Superior university newyork |
2. Declaration of originality
I hereby declare that this thesis is entirely my own work and that any other sources of information have been duly mentioned.
I hereby declare that any internet sources published or unpublished works from which I have drew references from are used as in text references and end list references.
I understand I may be called for viva and if so must attend. I acknowledge that this is my responsibility to check whether I am required to attend and that I will be available during the viva time.
3. Acknowledgment
All thanks are due to Almighty Allah, the compassionate and merciful, who knows about whatever is there in the universe, hidden and evident, and has enabled us to elucidate a drop from the existing ocean of knowledge. As for us all we know is nothing. All praises be to the Holy Prophet Muhammad (peace be upon him), the city of knowledge.
All praises to the Holy Quran, which is the key source of all the knowledge and the very guider for leading a successful life in any circumstances.
I acknowledge with deep sincerity and great pleasure in expressing my heartiest gratitude to my supervisor Mr. Salman Masood for providing guidance in this challengeable task of analyzing the Impact of Capital structure on profitability in Automobile of Pakistan.
Rehan Sarwar
4. Dedication
THIS THESIS IS
DEDICATED TO
My PARENTS
&
TEACHERS
WHO ARE KEEN TO SEE US
CONTRIBUTING SOMETHING
TOWARDS THE NATION.
5. Abstract
This study examined the impact of capital structure on profitability in automobile sector of Pakistan. A sum of four companies listed on the Lahore stock exchange was put under study for a period of six years (2005-2010). For this study I have collected data from the financial annual reports. Two main group of variables were used to point out capital structure i.e. debt ratio, cost of debt, cost of common stock equity and, profitability i.e. Net profit ratio. The variables were examined by using the cross sectional and time series methodology. In order to verify the theory, Descriptive statistics, Pearson correlation and Regression analysis were used. The results of regression show that there is no relationship between capital structure and profitability.
6. Table and Lists
6.1 Table of contents
Contents
1. Title page……………………………………………………………………………….1
6.2 List of Figures
Figure 1:---------------------------------------------------------------------------- 23
Figure 2:---------------------------------------------------------------------------- 27
6.3 List of Tables
Table 1: ---------------------------------------------------------------------------------42
Table 2: ---------------------------------------------------------------------------------43
Table 3: ---------------------------------------------------------------------------------43
Table 4: ---------------------------------------------------------------------------------44
Table 5: ---------------------------------------------------------------------------------50
6.4 Acronyms
MEL Millet Equipment Limited
R&D Research and development
SPSS Statistical Package for Social Sciences
SAP Structural adjustment programme
SEM Structural Equation Models
WACC Weighted average cost of capital
Chapter 1:
7. Title
8. Introduction:
The capital structure is very important decision for the company so that they maximize return to its various stakeholders. In addition, an appropriate capital structure is also important because it will help companies in dealing with the competitive environment in which the company operates. A company's capital generally refers to its mix of financial liabilities. In analyzing the capital structure, we focus on the type of funds, debt or equity in the company used to finance. Debt and equity are the two major classes of debt, with creditors and shareholders, the two types of investors in the company. Each of them has different risks, benefits are linked and monitored. During exercise less control the holders of bonds, they earn a fixed rate and are protected by contractual obligations with respect to their investments. Shareholders are the residual claimants, with most of the risk, and therefore have greater control over decisions. Modigliani and Miller (1958) argues that an "optimal" capital structure exists, if the risks to balance the bankruptcy by the tax savings from debt. Once this optimal capital structure is determined, a company would be able to maximize returns to its stakeholders and these returns would be higher than the yield on a company whose capital can be obtained only from shares (all-equity firms). The capital of a company should be fully compose of liabilities by the deduction of taxes on interest payments. But in practice there are bankruptcy costs and those costs are directly proportional to the debt of the company. Therefore causes an increase in debt increases bankruptcy costs. Therefore, they argue that an optimal capital structure will be achieved only if the tax benefits are sheltering, where an increase in debt is equal to the bankruptcy costs. In this case, the executives of the company are able to see if this optimal capital structure is reached, and try to keep it at the same level. This is the only way that the financing costs and the weighted average cost of capital (WACC) and corporate performance, companies which value can be minimized. With the help of theoretical models, top management of companies is able to calculate the optimal capital structure, but in real situations, many researchers found that most companies have no optimal capital structure (Simerly and Li, 2000). An ongoing debate in corporate finance concerns the question of a company's optimal capital structure. Specifically, there is a possibility of dividing a company's capital in debt and equity to maximize the value of the company? Both to finance in the traditional and contemporary literature, the center is the capital of the company, that is, the acquisition of assets from the firm's resources (i.e. equity) or to be financed by borrowing (ie debt). The capital structure is one of the most confusing issues in the corporate finance literature (Broun and Eichholtz, 2001). The term is generally defined as the combination of debt and equity, that the sum described make the equity of the company. The proportion of debt to equity is a strategic choice of managers in enterprises. The capital of a company is very important because it concerns in relation to the company's ability to meet the needs of its stakeholders. Modigliani and Miller (1958) were the first to the subject landmark of the capital and they argue that capital structure was irrelevant in determining the company's value and its future performance. on the other hand, Lubatkin and Chatterjee (1994) and many other studies have shown that there is a relationship between capital structure and shareholder value. In the recent literature, authors have shown that they are less interested in what impact the company's capital value. Instead, they place greater value on capital structure, including the impact influence on ownership / governance structure by top management of the company's strategic decisions (Hitt, Hoskisson, and Harrison, 1991). These decisions in turn impact on the overall performance of the firm (Jensen, 1986). Nowadays, the main issue for the capital structure is how to maximize the profit of the company. This paper is a review of literature on the various theories regarding capital structure and profitability of the company. The reason behind this argument is that is not in general the performance of a company linked to the compensation of executives of the company. Accordingly prefer managers surround themselves with all sorts of "luxury and amenities, rather than the distribution of corporate profits (payment of dividends) to its shareholders. The relationship between capital structure and profitability of major importance for all companies. Abor and Biekpe (2005) examine the determinants of capital structure of listed companies in the country. Abor (2005) examined the relationship between profitability and debt of 22 listed companies for a period of five years (1998-2002), and Amidu (2007), which examines the determinants of capital structure. Important for us is to be noted that the studies by and Abor Biekpe (2005) and Abor (2005) have shown that profitable firms depend more on the lever relative to equity, while Amidu (2007), an inverse relationship between profitability and leverage in its study found to examine the determinants of capital structure. This study has ignited the debate on corporate capital structure and profitability. Berger (1995) examines the relationship between equity and accounting return on equity from 1983 to 1989 and find an inconsistent positive causal relationship from capital to ROE due to an insolvency costs reflected in borrowing rates. Evanoff and Wall (2001) and Sironi (2001) found evidence that reflect subordinated credit spreads banking risks, but these studies are used primarily to support the role of market mechanisms in regulatory monitoring, and not the leverage / ROE relationship directly. Although much theoretical work has been done since Modigliani and Miller (1958), no consistent predictions have been achieved the relationship between profitability and leverage. Tax-models suggest that profitable firms should borrow more, ceteris paribus, because they have greater needs for income from corporate shield. However, pecking order theory suggests firms will use retained earnings first as mutual funds and then on bonds and new shares will only move if necessary. In this case, profitable companies tend to have less debt. Agency-based models also give us conflicting forecasts. On the one hand, Jensen (1986) and Williamson (1988) define debt as a discipline device to ensure that pay the manager, rather than build empires profits. For companies with free cash flow or high profitability, high debt may restrain management discretion. On the other hand, shows Chang (1999) that the optimal contract between the business culture within and outside investors as a combination of debt and equity can be interpreted, and profitable firms tend to use less debt. In contrast to theoretical studies show that most empirical studies, which have a negative leverage, effect on profitability in context. Friend and Lang (1988), and Titman and Wessels (1988) receive such evidence from U.S. firms. Kester (1986) finds that leverage negatively on the profitability in the U.S. and Japan. Recent studies with international data also confirm this observation, Rajan and Zingales (1995) and Wald (1999) for developed countries, Booth et al. (2001) for developing countries. Lange and Maltiz (1985) find leverage related positively to the profitability, but the relationship is not statistically significant. Wald (1999) claims even that the profitability of the largest effect on debt / asset ratios. In the automobile sector, the issue of capital structure has been significantly under-researched although this is not a case in the other industries. The power of the study therefore is to investigate the impact of capital structure on profitability in automobile sector Pakistan. In this paper determine the relationship between capital structure and profitability by using financial data of automobile sector from 2006-2010.
9. Purpose Statement
This research attempted to determine the impact of capital structure on profitability. Additionally, it examines how selected moderating variables (cost of debt and cost of common stock equity moderate this effect. The objective of this study will be to offer theoretical rationale and empirical assessment for a case that decision about the selection of capital structure. The purpose of this survey based study will be, to determine the impact of capital structure on profitability in automobile manufacturer sector of Pakistan and to further determine the cost of debt and cost of common stock equity. According to this purpose, the study will hold a lot of importance for the automobile manufacturer sector of Pakistan. I have used six years of financial data of four companies of automobile manufacturers sector. The financial data include debt ratio, cost of debt, cost of common stock equity and profitability ratio.
10. Significance of the study:
· This study will provide a number of significance that capital structure has major impact on profitability.
· Profitability has been affected by the different factors; this study will reveal the betterment in this situation by taking the optimal capital structure decisions.
· It will help the financial experts and advisers for the purpose of capital structure determination.
· This study will improve the strategy formation techniques by the use of optimal capital structure to decrease the cost of capital and to maximize the profit of the of the organization.
· This study will present sufficient explanation that would ultimately improve the profitability of the firm by the use of optimal capital structure.
· This work will also support the Research and Development (R&D) department to further examine the capital structure. In this way optimal capital structure would be develop in firms of Pakistan which would eventually be favorable for well economy, promotes innovation (access to technology), can be used by the producers of goods and of services alike and can help expansion into new markets where capital expenditure is required.
· Another importance of this work is that, it will be base on the quantitative research methodology and financial document study would be use for the purpose of data collection.
11. Theoretical framework:
11.1 Theoretical Stances:
a) The Miller-Modigliani theorem
In their seminal work in 1958, Nobel laureate Merton Miller and Franco Modigliani, provided the formal proof of its now-famous M & M irrelevance theorem. They show that there are arbitrage opportunities in perfect capital markets, if the value of a company depends on how it is financed. They also argue that if investors and firms can borrow at the same rate, investors can neutralize any decisions of the company's capital structure management (home-made may apply). The basic principles for the M & M's argument that the value of the company alone through the left side of the balance sheet, that is, by what is normally defined as the company's investment policy referred to. The economic substance of the company remains unchanged, whether the liabilities side of the balance sheet of the company in more or less cut debt. To increase the value of the company, it must invest in additional projects with a positive net present values. While the M & M capital structure irrelevance theorem clearly based on unrealistic assumptions, it can influence as a starting point for the factors, the company's policies seek to serve lever.
b) The trade-off theory
The trade-off theory of capital structure suggests that a company has the target leverage
Driven by three competing forces: (i) taxes, (ii) the cost of financial distress (bankruptcy costs), and (iii) agency for conflicts. Add tax debts of a company reduce its capital (corporate) tax liability and increase the after-tax cash flow available to the providers of capital. Thus, there is a positive relationship between the (corporate) tax shield and the value of the company. Bankruptcy costs when a company increases, excessive debt to finance its operations, it may default on this debt. However, it is not per se that is the problem of bankruptcy. If the loan payments are not met, when they are due and the loan is in default, the company simply transferred to the bondholders. However, there are deadweight (opportunity) costs incurred in the event of insolvency Corporate. They come in two forms, direct and indirect costs for windfall gains. Direct out-of-pocket costs for the administration of bankruptcy proceedings (legal and management time) are relatively small compared to the market values of companies. However, there are economies of scale in terms of direct costs of bankruptcy. While they seem less important for large companies, they can significantly for small businesses. Indirect costs of bankruptcy can provide for both large and small enterprises. As the company runs into financial trouble, it is obvious that the company, the investment policy changes, resulting in a reduction of fixed value. The clearest, the company can decide on short-sighted cuts in research and development, maintenance, advertising and education spending, which ultimately fixed at lower values. A hindrance bankruptcy behavior with customers. They are usually either due to fear of loss of affected services and lost confidence. In summary, it can be said, is the trade-off theory of capital structure that is an optimal debt-equity ratio. Companies are trying to tax benefits from increased leverage and the greater likelihood (and possibly higher costs balance) in financial distress.
Driven by three competing forces: (i) taxes, (ii) the cost of financial distress (bankruptcy costs), and (iii) agency for conflicts. Add tax debts of a company reduce its capital (corporate) tax liability and increase the after-tax cash flow available to the providers of capital. Thus, there is a positive relationship between the (corporate) tax shield and the value of the company. Bankruptcy costs when a company increases, excessive debt to finance its operations, it may default on this debt. However, it is not per se that is the problem of bankruptcy. If the loan payments are not met, when they are due and the loan is in default, the company simply transferred to the bondholders. However, there are deadweight (opportunity) costs incurred in the event of insolvency Corporate. They come in two forms, direct and indirect costs for windfall gains. Direct out-of-pocket costs for the administration of bankruptcy proceedings (legal and management time) are relatively small compared to the market values of companies. However, there are economies of scale in terms of direct costs of bankruptcy. While they seem less important for large companies, they can significantly for small businesses. Indirect costs of bankruptcy can provide for both large and small enterprises. As the company runs into financial trouble, it is obvious that the company, the investment policy changes, resulting in a reduction of fixed value. The clearest, the company can decide on short-sighted cuts in research and development, maintenance, advertising and education spending, which ultimately fixed at lower values. A hindrance bankruptcy behavior with customers. They are usually either due to fear of loss of affected services and lost confidence. In summary, it can be said, is the trade-off theory of capital structure that is an optimal debt-equity ratio. Companies are trying to tax benefits from increased leverage and the greater likelihood (and possibly higher costs balance) in financial distress.
c) Agency costs
Jensen and Meckling (1976) define agency costs as the sum of expenditure on monitoring by the principal, bonding costs of agency and a residual loss. In many parts of the corporate finance literature assumes that agency costs are an important determinant of corporate capital structure (see Harris and Raviv (1991)). Three forms of agency problems have received special attraction: (i move) risk (or asset substitution), (ii) the problem of under-investment and (iii) the free cash flow hypothesis. Risk Shifting or Bondholder expropriation hypothesis claims that exploit the shareholders the incentive to bondholders as soon as the debt issued. Agencies whose ultimate responsibility is to shareholders, are likely to make investments that maximize shareholder wealth rather than total firm value. Mostly because capital can be viewed as a call option to managers risky negative net present value (NPV) tend projects in which the value is reduced to a decrease in the value of the debt and accept a smaller increase to the value of equity. This is known as the over-investment problem. It is known from option pricing theory that the sensitivity is the value of an option in terms of volatility (ie, the option Vega) At the highest for-money option. This means that the shareholder-Bondholder Conflict expropriation is for the most highly financially distressed companies. Therefore, the asset substitution conflict is often classified as indirect costs of bankruptcy. Obviously, making the expropriation potential it difficult for companies to raise debt at reasonable prices. Ex-ante bond investors get their just compensation. Because they correctly anticipate future behavior letter to shareholders, they charge a premium if they could not demand the company to commit not to expropriate bondholders plausible. While the ex-ante bondholders are equal go well, shareholders face the opportunity cost of not able to issue bonds (with its other benefits, such as tax savings). This effect, also known as asset-substitution effect, is an agency cost of debt financing. Since the expected cost is included for opportunistic behavior in the price of the Notes, Jensen and Mecking (1976 postulate) that the company made this agency the cost of debt trades against the benefits of debt. The ex-ante solution to the over-investment problem is thus that the optimal capital structure is tilted towards equity. Underinvestment problem of underinvestment problem refers to the tendency of managers to ensure positive net present value projects in which the value consists of an increase in the value of the debt and a smaller decline to avoid the value of equity. Myers (1977) shows that there is a rational basis for this short-sightedness, if shareholders have not received any chance of extinction of a valuable project, if the debt due. Therefore, the company will refuse to accept ex post good investment opportunities, reducing the firm ex-ante value. Brealey and Myers (2000) argue that the problem relates to inadequate investment in theory, all companies with leverage, but it is again most pronounced for highly indebted firms in financial distress. The higher the probability of failure, the greater the bond holders gain from rising value projects. In addition, businesses whose value is composed primarily of investment opportunities or growth options, most likely to suffer from underinvestment problem. As with the asset substitution problem, the problem of under-investment capital structure tilts in the direction of justice. Mature companies with lots of good reputation, but few profitable investment opportunities whose value is mainly due to assets in-place, find it optimal to choose safer projects. In contrast, to select young company with many growth opportunities and low prestige riskier projects. If they survive without a default, they will eventually go to the safe project. Because of their lower cost of debt, so that mature companies can run higher leverage ratios than firms whose value is derived primarily from the growth opportunities. Free Cash Flow Hypothesis Easterbrook (1984) and Jensen (1986) argue that for companies, most of the assets-in-place and can produce stable operating cash flow leverage high-value add by improving financial discipline of the managers. Free cash flow is cash flow in excess of that needed for all projects that have positive net present values fund. Companies with significant free cash flow face conflicts of interest between shareholders and managers. The problem is how to motivate managers to distribute excess funds rather than investing it below the cost of capital or wasting it on organizational inefficiencies. Worse yet, the managers can invest less effort in managing firm resources, but transfer firm resources to their personal benefits, such as by consuming services, such as corporate aircraft and building "empires". Instead of investing back into the low-projects could be paid executives of companies with stable cash flows, free cash by increasing dividends or buying back stock. However, leverage is a more effective means to address the free cash-flow problem. This is because contractual payments of interest and principal are required to return a credible signal as a discretionary dividend payments or share repurchases in a little excess capital to investors. Bondholders may bring the company into bankruptcy court if managers do not keep their promise to the interest and principal payments. Accordingly, reduced debt agency costs of free cash flow for mature companies by reducing the cash flow for the expenditure at the discretion of managers. Information costs and signaling impact capital theory has yet another dimension with the explicit modeling of private information in financial theory. Two main areas have emerged in the literature on asymmetric information. In the first approach is debt as a means of confidence to the investors considered signal. In the second approach argues that the capital structure designed to mitigate the distortions in investment decisions caused by information asymmetries. i) Signaling share of debt in a number of approaches, the choice of capital structure signals to outside investors the information from insiders. Ross (1977) estimates that the managers (the insiders) know the true distribution back to the company, but investors do not. He argues that investors interpret higher levels of leverage as a signal of higher quality. The intuition behind his argument is that debt and equity differ in one important way, which is essential for signaling inside information. Debt is a contractual obligation to repay the principal and interest. Otherwise, make these payments can lead to bankruptcy and can lose their jobs as managers. In contrast, the equity is more forgiving. Although shareholders will at least maintain dividends, managers expect more discretion and they can cut in times of financial distress. Therefore, by debt in the capital structure can be interpreted as a credible signal of high future cash flows and management's confidence about their own company. Low-quality firms do not imitate higher quality firms by issuing more debt, higher costs because they are bankrupt at every level of debt. Therefore constitutes Ross (1977) that investors take greater debt, a signal of higher quality and profitability and leverage are, therefore, are positively related.
11.2 Theoretical model:
Figure 1
Common elements
Cost of debt |
profitability |
Capital Structure |
Cost of common stock Equity |
12. Objectives of the study
Main objective
To determine the relationship between capital structure and profitability in the in the automobile sector of Pakistan
Sub Objectives of the study
1) To determine the impact of capital structure on cost of debt in the automobile sector of Pakistan
2) To determine the impact of capital structure on cost of common stock equity in automobile sector of Pakistan
3) To determine the impact of cost of debt on profitability in automobile sector of Pakistan
4) To determine the impact of cost of common stock equity on profitability in the automobile sector of Pakistan
13. Research Question and Hypothesis
13.1 Research Question:
What is the impact of capital structure on profitability?
13.2 Hypotheses for the study:
H1: There is significant relationship between capital structure and profitability
H0: There is no relationship between capital structure and profitability
H2: There is significant relationship between capital structure and cost of debt
H0: There is no relationship between capital structure and cost of debt
H3: There is no relationship between capital structure and cost of common stock equity
H0: There is no relationship between capital structure and cost of common stock equity
H4: There is significant relationship between cost of debt and profitability
H0: There is no relationship between cost of debt and profitability
H5: There is significant relationship between cost of common stock equity and profitability
H0: There is no relationship between cost of common stock equity and profitability
14. Structure of the Thesis
The arrangement of the thesis consists of four chapters. In the begging I will show the Title page, acknowledgement, dedication and table of lists. The Chapter one will be about the introduction of the thesis, problem and deficiencies in the past studies would be point out and significance of the study will also be point out. Purpose statements of the study will be discuss, the Significance of the study will also be mention, the objectives of this study will be mentioned. Research question and the Hypothesis will be mentioned for the study. The theoretical framework would be mentioned including of theoretical stances and model. After the first chapter, chapter two will be discussed which about the literature review in which existing literature would be reviewed and in it I will give the introduction of the literature review , literature flow diagram will be shown , then actual literature review will be performed , and then I will give the conclusion. Then chapter three will be about the methodology in which I will give the introduction, paradigm, research approach that will be adopted, research design that will be adopted, research site will be mentioned, then population / sample would be shown, then strategy of inquiry and method will be sown. Additional I will show the validity and reliability will be tested and then analysis would be performed. In last chapter, I will show the analysis and results generated. In which I will first provide the introduction, after that discussion would be performed then through that data I will draw the conclusion. At lost overall conclusion of the thesis will be drawn.
Chapter 2:
15. Literature review:
15.1 Introduction:
This chapter is related to the literature review that show the past studies that have been done in the declared study. This will show the literature flow diagram, literature review and then I will draw the conclusion.
15.2 Literature flow Diagram:
Figure 2
General discussion |
Capital structure Cost of Debt Profitability |
Capital structure Cost of common stock Profitability |
Summary |
15.3 Literature review:
Capital structure, Cost of Debt, Profitability
The most important financial decisions facing companies is the selection between debt and equity capital. This decision can effectively and efficiently be taken when managers are first of all aware of how capital structure influences firm profitability. This is because; this awareness would enable managers to know how profitable firms make their financing decisions in particular contexts to remain competitive. In the corporate finance literature, it is believed that; this decision differs from one economy to another depending on country level characteristics. According to (Bos and Fetherston, 1993), capital structure affects both profitability and riskiness of firms. These believe has been held by earlier researchers such as Miller and Modigliani, (1963) and Titman and Wessels, (1988). As a result, numerous studies have been conducted by academic writers to determine the effect of capital structure on firm profitability. Most ofthese studies concentrated on different segments of different economies and industries but with little attention to the financial services sector. Thus, lacking significantly in the literature are studies that are purported to investigate the relationship between debt and profitability in the banking sector. According to Modigliani and miller (1958) demonstrated that, in an idealized world exclusive taxes, the value of a company does not depend on the debt equity mix. Simply put, debt policy is irrelevant to the value of the company. However, this conclusion is with what one sees in the real world, where capital matters since banks operate in an increasingly imperfect and competitive world. As a result, Modigliani and Miller (1963) reviewed their earlier proposition to include taxes and other market imperfections and contend that capital structure matters and firms can really maximize value by using more debt in their operations thus as to take benefit of tax protect benefits of leverage. The association between capital structure and company profitability is always explained corporate finance literature within the framework of ‘Pecking Order Theory’. Within this framework, firms would always favor internal sources of finance as opposed to external sources ( Myer, 1984). These authors argue that internal funding which is specifically the use of retained earnings is cheaper as a source of finance relative to external funding which is exclusively the use of debt and equity. This preference is due to the cost that is related by the information asymmetry that exist between managers and outside market participants thus making external funding expensive. Generally, investors are of the view that managers would only issue overvalued shares and the vice versa thereby raising cheap capital. Although this proposition may not always be true, investors often demand higher returns to compensate when there is a new issue thus making external funding relatively expensive (Barclay and Smith, 2005). As a result, astute managers would ignore external funding and use internal sources instead. Numerous attempts to explain the influence of debt policy on firm profitability have yielded inconclusive results. However experiential facts from some past studies appear to be dependable with the pecking order theory. Some studies found a inverse relation between leverage and profitability. Within this framework, Titman and Wessels (1988) argue that companies with high profitability levels, all things being equal, would maintain comparatively lower debt levels since they can realize such funds from internal sources. Furthermore, Cassa and Holmes (2003) found inverse relationship between debt and profitability. Furthermore, Kester found a inverse relationship between debt and profitability. Moreover Rajan and zingales (1995) also verify inverse correlation between leverage and profitability. According to Fama and French (1998), debt usage does not necessarily funding tax advantage; high leverage may rather generate agency troubles among debt holders and share hodlers that forecast inverse relation between profitability and leverage. Graham (2000) argued in his research that profitable and large companies present short debt levels. In the banking sector, Amidu (2007) devised a study to determine the determinants of capital structure of banks in Ghana and found inverse relationship between total debt and profit ability. Basically the inference of the above empirical results are that high profitable companiesuse low debt in granting their operation. Despite the above empirical works supporting the pecking order theory, some authors are of a different opinion. These authors observed positive relation between debt and profitability. For example, Petersen and Rajan (1994) found a positive relationship between debt and profitability. Furthermore, Ooi (1999) argue that high profitable companies are more smart to financial firms as loan providing scenario. The reason is that, those firms are expected to have higher tax shields and low bankruptcy cost. In a study expanded to determine the relation between leverage and profitability, Taub (1975) in a regression analysis of four profitability metrics against debt ratio found positive relationship between profitability and debt. According to Champion (1999), and Leibestein (1966), companies can use more debt to enhance their financial performance because of debts’ capability to cause managers to improve productivity to avoid bankruptcy. The point here is that, debt must be repaid while dividend payment is not obligatory and can even be postponed if the firm is financially ‘hard up’. Moreover Roden and Lewellen (1995) investigate positive relation between debt and profitability in the study developed to find the percentage of total debt in leverage buyouts. In a study designed to examine the impact of capital structure on profitability of registered companies on the Ghana stock exchange, Abor (2005) give a statement that there is negative relation between debt and profitability. There also exists a positive association between debt and profitability, the earning power of the company’s assets offsets the average interest cost of debt (Hutchinson, (1995)). Myers, in 1977 study was the first to point out that the possibility of high levels of debt relationships, leaders can help encourage positive net present value projects that refuse to end decreasing shareholder value. The presence of "risky" debt that a lower market value than the nominal shows, has a particularly negative impact on firms' investment decisions. Myers' (1977) analysis based on the concept that business is value from assets in place and growth opportunities (on future ability to make investments profitable basis) are based. Growth opportunities for options whose present value is the result of not only the expected cash flow in comparison, but also the probability that the company actually uses it. In other words, the value depends on growth opportunities in investment in the manager's (decision makers) discretion, who is in power to exercise these options. is the way that assets are funded in the place, and thus the way the company's capital structure, the ability to create impact and benefits of growth opportunities, as set in this way, pressure on the quality of the company decision making. Myers (1977) shows that follow, if risky debt managers who act in the interests tend to a biased decision-making process that profitable investments, the positive net value of the company's value could lead to reject offer. In other words, the shareholders of companies that risky debt is not prepared to finance projects, thus taking on the costs that would benefit all or most of the company debt holders, in which case the present value of the project, while positive, would the the market value of debt to rise to the corresponding target value, without having other benefits for shareholders. In fact, risky debt would be considered a "tax" on profits from the new plants come as most of the value created would act only serve to enable the holders of Notes, their loans (Stein 2001 to recover). In such a situation, the investment would be only if the NPV is positive and higher than the face value of debt (Myers 1977, Bekovitch and Kim in 1990). In fact, managers tend, in general to investments with a present value provide a residual payout to shareholders to choose, while also positive and therefore cover the debt value. The presence of risky debt creates ex post potential situations in which management serve the interests of the shareholders only by sub-optimal decisions for all stakeholders (Myers 1977). This would mean companies that debt is not able, positive net present value investment projects to be financed, so losing opportunities for growth, and in the long term value. Lack of investment in risky projects, incentives for risk avoidance Brito and John (2002) show how the presence of risky debt do not create more shift risk, but that may in some situations, situations of risk avoidance (lack of investment to generate in risky projects) who are opposed to the former. Incentives for risk selection shift have been traditionally analyzed (Jensen and Meckling 1976) with theoretical models on finite time (period 0 and 1) is based, without regard to the company as a company in constant development and therefore cannot come in the light of the presence of growth opportunities, up in the future, which are a fundamental component of the company's value. Based on these considerations, Brito and John (2002) to re-examine incentives to shift risk in a model in which during the final phase of the company still shows growth opportunities that have not yet been realized, and show how such a strong influence on agency costs are determined by risky debt. In fact, these growth opportunities eliminate the underinvestment problem of Myers (1977) and reduce the problem of risk shifting, sometimes described by transformation in opposite situations of risk avoidance. Although risk shifting problems seem to be particularly relevant, they can be observed in the economic reality is that often these kind of indebted companies a conservative and prudent investment policy, where they try to focus on its core business through the sale of assets and extra reduced, instead of the concentration adopted increasing the company's risk (Brito and John 2002). While incentives for risk shifting generated from the shareholders the awareness that, in each case by the principle of limited liability (protected by put options on corporate activity are), risk avoidance attitudes by the fear that growth opportunities can be lost are produced, if the company were offered for sale. The impact of risky debt on firm decision-making depends on whether or not there are future opportunities for investment value; excessively risky investment policy was to the company the ability damage, at least until the time when seize growth opportunities to survive are taken. Can take advantage of growth opportunities such course only if they manage to keep control of the company, so you keep from bankruptcy, in fact, would make torture and eventual bankruptcy give debt holders fixed property. The entrepreneur is thus obliged to save the company future ability to obtain the necessary financial resources to take in order to benefit from growth opportunities. The main conclusion of Brito and John (2002) is that the presence of growth opportunities, which has not yet claimed a remarkable impact on the cost of the Agency for risky debt: Firms with low growth prospects that in mature industries and work with high leverage can be stimulated to shift into risky projects (risk), while the opposite is overinvest companies with good economic prospects of investing and avoid having excessively risky investments (risk avoidance) is stimulated. Incentives for risk avoidance, that usually are the result of information asymmetries, so that we understand why the company adopted with high debt and risky growth opportunities not yet exploited rather conservative investment policy. On the other side, where companies are affected with low debt, high liquidity, but little prospect for growth opportunities, particularly in the case of mature companies, managers could have a negative net present value of companies' investment projects from purely opportunistic reasons (empire building). The origins of managerial overinvestment can in the way the power of decision is that the management found that it can exercise in investments for its own benefit. In this case, as noted by Jensen (1986) and Stulz (1990), an increase of leverage disciplines administration's conduct, indeed obliged, the presence of debt managers always be able to pay the interest and meet deadlines and increases their commitment to more efficient management. Obviously, with an increase in the debt of a company, holders of debt securities (such as creditors) indicate a key role in the management structure of the company that the debt-holder, the upper hand in the decision making process adopted company on the strategies and be. However, this may not share a conflict between shareholders and holders of Notes, they carry the same ideas. Debt-holder will ensure that the company makes enough profit to be able to pay its debts. On the contrary, the shareholders are more interested that they get back. However, if the profit of the company has just enough to cover his debts is, there will be no excess cash flow will be left out as dividends paid, because the holders of the debt have priority over shareholders. It can be argued that, if debt-holders exert too much pressure on the management of the company, this may lead to a decline in performance since the debt holders would prefer that the company is to invest in less risky projects to repay debts and to prevent lead the company to invest in projects, the long-term profitability
and with a higher risk. Although much theoretical work has been done since Modigliani and Miller (1958), no consistent predictions have been achieved the relationship between profitability and leverage. Tax-models suggest that profitable firms should borrow more, ceteris paribus, because they have greater needs for income from corporate shield. However, pecking order theory suggests firms will use retained earnings first as mutual funds and then on bonds and new shares will only move if necessary. In this case, profitable companies tend to have less debt. Agency-based models also give us conflicting forecasts. On the one hand, Jensen (1986) and Williamson (1988) define debt as a discipline device to ensure that pay the manager, rather than build empires profits. For companies with free cash flow or high profitability, high debt may restrain management discretion. On the other hand, shows Chang (1999) that the optimal contract between the business culture within and outside investors as a combination of debt and equity can be interpreted, and profitable firms tend to use less debt. In contrast to theoretical studies show that most empirical studies, which have a negative leverage effect on profitability in context. Friend and Lang (1988), and Titman and Wessels (1988) receive such evidence from U.S. firms. Kester (1986) finds that leverage negatively on the profitability in the U.S. and Japan. Recent studies with international data also confirm this observation, Rajan and Zingales (1995) and Wald (1999) for developed countries, Booth et al. (2001) for developing countries. Lange and Maltiz (1985) find leverage related positively to the profitability, but the relationship is not statistically significant. Wald (1999) claims even that the profitability of the largest effect on debt / asset ratios. In this study, the profitability is defined as earnings before interest and taxes (EBIT) scaled by total assets. The cost of debt, financial distress (Scott,
1976), personal taxes (Miller, 1977), debt overhang (Myers, 1977) and the Agency for conflicts between managers and investors or between different groups of investors. For the most part, these theoretical predictions were tested using reduced form regressions that attempt to fluctuations in the capital structure policy of the basis of the estimated coefficients for the slope factors as company size, tax status, asset tangibility, to explain the profitability and growth options ( Rajan and Zingales, 1995, Frank and Goyal, 2009; Graham, Lemmon and Sound Home, 1998). We appreciate what must be the (perceived) marginal cost of debt it be to streamline the typical company's capital structure decisions.
and with a higher risk. Although much theoretical work has been done since Modigliani and Miller (1958), no consistent predictions have been achieved the relationship between profitability and leverage. Tax-models suggest that profitable firms should borrow more, ceteris paribus, because they have greater needs for income from corporate shield. However, pecking order theory suggests firms will use retained earnings first as mutual funds and then on bonds and new shares will only move if necessary. In this case, profitable companies tend to have less debt. Agency-based models also give us conflicting forecasts. On the one hand, Jensen (1986) and Williamson (1988) define debt as a discipline device to ensure that pay the manager, rather than build empires profits. For companies with free cash flow or high profitability, high debt may restrain management discretion. On the other hand, shows Chang (1999) that the optimal contract between the business culture within and outside investors as a combination of debt and equity can be interpreted, and profitable firms tend to use less debt. In contrast to theoretical studies show that most empirical studies, which have a negative leverage effect on profitability in context. Friend and Lang (1988), and Titman and Wessels (1988) receive such evidence from U.S. firms. Kester (1986) finds that leverage negatively on the profitability in the U.S. and Japan. Recent studies with international data also confirm this observation, Rajan and Zingales (1995) and Wald (1999) for developed countries, Booth et al. (2001) for developing countries. Lange and Maltiz (1985) find leverage related positively to the profitability, but the relationship is not statistically significant. Wald (1999) claims even that the profitability of the largest effect on debt / asset ratios. In this study, the profitability is defined as earnings before interest and taxes (EBIT) scaled by total assets. The cost of debt, financial distress (Scott,
1976), personal taxes (Miller, 1977), debt overhang (Myers, 1977) and the Agency for conflicts between managers and investors or between different groups of investors. For the most part, these theoretical predictions were tested using reduced form regressions that attempt to fluctuations in the capital structure policy of the basis of the estimated coefficients for the slope factors as company size, tax status, asset tangibility, to explain the profitability and growth options ( Rajan and Zingales, 1995, Frank and Goyal, 2009; Graham, Lemmon and Sound Home, 1998). We appreciate what must be the (perceived) marginal cost of debt it be to streamline the typical company's capital structure decisions.
Capital structure cost of common stock equity, profitability
It is suggested by the agency theory (Jensen et al 1976, Jensen 1986) the constitution of leverage and ownership in the capital statuses can be used to lower or even minimize total costs of agency. Two types of disagreement are proposed by them and they are between managers and shareholders and between debt holders and shareholders. Through that it is in stated to be expected that some correlation between leverage and structure of ownership 9 this would include ownership concerning the managerial position ) and correlated positively from the point of view of shareholdings of managerial level which is further supported by the Berger et al (1997) and puts positive correlation as assured. If we look at the other side , friend and Lang (1988) were with other opinion Experimental studies are with mixed results that can be explained further as the structure of ownership is believed to influenced with capital structure but still no proper relationship is predicted between leverage and ownership structure (Jensen 1986) has further shown the disagreement between the manager and the interests of the shareholders , agent of individual nature and have given a suggestion that debt so consider to be like a remedy that would be against the costs of agency. Debt would ultimately has to be repaid and would enforce the company to go for excessive cash flow and that would ultimately lower the flow of cash at the manager’s judgment and would be subject to dangers associated with no optimal investment. (sltuz 1990) has indentified that the leverage can be increased by the shareholders when there are personal objectives of the manager . further the cash flow hypotheses are investigated through numerous studies. One sprain concerning experimental work analyze the problem concerning over investment and conducting further analysis of relationship between opportunities associated with growth and cash flow of free nature in one dimension and on the other dimension is leverage. Findings reflect the negative relationship between Opportunities concerning growth and debt ( Smith et all 1992) ,( Lang et al 1996) and further the leverage changes are assured with the changes in the flow of cash of positive nature. (crutchely et al 1996).
Another appear is concerning the hypothesis associated with flow of cash in structural policy of corporate capital which is concerning the study of specific an events that are of capital structure and projected that firms act according to theory of cash flow (Denis, 1993), (Blanchard et al 1994) ,( Jensen et al 1976) had an argue that equity associated with the managerial levels ownership would ultimately lower the managerial incentives to engage in behavior of no optimal nature. The way ownership of managerial level increases then it’s the manager that would be more affected with the behavior of divergent type. That would lead to substitution opportunities for leverage pressure and ownership of managerial level. Further numerous studies have shown inverse association between common stock equity and debt. (Friend et al, 1988), Jensen, (1920, Chen et al ( 1999), Shleifer et al ( 1986) and (pound 1988) have suggested that the investors of institutional nature serve as an mechanism of alternative type to overcome the problems associated with the overinvestment. Investors of institutional nature are with greater expertise in interpretations and gathering of information concerning the firms. So that shows leverage and ownership of institutional nature both have substitution contribution towards controlling self inertest of managerial nature and if imposition of managerial preferences is encourage by the investor of institutional nature through their process of governance. Evidence does exist and suggest that there is negative relation between leverage and equity.
15.4 Summary:
To add to the above, scholarly publications by some celebrated researchers have also supported the idea that there is positive relationship between profitability and company (Nerlove, 1968 and Baker, 1973). Most studies revealed a significant positive association between debt and firm profitability while many also found negative relations. This inconclusive result is prevalent because of lack of a universal theory that explains the debt equity choice. However, one remarkable observation is that all the theories of capital structure have directly or indirectly indicated the influence of debt on firm profitability. The conclusion drawn from these empirical works suggests that large companies use more debt relative to equity in funding their operations. From the previous discussions based on the available empirical literature, it is clear that results from investigations into the relation between profitability and capital structure are uncertain, and requires more work.
Chapter 3:
16. Methodology:
This chapter introduces the methodology adopted in this thesis. This chapter consists on research paradigm, research approach, research design, design processes of research, research site, population and the sample selected. Strategies of inquiry, method of data collection, validity and reliability measures would also be conducted.
16.1Research paradigm:
The research paradigm that is adopted is positivism because positivist assumes that true knowledge is based on experience of senses and can be obtained by observation and experiment.
16.2 Research approach
The important thing in the selection of approach is the nature of research problem. So I have decided to choose deductive or quantitative research approach. The reason to select this research approach is that it is the collecting of numerical data and analysis of data that would be require testing and verifying the theory.
16.3 Research design
The research approach that is adopted to conduct this thesis is experimental research design which is a further extension of the Quantitative research method. This particular approach is adopted as it would actually measure the Dependency of the dependent variable on the independent variable concerned. So it is the independent variable that impacts on the dependent variable.
16.4 Research Site
Automobile sector of Pakistan is in concern and that is the targeted research site in concern. So the data would be collected from the automobile sector of Lahore which is the hub of automobile sector of Pakistan.
16.5 Population and sample
The targeted sample is from automobile sector of Pakistan. Population that is target of this research is from finance division of Automobile sector and is concerned with the executives appointed in the organizations in the concerning organizations of automobile sector of Pakistan.
16.6 Strategy of inquiry
The strategy of inquiry is concerned with the Structural Equation Models (SEM) as it is concerned with both testing of theory and development of a theory as well. Furthermore this strategy of inquiry is also suitable for understand of the researcher concerning the construct and measurement of consistency nature of the construct.
16.7 Method
This section explains how each of the variables investigated in this research were measured. .The data from the financial statements and annual reports have been used that were retrieved from the Lahore Stock Exchange. I have used 6 years of financial data of four companies of automobile manufacturers sector. The financial data include debt ratio, cost of debt, cost of common stock equity and profitability ratio.
16.8 Validity and reliability:
16.9 Validity:
For the purpose of validity checks I would consult the Sohail Nisar chief finance officer of the Millet equipment limited Lahore. Moreover validity would also be ensuring by the consultation of the budgeting and costing manager of MTL, Mian Faisal Haroon. Moreover the validity would be guarantee by the SPSS (Statistical Package for Social Sciences).
16.10 Reliability:
For the reliability assurity I would make a comparison between the actual data existing in the financial statements and the annual reports and the outcomes of the data generated using SPSS software. Further reliability checks would be made by adopting concerned reliability type that is Test-retest reliability as it would be adopted. It checks that what would be the similarity in the results if the research is to be repeated in the same conditions.
14.11 Analysis Procedure
The data analysis is made with the help of all the declared method . The data collected through financial reports of selected firms. After the collection of data SPSS software is used for the purpose of data analysis.
16.12 Summary:
This chapter consist of overall methodology which allocate the data analysis to be conducted and how it would further generate the output. The elements of the chapter are research paradigm, research approach, research site, population and sample, strategy of inquiry, Method, validity and reliability and analysis Procedure.
Chapter 4:
17. Analysis and Results
17.1 Introduction
The analysis of the data would be done with the help of all the mentioned techniques appropriate for the said purpose. This chapter reports the findings of the research The financial statement which is made up of income statements and balance sheets of the sampled automobile firms were the main sources of data for this study. Further, scholarly articles from academic journals, relevant textbooks on the subject and the internet search engines were also used. Specifically, the financial statements of automobile companies in the sample were collected for period 2006-2010 and a balanced panel of four companies emerged for the study. The summary of variables is shown in table 1 below.
Table 1. Variables used in the Study
Category | Variables | Measurement or Ratios used |
Dependent Variable | Profitability | Net profit/ Sale * 100 |
Independent Variables | Capital structure Cost of Debt Cost of Common stock | Total debt/Total Assets * 100 Prevailing Interest rate Dividend paid/ Share capital |
The data generated through the documented study would be further analyzed with the help of SPSS (Statistical Package for Social Sciences).
17.2 Analysis and Results
Table 2. Code Name for Companies
Code | Company |
A | Atlas Honda |
B | Hino Pak Motors |
C | Suzuki Motor company |
D | Al-Ghazi Tractors |
a) Time series analysis
Table 3. Profitability Ratio Of the four companies from 2005-2010
2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |
A | 4.2% | 3.9% | 3.3% | 3.4% | 1.6% | 2.8% |
B | 6.08% | 3.82% | 5.07% | 7.54% | 0.58% | -1.33% |
C | 5.7% | 6.3% | 7% | 5.5% | 1.6% | 1% |
D | 11.16% | 1.6% | 1.4% | 1.37% | 1.36% | 1.39% |
Interpretation of profitability ratio:
It is clear that the above table 3 shows the profitability ratio of the different companies A, B, C, D in different years.
Profitability ratio of company A in 2005 is 4.2% which is the highest in six year and then next four years it slowly decrease which are 3.9%, 3.3%, 3.4%, and 1.6% respectively. And in 2010 it improves which is 2.8%.
Profitability ratio of company B in 2005 is 6.08% and in 2006 it too much decrease which is 3.82% d ratio of 2008 is 7.54% which is the highest in six year and in 2010 company bear the loss which is 1.33%.
Profitability ratio of the company C in first four year is stable but in last two year it too much decline which are 1.6% and 1% respectively.
Profitability ratio of the company D in 2006 is 11.6% which is the highest ratio among other years then next five years it rapidly decrease which are 1.6%, 1.4%, 1.37%, 1.36% and 1.39% respectively.
Table 4. Debt Ratio Of the four companies from 2005-2010
2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |
A | 64.7% | 64.9% | 62.5% | 59.6% | 55% | 54.3% |
B | 61.2% | 53.8% | 58.3% | 55.7% | 61.1% | 69.1% |
C | 59% | 58% | 52% | 34% | 17% | 19% |
D | 34% | 51.2% | 37.4% | 57.6% | 51.2% | 43.68% |
Interpretation of Debt Ratio
The above table 4 shows the debt ratio of different companies A, B, C, D of different years.
Debt ratio of Company A in 2005 to 2010 is 64.7%, 64.9%, 62.5%, 59.6%, 55% and 54.3% respectively. These values tell a mixed trend of increasing and decreasing that ultimately in 2010 shows a decrease from previous years.
Debt ratio of Company B 2005 to 2010 is 61.2%, 53.8%, 58.3%, 55.7%, 61.1% and 69.1% accordingly. A decrease in 2006 with an increase in 2007 following again decrease and increase lastly shows a greater increase of 7%.
Debt ratio of Company C 2005 to 2010 is 59%, 58%, 52%, 34%, 17% and 19% respectively. These figures show us a decreasing trend from 2006 to 2009 then a slight increase of 2%.
Debt ratio of Company D 2005 to 2010 is 34%, 51.2%, 37.4%, 57.6%, 51.2% and 43.68%. This company has a dramatic increasing and decreasing trend. In 2006 it increase, in 2007 it decrease, again increase in 2008 following a slighter decrease till 2010.
b) Cross sectional analysis
Ratios In 2005
Ratios | A | B | C | D | Average |
Profitability | 4.2% | 6.08% | 5.7% | 11.16% | 6.79% |
Debt | 64.7% | 61.2% | 59% | 34% | 54.73% |
Profitability Ratio in 2005 shows the Average of 4 companies at 6.79% which also shows that company C has the higher profitability ratio comparing with average one.
Debt Ratio in 2005 of 4 companies show an average of 54.73% where company A and B has the higher debt ratios than the average, that reveals a negative sign for both companies.
Ratios In 2006
Ratios | A | B | C | D | Average |
Profitability | 3.9% | 3.82% | 6.3% | 1.6% | 3.91% |
Debt | 64.90% | 53.8% | 58% | 51.2% | 56.98% |
Profitability Ratio in 2006 of 4 companies is 3.91% averagely, where company C has the higher and positive ratio. From these companies D has the least low profitability ratio.
Debt ratio in 2006 of 4 companies averagely shows 56.98%, hence company A and C has the higher ratio by telling a limited scope of their growth.
Ratios In 2007
Ratios | A | B | C | D | Average |
Profitability | 3.30% | 5.07% | 7% | 1.4% | 4.19% |
Debt | 62.5% | 58.3% | 52% | 37.4% | 52.55% |
Profitability ratio in 2007 has an average rate of 4.19% of four companies. Company C and B are the industry leaders because they have grater ratio than average.
In 2007 Debt ratio, table shows an average of 52.55% of four companies. Company A and B have high debt ratio.
Ratios In 2008
Ratios | A | B | C | D | Average |
Profitability | 3.4% | 7.54% | 5.5% | 1.37% | 4.45% |
Debt | 59.6% | 55.7% | 34% | 57.6% | 51.73% |
Profitability ratio in 2008 has an average ratio of 4.45% of industry. By comparing company B and C have optimal profitability ratios that can hold a long industry share.
Debt ratio in 2008 with an average of 51.73% showing that company C has good debt ratio.
Ratios In 2009
Ratios | A | B | C | D | Average |
Profitability | 1.60% | 0.58% | 1.6% | 1.36% | 1.29% |
Debt | 55% | 61.1% | 17% | 51.2% | 46.08% |
In 2009 profitability ratio of industry has an average of 1.29%, from these companies B is the one who failed to meet the average profitability ratio while company C has dimensional ratio of profitability.
Debt ratio of four companies in 2009 averagely is 46.08%. Company C has the good ratio to maintain its debt and to attract the investors.
Ratios In 2010
Ratios | A | B | C | D | Average |
Profitability | 2.8% | -1.33% | 1% | 1.39% | 0.97% |
Debt | 54.30% | 69.1% | 19% | 43.68% | 46.52% |
Profitability ratio in 2010 of four companies has an average of 0.97%. Higher ratio is of company A and lower ratio is of company B.
Debt ratio of four companies in 2010 has an average of 46.52% where company B has greater ratio and Company C has the least low ratio.
Capital Structure and cost of debt at Average of Four Companies
In 2005
A | B | C | D | Average | |
Cost of Debt | 11% | 11% | 11% | 11% | 11% |
Cost of Capital | 0% | 0% | 0% | 200% | 50% |
In 2006
A | B | C | D | Average | |
Cost of Debt | 11% | 11% | 11% | 11% | 11% |
Cost of Capital | 0% | 0% | 50% | 300% | 87.50% |
In 2007
A | B | C | D | Average | |
Cost of Debt | 12% | 12% | 12% | 12% | 12% |
Cost of Capital | 0% | 0% | 0% | 300% | 75% |
In 2008
A | B | C | D | Average | |
Cost of Debt | 14% | 14% | 14% | 14% | 14% |
Cost of Capital | 65% | 0% | 50% | 350% | 116.25% |
In 2009
A | B | C | D | Average | |
Cost of Debt | 14% | 14% | 14% | 14% | 14% |
Cost of Capital | 64.7% | 23.9% | 10% | 350% | 112.15% |
In 2010
A | B | C | D | Average | |
Cost of Debt | 11% | 11% | 11% | 11% | 11% |
Cost of Capital | 26% | 17.5% | 5% | 350% | 99.63% |
Table 5. Average values of financial indicators for automobile sector, 2005-2010
Variables | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 |
Profitability Ratio | 6.79% | 3.91% | 4.19% | 4.45% | 1.29% | 0.97% |
Debt Ratio | 54.73% | 56.98% | 52.55% | 51.73% | 46.08% | 46.52% |
Cost of Debt | 11% | 11% | 12% | 14% | 14% | 11% |
Cost of common stock equity | 50% | 87.50% | 75% | 116.25% | 112.15% | 99.63% |
· Overall if we look at the table Profitability Ratio in 2006 decreased then there was a slight increase for till 2008 then a dramatic decrease in 2009 leads till 2010 and end at 0.97%
· The Debt Ratio on average industry basis increase in 2006 with decrease in 2007 to 2009, then a little increase in 2010 and diminish at 46.52%.
· Comparatively Cost of Debt in year 2005 and 2006 is looking constant then 1% increase in 2007. Again in 2008 there is an increase of 2% till 2009 and following a decrease in 2010. The final figure on average is 11%.
· Somehow if we look at the Cost of Capital it shows us a different trend. Like in 2006 it increase, in 2007 it decrease, in 2008 it again increase and in 2009 it again increase leading a decrease in 2010.
Descriptive statistics
Descriptive analysis used to describe the data by using descriptive summary which is as follow:
Descriptive statistics | |||||
N | Minimum | Maximum | Mean | Std. Deviation | |
capital structure | 6 | 46 | 57 | 51.43 | 4.376 |
cost of debt | 6 | 11 | 14 | 12.17 | 1.472 |
cost of common stock equity | 6 | 50 | 116 | 90.09 | 24.914 |
profitability | 6 | 1 | 7 | 3.60 | 2.172 |
Valid N (listwise) | 6 | ||||
Where:
· Profitability = Net Profit/sale * 100
· Capital structure =Total Liability/total assets * 100
· Cost of debt = Prevailing interest rate
· Cost of common stock Equity = Dividend/share capital * 100
The above table presents the descriptive statistics that show the overall picture of all the three independent and one is dependent variable. The data has been taken of 6 years for all the variables since 2005 to 2010. In the above table the mean values and the values of standard deviation of all the 4 variables have been shown. Mean value provides the idea about the central tendency of the values of a variable. For example if we observe the above output to assess the average response rate or the respondent then we come to know the mean of different variables like capital structure (51.43), cost of debt (12.17), cost of common stock equity (90.09), profitability(3.60). Standard deviation gives the idea about the dispersion of the values of a variable from its mean value. So, if we observe then in the response rate for the variable cost of debt value of standard deviation is (1.472) which is the lowest value as compare to other variables value but if we observe the value of cost of common stock equity is (24.914) which is quite high as compare to other two independent variables which clearly shows that the response regarding profitability of other variables were not the same. Since the different units of measure have been applied for different variables, but the dispersion of a variable using standard deviation is not enough because standard deviation can’t be compared to that of other variable unless both the variables have the same unit of measure. These statistics are helpful to have an idea about the central tendency and the dispersion of a variable in absolute terms rather than relative terms.
Correlations
This is the correlation, which shows the relationship between variables named in above table of correlation. The independent variables are (Capital Structure, cost of debt and cost of common stock equity) and the depended variable is Profitability.
SPSSS software is used for checking the results of variables relationship.
Scatter Plot between capital structure and profitability
Difference is of: 0.164
I would apply Spearman’s correlation
Spearman’s correlation between capital structure and profitability
Correlations | ||||
profitability | capital structure | |||
Spearman's rho | profitability | Correlation Coefficient | 1.000 | .543 |
Sig. (2-tailed) | . | .266 | ||
N | 6 | 6 | ||
capital structure | Correlation Coefficient | .543 | 1.000 | |
Sig. (2-tailed) | .266 | . | ||
N | 6 | 6 | ||
Interpretation
To find the relationship between capital structure and profitability spearman’s correlation has been applied as shown in the above table. We selected spearman correlation instead of Pearson’s correlation because the relationship between the said two variables is monotonic but non-liner as shown by scatter plot:
The value of the correlation coefficient ( r ) is 0.543 at the significance level of 0.226 which provides the evidence in the favor of null hypothesis, which states:
H0= There is no correlation between capital structure and profitability.
H1= There is significant correlation between capital structure and profitability.
Since the significance level of correlation coefficient (0.226 is greater than 0.05) so we would accept H0 and we would conclude that there is no correlation.
The value of correlation coefficient (r) is equal to 0.543 is greater than 0.30 so the correlation between two variable is moderate.
Scatter Plot between profitability and cost of debt
Difference is of: 0.015
I would apply Pearson’s correlation
Pearson’s correlation between profitability and cost of debt
Correlations | |||
profitability | cost of debt | ||
profitability | Pearson Correlation | 1 | -.237 |
Sig. (2-tailed) | .651 | ||
N | 6 | 6 | |
cost of debt | Pearson Correlation | -.237 | 1 |
Sig. (2-tailed) | .651 | ||
N | 6 | 6 | |
Interpretation
To find the relationship between profitability and cost of debt Pearson correlation has been applied as shown in the above table. We selected Pearson correlation instead of spearman’s correlation because the relationship between the said two variables is liner as shown by scatter plot:
The value of the correlation coefficient (r) is 0.237 at the significance level of 0.651 which provides the evidence in the favor of null hypothesis which states:
H0= There is no correlation between profitability and cost of debt
H1= There is significant correlation between profitability and cost of debt
Since the significance level of correlation coefficient (0.651 is greater than 0.05) so we would accept H0 and we would conclude that there is no correlation.
The value of correlation coefficient (r) is equal to 0.237 is greater than 0.00 and less than 0.30 so the correlation between two variable is weak.
Scatter Plot between profitability and cost of common stock equity
Difference is of: 0.15
I would apply Spearman’s correlation
Spearman’s correlation between profitability cost of common stock equity
Correlations | ||||
profitability | cost of common stock equity | |||
Spearman's rho | profitability | Correlation Coefficient | 1.000 | -.371 |
Sig. (2-tailed) | . | .468 | ||
N | 6 | 6 | ||
cost of common stock equity | Correlation Coefficient | -.371 | 1.000 | |
Sig. (2-tailed) | .468 | . | ||
N | 6 | 6 | ||
Interpretation
To find the relationship between profitability and cost of common stock equity spearman’s correlation has been applied as shown in the above table. We selected spearman correlation instead of Pearson’s correlation because the relationship between the said two variables is monotonic but non-liner as shown by scatter plot:
The value of the correlation coefficient (r) is 0.371 at the significance level of 0.468 which provides the evidence in the favor hypothesis which states:
H0= There is no correlation between profitability and cost of common stock equity
H1= There is significant correlation between profitability and cost of common stock equity
Since the significance level of correlation coefficient (0.468 is greater than 0.05) so we would accept H0 and we would conclude that there is no correlation.
The value of correlation coefficient (r) is equal to 0.371 is greater than 0.30 and less than 0.70 so the correlation between two variable is moderate.
Scatter Plot between capital structure and cost of debt
Difference is of: 0.01
I would apply Pearson’s correlation
Pearson’s correlation between capital structure and cost of debt
Correlations | |||
capital structure | cost of debt | ||
capital structure | Pearson Correlation | 1 | -.436 |
Sig. (2-tailed) | .388 | ||
N | 6 | 6 | |
cost of debt | Pearson Correlation | -.436 | 1 |
Sig. (2-tailed) | .388 | ||
N | 6 | 6 | |
Interpretation
To find the relationship between capital structure and cost of debt Pearson’s correlation has been applied as shown in the above table. We selected Pearson correlation instead of spearman’s correlation because the relationship between the said two variables is liner as shown by scatter plot:
The value of the correlation coefficient (r) is 0.436 at the significance level of 0.388 which provides the evidence in the favor of null hypothesis, which states:
H0= There is no correlation between capital structure and cost of debt.
H1= There is significant correlation between capital structure cost of debt.
Since the significance level of correlation coefficient (0.388 is greater than 0.05) so we would accept H0 and we would conclude that there is no correlation.
The value of correlation coefficient (r) is equal to 0.436 is greater than 0.30 so the correlation between two variable is moderate.
Scatter Plot between capital structure and cost of common stock equity
Difference is of: 0.012
I would apply pearson’s correlation
Pearson’s correlation between capital structure and cost of common stock equity
Correlations | |||
Capital structure | Cost of common stock equity | ||
Capital structure | Pearson Correlation | 1 | -.588 |
Sig. (2-tailed) | .220 | ||
N | 6 | 6 | |
Cost of common stock equity | Pearson Correlation | -.588 | 1 |
Sig. (2-tailed) | .220 | ||
N | 6 | 6 | |
Interpretation
To find the relationship between capital structure and cost of common stock equity Pearson’s correlation has been applied as shown in the above table. We selected Pearson correlation instead of spearman’s correlation because the relationship between the said two variables is liner as shown by scatter plot:
The value of the correlation coefficient (r) is 0.588 at the significance level of 0.220 which provides the evidence in the favor of null hypotheses which states:
H0= There is no correlation between capital structure and cost of common stock equity
H1= There is significant correlation between capital structure and cost of common stock equity.
Since the significance level ofcorrelation coefficient (0.220 is greater than 0.05) so we would accept H0 and we would conclude that there is no correlation.
The value of correlation coefficient (r) is equal to 0.588 is greater than 0.30 so the correlation between two variable is moderate.
Scatter Plot between cost of debt and cost of common stock equity
Difference is of : 0.216
I would apply Spearman’s correlation
Spearman’s correlation between cost of debt and cost of common stock equity
Correlations | ||||
Cost of debt | cost of common stock equity | |||
Spearman's rho | Cost of debt | Correlation Coefficient | 1.000 | .679 |
Sig. (2-tailed) | . | .138 | ||
N | 6 | 6 | ||
Cost of common stock equity | Correlation Coefficient | .679 | 1.000 | |
Sig. (2-tailed) | .138 | . | ||
N | 6 | 6 | ||
Interpretation
To find the relationship between cost of debt and cost of common stock equity spearman’s correlation has been applied as shown in the above table. We selected spearman correlation instead of Pearson’s correlation because the relationship between the said two variables is monotonic but non-liner as shown by scatter plot:
The value of the correlation coefficient (r) is 0.679 at the significance level of 0.138 which provides the evidence in the favor of null hypothesis which states:
H0= There is no correlation between cost of debt and cost of common stock equity
H1= There is significant correlation between cost of debt and cost of common stock equity
Since the significance level of correlation coefficient (0.138 is greater than 0.05) so we would accept H0 and we would conclude that there is no correlation..
The value of correlation coefficient (r) is equal to 0.679 is greater than 0.30 so the correlation between two variable is moderate.
Regression
Model Summary | ||||
Model | R | R Square | Adjusted R Square | Std. Error of the Estimate |
1 | .942a | .887 | .718 | 1.154 |
a. Predictors: (Constant), cost of common stock equity, capital structure , cost of debt | ||||
The value of adjusted R2 is equal to 0.718 which shows that 71.8% variations in profitability are explained by the variation of the three independence variables.
Coefficientsa | ||||||
Model | Unstandardized coefficients | Standardized Coefficicients | t | Sig. | ||
B | Std. Error | Beta | ||||
1 | (Constant) | -16.278 | 10.107 | -1.611 | .249 | |
capital structure | .306 | .146 | .617 | 2.101 | .170 | |
cost of debt | .812 | .496 | .550 | 1.638 | .243 | |
cost of common stock equity | -.064 | .033 | -.733 | -1.961 | .189 | |
a. Dependent Variable: profitability | ||||||
The coefficient table presents the results of the regression analysis. The objective of the regression in this study is to find such an equation that could be used to find the impact of capital structure, cost of debt and cost of common stock equity on profitability. The specified regression equation takes the following form:
Regression Equation
P = C+B1(CS)+B2(CD)+B3(CMSE)
P = 16.278+.306(CS)+.812(CD)+.64(CMSE)
P = 16.278+.306+.812+0.64
P = 18.036
The above regression equation shows that how the profitability depends on capital structure, cost of debt and cost of common stock equity. The value of constant is 16.278 which is a part of profitability which does not receive from the independent variables.
The slope coefficient of capital structure is 0.306 which shows that an increase of one unit in capital structure would bring an increase of .306 units in profitability. The value of corresponding T ratio is equal to 2.101 at the significance level .170 which gives an evidence in the favor of null hypothesis which state
H0: There is no effect of capital structure on profitability
H1: There is significant effect of capital structure on profitability
From the acceptance of null hypothesis shows that capital structure does not affect the profitability.
The slope coefficient of cost of debt is 0.812 which shows that an increase of one unit in cost of debt would bring an increase of .496 units in profitability.
The value of corresponding T ratio is equal to 1.638 at the significance level .243 which gives an evidence in the favor of null hypothesis which state
H0: There is no effect of Cost of Debt on Profitability
H1: There is significant effect of Cost of Debt on Profitability
From the acceptance of null hypothesis shows that cost of debt does not affect the profitability.
The slope coefficient of cost of common stock equity is 0.64 which shows that an increase of one unit in cost of common stock equity would bring an increase of .33 units in profitability.
The value of corresponding T ratio is equal to 1.961 at the significance level .189 which gives an evidence in the favor of null hypothesis which state
H0: There is no effect of Cost of Common Stock Equity on Profitability
H1: There is significant effect of Cost of Common Stock Equity on Profitability
From the acceptance of null hypothesis shows that Cost of Common Stock Equity does not affect the profitability.
17.3 Summary
Our research is based on financial management in automobile sector. The topic of our study was “investigating the impact of capital structure on profitability. We have used different kind of techniques for checking the effect of independent variables on the dependent variable. A sum of 4 companies listed on the Lahore stock exchange was put under study for a period of six years (2005 - 2010). For this study I have collected data from the financial annual reports. We have used different Statistical tools Descriptive analysis, Correlation and Regression for getting the overall results of our study. We found through these techniques that overall result of our study is significant negative relationship.
Chapter No. 5
18. Discussion, Conclusion and recommendations
18.1 Introduction
In this chapter, overall discussion of the thesis would be conducted. Furthermore overall conclusion would also mention. And at the en d suggestion recommendations would also mention.
18.2 Discussion
In this study we have determined the relationship between capital structure and profitability. A sum of 4 companies listed on the Lahore stock exchange was put under study for a period of six years (2005 - 2010). For this study I have collected data from the financial annual reports. There were four variables included in this study. The dependent variable is “profitability” while the independent variables are “capital structure, cost of debt and cost of common stock equity. We used different kind of techniques for getting the result and we have used the descriptive technique for getting the result of the mean and standard deviation of these variables after the descriptive we have used correlation technique for checking the correlation between these variables and the significant level of these variables. In the correlation the study find negative relation of the independent variables on dependant variable The impact of all independent “ capital structure, cost of debt and cost of common stock Equity were found to be negative in the correlation. After the correlation technique used the coefficient of regression technique for checking the coefficient, t-test and (R-square). Through the results we found that there is no effect of capital structure, cost of debt and cost of common stock equity on profitability. In the regression we also used the R-square test and we found that the R-square percentage is 71.8% which shows 71.8% dependent variable is affected by these independent variables.
18.3 Conclusion
The study examined the relationship between capital structure and profitability of the automobile sector in Pakistan over the period 2005-2010. A sum of 4 companies listed on the Lahore stock exchange was put under study for a period of six years (2005 - 2010). For this study I have collected data from the financial annual reports. Two sets of variables were used to point out capital structure i.e. debt ratio, cost of debt, cost of common stock equity and, profitability i.e. Net profit ratio. The variables were examined by using the cross sectional and time series methodology. In order to verify the theory, Descriptive statistics, Pearson correlation and Regression analysis were used. In this study profitability has been used as dependent variable while capital structure, cost of debt and cost of common stock equity used as the independent variables. The purpose of this study is to guide both researcher and policy makers, to develop and implementation of such policies that improve the profitability in automobile sector. Using the time-series and cross-sectional methodology, it was discovered that total debt are insignificant in determining profitability. Descriptive analysis is used to describe the data by using descriptive summary. Correlation analysis used to describe the relation between variables by checking the acceptance or rejection of hypothesis and to see the nature of relationship between variables. In the correlation analysis capital structure and cost of common stock equity have moderate relation. Cost of debt has weak relation. In regression analysis all independent variables have no effect on profitability.
18.4 Suggestions and Recommendation
Capital structure should be economically based
We should not consider profitability as primary factor by surpulus debt raise and prices of automobile product should not be increase
Cost of equty should be low through proper management of amount raised through equity
Profitability should be forecasted by keeping these three factors
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