM) propositions put forward the net operating income approach. It states irrelevance of capital structure in a perfect market to its value; hence, how a firm is financed does not matter. The MM propositions lay the foundation for contemporary thinking on capital structure. However this theory based on stringent assumptions of perfect market those are not prevailing in practice. As the value of the firm is depends on underlying future profitability and risk of the firm, current study is devoted to the profitability and capital structure relationship in UK firms.
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1.1 Context and relevance of the Study The matter of capital structure has gained much interest, since the MM Propositions of capital structure irrelevance. Different theories such as packing order theory and agency cost theory were proposed. Various aspects of capital structure have been put to test and researched. The question is whether the capital structure is relevant in a real market or irrelevant and whether a company's profitability and hence value is affected by the capital structure it employs or not? Profitability is regarded as a major determinant of capital structure, a part that bankruptcy costs, agency costs, taxes, and information asymmetry etc. are considered in determination of capital structure. The topic of capital structure has been widely explored, though the study is relevant in the different time period and different context to find out whether the evidence concerning the capital structure issue and its various aspects are relevant to a given set of companies in a given period. Given this significance, current study attempts to understand and research on capital structure and its effect on profitability, an important relationship that is not given much attention before, of large firms in UK in the present context. The study also analyse if an optimal capital structure exist that maximizes profitability and hence the value of the large UK firm. The research is focused on the recent period of five years (2005 -2010) for large publicly traded companies on FTSE 100. 1.2 Research Objectives The present study is aimed at achieving one main and two secondary objectives. The main objective is to scrutinise the relationship between the capital structure and profitability of the large publicly traded UK firms and to ascertain whether a firm’s 4
profitability is related with its capital structure or not 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 FTSE 100 listed companies. Third objective is to find out any trend of capital structure being exhibited by the UK companies.
1.3 Research Questions and Hypothesis The above objectives are translated in two research questions and will be answered based on the empirical evidence generated. The main research question is that “whether a firm’s profitability is related with its capital structure or not?” Hypothesis The first questions can be presented as following hypothesis. The present study shall be undertaken to evaluate this hypothesis based on the tests of the null hypothesis. H1: The profitability of a company is significantly correlated to its capital structure. H0: The profitability of a company is not significantly correlated to its capital structure. The secondary objectives of this study are translated in the determinant question regarding the optimality and trend of capital structure. The second question, will be discussed descriptively is that, is there an optimal capital structure exists among or any trend of capital structure being exhibited by FTSE 100 listed companies?
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1.4 Scope and Limitations of the Study Scope This is an academic study that would shed some light on the matter of capital structure which has been discussed in various different perspectives since the M&M propositions. The significance of this study is that it further enhances the research into capital structure of listed firms in UK. Profitability and Capital structure relationship is an ongoing issue and its relevance may change in different period because of the changes in macro and micro economic factors. For practitioners and corporate finance people such as finance executives, controllers and directors of listed firms, this study is relevant and of much interest to get insight of the capital structure and whether it has any effect on the profitability. Limitations The findings of this study will be limited from the following aspects: This study included only FTSE 100 listed companies on the London Stock Exchange (LSE). Hence, its findings will not applicable for all the listed companies in UK. The sample of listed companies with five year results only included in this study. The companies, for which no five year results available, will not be included in this study. The study excludes financial, utility and other highly regulated industry to avoid any distortions in the result due to industry specific requirements.
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CHAPTER 2 BACKGROUND AND LITERATURE REVIEW There are various capital structure theories developed by corporate finance academia those analyse how a firm could combine the securities to maximise its value. The Modigliani and Miller (1958) introduced their propositions under the perfect capital market assumptions and assert that the capital structure of a firm is irrelevant to total firm value. They refers to an ideal market where there are no taxes corporate or personal, no transaction costs, no agency costs as and managers are rational. It further assumes that investors and firms can borrow at the same rate without restrictions and all relevant information is freely available. After MM propositions, many studies were focused on the determination of capital structure. Most of such studies done by relaxing various assumption in that model and shows how it contributes to the determination of the firm’s capital structure and what extent. Many theories such as the pecking order theory, the trade-off theory and the agency cost theory have been developed. Though much attention was not given to one major aspect of the capital structure, which is the impact on the profitability and value of the firm. The value comes from the future profit of the firm. Thus capital structure affects value of the firm through the profitability and hence there is a direct relationship between them. Capital Structure The term capital structure is defined by Van Horne & Wachowicz (1995, p.470) as “The mix of a firm’s permanent long-term financing represented by debt, preferred stock, and common stock equity.” 7
In practice there may be different type of Debt and Liabilities a firm might have on its balance sheet. 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 and ability to generate net income or profit on a consistent basis. The term profitability can be defined and measured in several ways depending on the purpose. The simplest and common meaning of profitability is the net income. It is often measured by earnings ratio. In this study Profitability will be expressed as return on asset and return on equity. 2.1 Early Study on Capital Structure by W A Chudson One of the earliest comprehensive researches into capital structure of business firms was done by Chudson Walter Alexander (1945) on US companies in manufacturing, mining, trade, and construction industry from the year 1931 to 1937. This study is still relevant today as before due to the seven questions which he endeavoured to answer. Out of those questions the relevant to this study are as follows. 1. How does the structure of assets and liabilities of a firm reflect the industry in which it operates, its size and level of profitability? 2. Is there any component of balance sheets either asset or liability, whose range is so narrow that it is possible to speak of a normal pattern of capital structure?
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These questions are reflected in the research questions of the present study as it looks in to the relationship between profitability and capital structure, the existence of an optimal capital structure, and any trend of capital structure. Chudson’s (1945) research demonstrated an undisputable relationship between corporate financial structure and the firm’s profitability.
As far as this study is
concerned, it will test that successfully proven relationship between the profitability of a company with various capital structure variables including debt and equity capital. 2.2 M & M Propositions Merton Miller and Franco Modigliani (1958) in their famous Miller-Modigliani (MM) propositions put forward the net operating income approach and demonstrated that the capital structure is irrelevant in a perfect market. Accordingly, the first Proposition holds that the value of a firm is independent of its capital structure. While the second proposition stats that when first proposition held, the cost of equity capital was a linear increasing function of the debt/equity ratio. As Miller (1988) wrote subsequently these propositions implied that the weighted average of these costs of capital to a firm would remain the same no matter what combination of financing sources the firm actually chose. Barges (1962) tested and evaluated the M&M propositions predominantly on the validity of the hypothesis that the cost of capital to the firms is unaffected by capital structure. He found that the hypothesis of independence between average costs and capital structure untenable and suggested that the over-all cost of capital of a firm can be reduced through the use of debt funds.
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Notwithstanding any criticism MM hypothesis is a solid argument of Independence of capital structure. It is based on Net Operating Income approach. Accordingly total value of firm depends on underlying profitability and risk. It is not affected by change in Debt equity mix. This study will test this argument of capital structure irrelevance. 2.3 Profitability and Leverage theories Since MM propositions presented, many studies were conducted with focus on the determination of capital structure and many theories were presented. Most studies were conducted by releasing MM assumptions focusing on the extent to which each of the assumptions contributes to the determination of the firm’s capital structure. All these theories explains the relationship between leverage and the value of the firm and hence profitability of the firm. Nevertheless, all these theories are actually based on asymmetric information (Myers, 1984), tax deductibility (Modigliani and Miller, 1963; Miller 1977), Bankruptcy costs (Stiglitz, 1972; Titman, 1984) and agency costs (Jensen and Meckling, 1976; Myers, 1977). 2.3.1 Pecking Order Theory The Pecking Order Theory is based on assertion of information asymmetry between management and investors. Accordingly the stock price of a firm may not reflect correct value of the firm. Myers and Majluf (1984) suggest that management issue the security which is overvalued and therefore, undervalued firms tend to avoid issuing equity. They argue that in imperfect capital markets, leverage increases with the extent of information asymmetry. They provided theoretical support to Donaldson’s (1961) findings that firms prefer to use internally generated funds. According to Myers (1995), the dividend policy is
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sticky and the firms prefer internal to external financing. Firms prefer using internal sources of financing first, then debt and finally external equity obtained by stock issues. Therefore, Pecking Order Theory does not suggest a well-defined target debt ratio or optimal capital structure. The more profitable the firms are, the more internal financing they will have. In essence, it explains a negative relationship between profitability and capital structure. The various studies such as Myers and Majluf (1984), Harris and Raviv, 1991; Rajan and Zingales (1995), Booth et al. (2001) have supported this relationship. 2.3.2 Agency Costs Theory The Agency Costs Theory emphasize that capital structure was influenced by conflicts and agency issues. Jensen and Meckling (1976) show that monitoring cost is born by shareholders. Debt holder will charge high interest rate if there is less monitoring. It will reduce profitability and value of firm. On the other hand in case of high monitoring and resultant protective covenant hinder profitability and value of firm. Firms with longer credit histories would have lower cost of debt. Fama and Miller (1972), using agency cost theory, proved that leverage was positively associated with firm value. 2.3.3 The Trade off theory The trade-off theory is based on the considerations of benefits and the costs of debt. Accordingly firms optimise their capital structure and debt ratios move towards the targets in such a manner that it maximise its profitability by adopting a trade off between the tax deductibility of interests, bankruptcy costs and agency costs. If the 11
firms are profitable, they should prefer debt to benefit from the tax shield. Profitable firms can borrow more because greater possibility of repayment of debt. However after a certain level of leverage, the profitability and the value of the firm will reduce due to interaction of bankruptcy costs and agency costs. This theory is consistent with traditional approach of capital structure. 2.4 Capital Structure Studies in UK Two major studies in UK found profitability is negatively related with the capital structure of the firm. These are as follows, Rajan and Zingales Rajan and Zingales (1995), in their study of determinant of capital structure find that profitability is negatively related to gearing. Their results were consistent with Toy et al. (1974), Kester (1986) and Titman and Wessles (1988). More profitable firm will obviously need less borrowings, however 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. Alan A Bevan and Jo Danbolt Alan A Bevan and Jo Danbolt (2002) found that the results of their study are consistent with the pecking order theory; the regression coefficients for the effect of profitability on corporate gearing are systematically negative and statistically significant. However the results contradict the tax shield hypothesis. They concluded that “the profitability has generally the strongest explanatory power of the crosssectional variation in UK gearing levels”.
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2.5 Conclusion: Various Studies on Capital Structure As the issue of capital structure gained prominence and interest, a number of studies had been done over the years to explore the relationship between capital structure and a firm’s various characteristics e.g. growth opportunities, non-debt tax shields, firm’s volatility, asset systematic risk, asset unique risk, internal funds availability, asset structure, profitability, industry classification, and firm size. This study is concerned particularly on the relationship between capital structure and 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). Myers (1995) wrote that the strong negative correlation between profitability and financial leverage is one of the most striking facts about corporate financing. Bradley, Jarrell and Kim (1984) concluded that an inverse relationship between earnings and leverage and optimal capital structure actually existed as proposed by finance theorists. They conducted their study by using Ordinary Least Squares method to analyze the capital structure of 851 industrial firms for a period of twenty years from1962 to 1981. Most of such studies were conducted in US and hence represents financing and profitability relationship in US economy and might not be applicable in other countries around the globe. Some of the studies conducted in UK and other countries as well, though changing business and economic environment and time period may have their impact on such capital structure and profitability relationship. Further as discussed earlier much attention was not given to one major aspect of the capital structure, which is the impact on the profitability and hence the value of the firm. It is clear from above discussion that the value of firm changes with changes in 13
capital structure. This relationship is explained by underlying profit and risk of the firm. So understanding the effect of capital structure on the profitability and hence the value of the firm in the current economic and business environment is the main motivation for this study.
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CHAPTER 3 RESERCH FRAMEWORK I intend to use two major sets of variables (Ratios) i.e. Debt and Profitability to ascertain the relationship between the capital structure and profitability. The first set includes Gearing ratios Debt/Equity Ratio and Debt Ratio. The other set includes profitability ratios Return on Equity, and Return on Assets. The variables will be analyzed using the descriptive/time-series statistics, Correlation and regression technique. Further Excel Trend analysis will be used for understanding trends given by regression analysis. 3.1 The Research Model and Methodology The following model outlines the framework for research. It consist two major components i.e. the profitability of a firm as the dependent variables and the capital structure of a firm as the independent variables. The direction of arrow below indicated the expected direction of causality is expected to scrutinise. However profitability and capital structure relationship is a two way relationship. DEBT RATIO
ROE
DEBT/EQUITYRATIO
ROA
The research design given above reflects the direction of analysis which will explain the relationship among the two main groups of variables. The variables, as much as possible, will be selected on the basis of the literature being reviewed. Thus, while this study is expected to give exciting results and may reflect the changing environment and time, though there will be direct ties to earlier studies.
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One prominent issue here is the direction of the causality in the model. This research is based on the notion that the capital structure being practised by a firm would affect its profitability. This particular cause-and-effect relationship had been proved in various studies as found in the literature being reviewed. Though it should be kept in mind that a number of researchers have argued that it was profitability which would influence the capital structure and most of studies are based on this notion. However, this study is focused on the importance of the relationship between two variables and not the direction of causality. 3.2 Data Sample The data used for the empirical analysis will be derived from Hemscott database contains balance sheet, profit and loss and certain Key Ratio information for FTSE 100 companies in UK. For the purposes of this dissertation, I expect to utilise this data to obtain the required variables over five year period for all non-financial, non utility companies. 3.3 Variables In the first instance, great care was taken to define the dependent and independent variables to be used in the descriptive statistics, co variance and regression analysis. As there are several alternative measures of profitability and gearing, only relevant measures are chosen for those analyses. Dependent Variable Profitability is dependent variable in this analysis and two measures of profitability employed in this analysis are Return on Equity (ROE) and Return on Assets (ROA).
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ROE is the return on equity and is measured as earnings before tax (EBT) divided by owners’ capital or equity (EQUITY). ROE = EBT/EQUITY ROA is return on assets and is measured as earnings before interest and tax divided by total assets (Titman and Wessels, 1998 and Fama and French, 2002). The ratio of earnings before interest and tax (EBIT), to the book value of total assets (TA) is, ROA = EBIT/TA Independent Variables Gearing Ratio represents capital structure. Therefore, in order to examine the sensitivity of the profitability to capital structure following two ratios are used in this analysis and defined as: Debt to Total Assets: This is a simple ratio of total debt (TA) to total assets (TA). DEBT RATIO= TD/ TA Debt to Capital: This is the ratio of total debt to capital, where the capital includes total debt (TD), equity (ECR), and preference shares (PS). DEBT/EQUITY RATIO = TD / (TD + ECR + PS) In addition, other two independent variables intended to use are i.e. Risk given by variance in profitability and size given by natural log of Sales as these variables have direct impact on profitability and capital structure relationship.
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CHEPTER4 RESEARCH PLAN AND IMPLEMENTATION Research work starts from week beginning from October 4, 2010 and is expected to complete in 10 weeks time. The work is scheduled as follows. 4.1 Research Schedule
Research Schedule Week Star Date : 04-10-2010 Week
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Background reading & literature review
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Research design and plan
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Choice of methodology
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Gathering data
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Data analysis and refine Writing up draft
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Editing final document
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Produce final document
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Document passed to supervisor to read
4.2 Resources I intend to use following resources Hemscott database for data collection. MS Excel for analysing data. University of Wales online library, resources available on internet, and some books and journal on finance available in various libraries.
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References Alan A Bevan and Jo Danbolt, (2002) Capital Structure and Its Determinants in the United Kingdom: A Decompositional Analysis Working Paper 2000/2, Department of Accounting and Finance, University of Glasgow. Chudson, Walter Alexander. (1945) The Pattern of Corporate Financial Structure: A Cross-Section View of Manufacturing, Mining, Trade, and Construction, 1937. Ph.D. Thesis submitted to the Faculty of Political Science, Columbia University. Barges, Alexander. (1962). The Effect of Capital Structure on the Cost of Capital: A Test and Evaluation of the Modigliani and Miller Propositions. Ph.D. (Finance) Thesis submitted to the Graduate School of North Western University. Fama, Eugene F. and Merton H. Miller. (1972) The Theory of Finance. New York: Halt, Rinehart and Winston. Fama, Eugene F. and Kenneth R. French, (2002) Testing Trade-Off and Pecking Order Predictions About Dividends and Debt. The Review of Financial Studies, Vol. 15, No. 1, pp. 1–33. Harris, Milton and Artur Raviv. (1985). A Sequential Signalling Model of Convertible Debt Call Policy. Journal of Finance, Vol. 40. Pp. 1263-1281. Jensen, M., (1986) Agency costs of free cash flow, corporate finance and takeovers. American Economic Review, Vol. 76, pp. 323-329. Jensen, M. and Meckling, W., (1976) Theory of the firm: managerial behaviour, agency costs and capital structure. Journal of Financial Economics, Vol. 3, pp. 305360.
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Miller M.,(1977) Debt and taxes. Journal of Finance, Vol. 32, pp. 261-275. Modigliani, F. and Miller, M.H., (1958) The cost of capital, corporate finance, and the theory of investment. American Economic Review, Vol. 48, pp. 261-297. Modigliani, F. and Miller, M.H., (1963) Corporate income taxes and the cost of capital: a correction. American Economic Review, Vol. 53, pp. 433-92. Myers, S.C., (1977) Determinants of corporate borrowing. Journal of Financial Economics, Vol. 5, pp. 147-175. Myers, S.C., (1984). The capital structure puzzle. Journal of Finance, Vol. 34, pp. 575-592. Myers, S.C. and Majluf, N.S., (1984) Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, Vol.13, pp. 187-221. Myers S C., (2002) Financing of Corporations, August 27, Handbook of the Economics of Finance. Rajan, R.G. and Zingales, L., (1995) What do we know about capital structure? Some evidence from international data. Journal of Finance, Vol. 50, pp. 1421-60. Stiglitz, J. E., (1972) Some aspects of the pure theory of corporate finance: bankruptcies and takeovers. Bell Journal of Economics and Management Science, Vol. 3(2), pp. 458-482. Van Horne, James C. and John M. Wachowicz, Jr. (1995) Fundamentals of Financial Management. 9th Edition, New Jersey: Prentice Hall.
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