Effects of Capital Structure on Firm Performance






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EFFECTS OF CAPITAL STRUCTURE ON FIRM PERFORMANCE 1 INTRODUCTION Capital structure is an important factor by which a company can increase its performance at its optimum level if the firm uses it in effective and efficient way The idea of the modern theory is taken from the theory of Modigliani and Miller in 1958, which was assumed under the perfect capital markets The debt can be optimal because it provides a shift of control in some states of the world (karine gobert) The capital structure i
  EFFECTS OF CAPITAL STRUCTURE ON FIRM PERFORMANCE1 INTRODUCTION Capital structure is an important factor by which a company can increase its performanceat its optimum level if the firm uses it in effective and efficient way The idea of themodern theory is taken from the theory of Modigliani and Miller in 1958, which wasassumed under the perfect capital markets The debt can be optimal because it provides ashift of control in some states of the world (karine   gobert  ) The capital structure is themix of debt, preffered stock and common equity with which the firm tends to increasecapital (http://wwwcsulbedu/~pammerma/fin300/ch13ppt) Theories of capitalstructure suggest may affect a firm’s debt equity choice (  http://financeellerarizonaedu/documents/facultypublications/KKahleTaxbenefitsofoptionspdf ) Capital structure is related to the ability of the firm to meet the needs of itsstakeholders (Boodhoo Roshan January 2009)The determinants of capital structure such as tax benefit variables, size, profitability,growth, collateral value of assets and uniqueness were explained by (Kathleen Mkahleand kudleep shastri in January 2002) There is a curvilinear relationship between ROEand debt-to-asset ratio (Shyan- Rong   Chou  ) The trade of theory defines the capitalstructure that how much debt and equity finance should be chosen by the company to use by balancing the costs and benefits (Frank and Goyal)the capital structured can alsosometimes leads to the bankruptcy and has a negative and adverse affect on the performance of the firm if properly not utilizes A firm is the algamation of assets withone owner that link with other assets to produce and sells merchandise (Eric Rasmusen’s Weblog) “If firm performance affect the choice of capital structure, then failure to takethis reverse causality into account may result in regression of a firm performance on ameasure of leverage may confound the effects of capital structure on performance withthe effect of performance on capital structure” (Allen Nberger)a firm’s capital structurerefers to the mix of its financial liabilities As financial capital is an uncertain but criticalresource for all firms, suppliers of finance are able to exert control over firms (RahulKuchhar, fall 1997)1  My motivation is quiet similar to Shyan-Rong Chou I will investigate the relation between Return on Equity (ROE) and the capital structure 12 Problem Statement My research problem is to find out and optimum level of capital structure through whicha firm can increase its financial performance more efficiently and effectively 13 Methodology I will collect my data through questionnaire which I will be distributing in some publicand private financial institutions Also by conducting informal interviewees with some of the employees of those very organizations 14 Objective The main objectives of my research are;1To compare the relationship between capital structure and firm performance2To find ways that can boost the performance of a firm3How to maintain the firm’s revenue under riskier condition Significance of capital structure • Reflects the firm’s strategy • Indicator of the risk profile of the firm • Acts as a tax management tool • Helps to brighten the image of the firm Literature review Modigliani-Miller provides the basis for modern thinking on capital structure and was for the first time introduces the concept of capital structure Their theory states that withouttaxes, bankruptcy costs and systematic information and in an efficient market, the firm’s2  value is not affected in which way the firm is financed (June 1958 free encyclopedia)The trade off theory of capital structure states that how much debt financed and equityfinance is chosen by the company to use by balancing the cost and benefits(Kraus andLichtenberger September 1973)Capital structure is also called financial structure of afirm because it has the ability to meet the needs of its stakeholders (Boodhoo RoshanJanuary 2009)Capital structure is very important for firm because it can maximize thestakeholders return Moreover in dealing with the competitive environment anappropriate capital structure is also important to firm (Boodhoo Roshan January 2009)Jenson and meckling (1976) introduce the concept of agency costs and investigate thenature of agency costs generated by the existence of debt and outside equity Therelationship between capital structures is non-linear The association is found to be parabolic Specifically the relation is negative up to a certain point Then, it reverses andturns positive (Pornist Jiraporn June 10, 2005) The issue of optimal capital structure inthe perfect market and in the imperfect market was explained by Raj S Dhankar and AjitS Boora (July 1996)the concept that how the capital the financial performance of thesmall and medium sized enterprises are affected by the capital structure was explained byAbor, Joshua (22 nd sept 2007)The influence of variables such as cash flows, investment expenditure and stock pricehistories were examined by Andres, Aydogan and Charlie hadlock (October, 7 2003)InMay 2004, M Kahle and Kuldeep Shastri explained that there is a negative relationship between shot term loans and long term loans to the saize of the debt ratio from optionexercise The impact of Ownership Structure and Corporate Governance on capitalstructure on Pakistan listed companies was explained by Arshad Hassan and Safdar AliButt in 2008 They further analyzed that debt to equity ratio is negatively correlated with board size and managerial shareholding Georges Dionne, Robert Gagne and AbdulHakim examined the Determinants of Insurers ‘Performance in risk Pooling, risk management and financial intermediation activities (30 th April, 2007) They alsoexplained how these variables affect the efficiency of financial institutions AdriennHercezg the optimal capital structure and its importance for a firm to maximize returns is based in the ability of that very organization to deal with its competitive environment3