New Finance Faces an Important Question Finance Essay

The logic for an organization is its objectives. Each business organization tries to achieve its objectives by integrating different functions related to finance, marketing, personnel and operations. Finance is one of the major and important financial areas of each profit and non-profit organization. Not only for organizations, finance is quite critical for one's personal decisions also like where to invest savings? Companies who are in need of new finance faces an important question whether to raise debt or equity. There is less empirical evidence on how companies select the proper ratio of equity and debt at given point in time. Capital structure is the mix of the long term sources of funds used by the firm. Prudent capital structure requires answer to the following questions What should be maturity composition of the firm's sources of funds??? In what proportion relative to the total should the various forms of permanent financing utilized??? The major influence of the maturity structure of the financing plans is the nature of assets owned by the firm. A firm heaving real capital investment, presented primarily by its fixed asset on its balance sheet, they have to finance those assets with permanent types of financial capital, investment in current assets should be financed with permanent capital. Assets are financed on temporary basis and it is also observed that companies current liabilities are consist of temporary capital. The objective of the capital structure is the source of the funds used by a firm in the way that will increase the company's common stock price. We may say that capital structure management is the objective by which firm seeks the mix of funds that will minimize its cost of capital.

IMPORTANCE OF CAPITAL STRUCTURE:

It makes economic sense of the firms to strive to minimize the cost of the using financial capital. Both capital costs and other costs, such as the manufacturing cost share a common characteristic in that it potentially reduces the size of the cash and dividend that could be paid to the common stock holders. The ultimate value of a share of common stock depends in parts on the returns investors expect to receive from holding the stock. Cash dividends comprise all part of these expected returns. All factors held constant that could affect share price expect capital cost. If capital costs would keep minimized, the dividend stream that flows to the common stockholders would be maximized. In result of this the firm's common stock price increases. The firm's capital cost can be affected by its capital structure, and then capital structure management is clearly an important subset of business financial management. Profitability is the primary goal of all businesses. Without profitability the business will not survive in the long run. Profitability is measured with income and expenses. Expenses are the cost of resources used up or consumed by the activities of the business. Profitability is defined in two ways "economic profit" and "accounting profit". Economic profit gives a long term perspective of the business. Accounting profit provides an intermediate view of the feasibility of business. One year losses may not permanently harm the business. Consecutive years' loss may make your business vulnerable. Profitability is measured with an "income statement" because income statement is measure of income and expenses during a given time period. Profitability measurement is an important measure of the business success. The most important task of business managers is to increase profitability of the firm. They always look for the ways to improve business profitability. A variety of profitability ratios are used to access profitability of the business.

CAPITAL STRUCTURE DECISION MAKING:

Capital structure decisions are of the strategic importance for the organizations. Capital structure decisions are complex ones that involve weighing a variety of factors. The decision of capital structure becomes even more difficult where economic condition, like our country, is uncertain. Capital structure decisions have direct impact on firm value and return to stakeholders. With respect to capital structure firms are divided into two classes," Unleveled" and "Leveled firms". An "unleveled firm" uses only equity capital. A "leveled firm" uses a mix of equity and various forms of liabilities like bank debt, marketable bonds and debentures. Firms with strong profitability, reserve funds and high market dominance tend to have stable sales levels, assets that make good collateral for loans and a high growth rate which adopt high-risk production strategy and use more debt. In other words, firms at relatively lower and higher levels of market power employ more debt because if a business can earn a higher rate of return than the interest rate at which it borrows, it becomes profitable for the business to borrow money, while firms at intermediate level of market dominance are vulnerable to rivals' competitive threat and reduce their debt. It is the financial manager's responsibility to raise the money for the investment in real assets. When a company needs funds they can adopt one of the two options they may issue shares to investors and promise to give them share of the profit or they may take loan from investors and promise them to pay a series of payments. It is the financial manager's responsibility to raise the money for the investment in real assets. When a company needs funds they can adopt one of the two options: They float shares and promise to give shares of the profit They make loan from investors and promise them to pay a series of interest payments. Therefore the focus of this study is to find whether the capital structure of the firm affect the profitability of the firm or not.

OBJECTIVE OF STUDY:

To identify what kind of capital structure is suitable for firms in Pakistan Debt financing ( whether short-term or long term ) to what extent affects profitability To find, what extent to which equity financing affects profitability

LITERATURE REVIEW:

Laurence Booth, Varouj Aivazian, Asli Demirguc-Kunt, Vojislav Maksimovic (October1999)

This study uses a new data set to assess whether capital structure theory is portable across countries with different institutional structures. They analyze capital structure choices of firms in ten developing countries, and provide evidence that these decisions are affected by the same variables as in developed countries. However, there are persistent differences across countries, indicating that specific country factors are at work. Their findings suggest that although some of the insights from modern finance theory are portable across countries, much remains to be done to understand the impact of different institutional features on capital structure choices.

I M Pandey (March 2002)

This paper provides new insights on the way in which the capital structure and market power and capital structure and profitability are related. They predict and show that capital structure and market power, as measured by Tobin's Q, have a cubic relationship. This is due to the complex interaction of the market conditions, agency problems and bankruptcy costs. They also show saucer-shaped relation between capital structure and profitability because of the interplay of agency costs, costs of external financing and debt tax shield.

Raghuram G. Rajan, Luigi Zingales

They investigate the determinants of capital structure choice by analyzing the financing decisions of public firms in the major industrialized countries. At an aggregate level, firm leverage is fairly similar across the G-7 countries. They find that factors identified by previous studies as correlated in the cross-section with firm leverage in the U.S., are similarly correlated in other countries as well. However, a deeper examination of the U.S. and foreign evidence suggests that the theoretical underpinnings of the observed correlations are still largely unresolved.

Jos© Marcos Carvalho de Mesquita, Jos© Edson Lara

The determination of a company's capital structure constitutes a difficult decision, one that involves several and antagonistic factors, such as risk and profitability. That decision becomes even more difficult in times when the economic environment in which the company operates presents a high degree of instability. Therefore, the choice among the ideal proportion of debt and equity can affect the value of the company, as much as the return rates can. In the present study, the authors tried to examine the influence of the capital structure of Brazilian companies regarding the factor profitability. The data used in this research corresponds to the financial statements of 70 companies collected in the past seven years. There is, the historical series covers the period immediately after the implantation of Plano Real, with its consequences in terms of reduction of inflation rates, increase of interest rates and instability of the exchange rate politics. The Ordinary Least Squares (OLS) method was employed in the estimation of a function relating the return on the equity (ROE) with the indexes of long and short-run debts, and also with the total of owner's equity. The results indicate that the return rates present a positive correlation with short-term debt and equity, and an inverse correlation with long-term debt.

Stewart C. Myers (spring, 2001),

The study of capital structure attempts to explain the mix of securities and financing sources used by corporations to finance real investment. Most of the research on capital structure has focused on the proportions of debt vs. equity observed on the right-hand sides of corporations' balance sheets. This paper is an introduction to that research. There is no universal theory of the debt-equity choice, and no reason to expect one. There are several useful conditional theories, however. For example, the tradeoff theory says that firms seek debt levels that balance the tax advantages of additional debt against the costs of possible financial distress. The tradeoff theory predicts moderate borrowing by tax-paying firms. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. Thus the amount of debt will reflect the firm's cumulative need for external funds. The free cashpow theory says that dangerously high debt levels will increase value, despite the threat of financial distress, when a firm's operating cash flow significantly exceeds its profitable investment opportunities. The free cash flow theory is designed for mature firms that are prone to over invest.

Erik Berglof and Ernst-Ludwig Von Thadden

We study the problems of financial contracting and renegotiation between a firm and outside investors when the firm cannot commit to future payouts, but assets can be contracted upon. They show that a capital structure with multiple investors specializing in short-term and long-term claims is superior to a structure with only one type of claim, because this hardens the incentives for the entrepreneur to renegotiate the contract ex post. Depending on the parameters, the optimal capital structure also differentiates between state-independent and state-dependent long-term claims, which can be interpreted as long-term debt and equity.

Milton Harris; Artur Raviv

This paper surveys capital structure theories based on agency costs, asymmetric information, product/input market interactions, and corporate control considerations (but excluding text based theories). For each type of model, a brief overview of the papers surveyed and their relation to each other is provided. The central papers are described in some detail, and their results are summarized and followed by a discussion of related extensions. Each section concludes with a summary of the main implications of the models surveyed in the section. Finally these results are collected and compared to the available evidence. Suggestions for future research are provided.

Long Chen; Xinlei Zhao (September 2004)

This article is evidence in favor of the tradeoff theory. This evidence suggests that transaction costs are unlikely to be the main interpretation for the negative fund-debt financing decisions, the use of debt decreases with profitability even though more is caused by firms' preference of internal to external funds. When resorting to external markets, more profitable firms show little incentive to rebalance their leverage ratios. Combined the profitability and leverage either. Second, through both theoretical and empirical illustration, profitable firms have lower (higher) marginal debt financing cost (benefits), suggesting that dynamic relation between profitability and leverage ratios. In addition, among firms facing internal tax considerations are unlikely to be the main reason for the negative relation between the competing theories since this pattern can arise as a mechanical result regardless of which the question of why more profitable firms have lower leverage ratios. We show that this relation theory best describes firm financing decisions. Their finding thus casts serious doubts on the We seek economic interpretations to two well-known empirical regularities. They first address we show that the mean reversion of leverage ratios may not be informative in distinguishing widely adopted convention of interpreting the mean reversion of leverage ratios as the definitive.

Sheridan Titman; Roberto Wessels (Mar., 1988)

This paper analyzes the explanatory power of some of the recent theories of optimal capital structure. The study extends empirical work on capital structure theory in three ways. First, it examines a much broader set of capital structure theories, many of which have not previously been analyzed empirically. Second, since the theories have different empirical implications in regard to different types of debt instruments, the authors analyze measures of short-term, long-term, and convertible debt rather than an aggregate measure of total debt. Third, the study uses a factor-analytic technique that mitigates the measurement problems encountered when working with proxy variables.

STEWART C. MYERS (JULY1984)

He contrasts two ways of thinking about capital structure: 1. A static tradeoff framework, in which the firm is viewed as setting a target debt-to-value ratio and gradually moving towards it, in much the same way that a firm adjusts dividends to move towards a target payout ratio. 2. An old-fashioned pecking order framework, in which the firm prefers internal to external financing and debt to equity if it issues securities. In the pure pecking order theory, the firm has no well-defined target debt-to-value ratio. Recent theoretical work has breathed new life into the pecking order framework. He argues that this theory performs at least as well as the static tradeoff theory in explaining what we know about actual financing choices and their average impacts on stock prices.

RESEARCH METHODOLOGY:

To examine proportion of debt and equity affects the profitability of the firms we use a following function. ROE=f (STD/TL, LTD/TL, SHE/TL, LTD /SHE, U) In this function we took ROE as a function of STD/TL, LTD/TL, SHE/TL, LTD /SHE, U Where; ROE is the profitability ratio and it corresponds to Net Profit to Equity, STD/TL corresponds to short-term debt to total liability, LTD/TL shows the ratio of Long-Term Debt to Total Liability, SHE/TL is the ratio of Share Holder's Equity to Total Liability, LTD /SHE corresponds to the Long-Term Debt to Share Holder's Equity, And U is the Error term. We use these ratios to determine that how much a portion of the capital structure in a firm

ROE:

A measure of how well a company used reinvested earnings to generate additional earnings, equal to a fiscal year's after-tax income divided by book value, expressed as a percentage. It is used as a general indication of the company's efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. Investors usually look for companies with returns on equity that are high and growing.

STD/TL:

This ratio indicates that how much a portion of short-term debt is used in total debt. This ratio helps us to determine the value of short-term debt that a company uses.

LTD/TL:

This ratio provides a value of long-term debt out of total debt. This ratio will help us to determine that how much a portion of long-term debt is used.

SHE/TL:

This ratio shows the company's equity in relation to debt, greater this ratio shows that there are excess earning available for dividend and there is a greater margin of safety for investors or low debt charges. Greater the ratio lower the risk.

LTD /SHE:

This ratio helps us to explain that how much a proportion of a company's long-term debt compared to its available capital is used. By using this ratio investor can identify the amount of company's risk exposure.

Results and Discussion:

The ratios are calculated and after that we took the average and standard deviation of the sector. The descriptive statistics of the analyzed data are shown in the tables below:

Fertilizer Sector:

Fertilizer sector has four listed companies and we also took four companies.

It has been observed that the sectors we have chosen use more portion of short-term debt than long-term debt. As the ratio STD/TL is greater than LTD/TL. It's also been observed that the correlation between ROE and STD/TL is 0.085 shows a positive relation and indicates that higher the portion of short-term debt in total liability higher will be the return on equity. There might be many reasons that why the companies use more short-term debt than long-term debt. Few are that a short-term loan can be obtained much faster than long-term credit, if a business requires funds in a hurry; it looks to the short-term credit markets. ROE has a negative correlation with the long-term debt as long term debt in companies financial statement is crucial. The method we used shows that the profitability of a firm is affected 73% by a mix of capital structure and 27% by other factors. The least square method we used proves our hypothesis that profitability is affected by capital structure.

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