TABLE OF CONTENTS

TABLE OF CONTENTS................................................................................................... 1
CHAPTER ONE.............................................................................................................. 3
1.

INTRODUCTION.................................................................................................. 3
1.1.

General Information.......................................................................................... 3

1.2.

Background to the Study.................................................................................... 4

1.3.

Statement of the Research Problem.......................................................................4

1.4.

Research Objective........................................................................................... 5

1.4.1.

Specific Objective...................................................................................... 5

1.4.2.

Research Questions.................................................................................... 6

1.5.

Significance of the Study................................................................................... 6

1.6.

Scope of the Study............................................................................................ 6

1.7.

Definition of Terms.......................................................................................... 6

CHAPTER TWO............................................................................................................. 8
2.

LITERATURE REVIEW.......................................................................................... 8
2.1.

Theoretical Framework...................................................................................... 8

2.1.1.

Capital Structure Irrelevance Theory...............................................................8

2.1.2.

Trade off Theory........................................................................................ 9

2.1.3.

The Asymmetry of Information Theory..........................................................10

2.1.4.

The Pecking Order Theory.........................................................................10

2.2.

Empirical framework...................................................................................... 11

2.3.

Conceptual Framework.................................................................................... 13

2.4.

Hypotheses................................................................................................... 13

CHAPTER THREE........................................................................................................ 14
3.

RESEARCH METHODOLOGY.............................................................................. 14
3.1.

Research Paradigm......................................................................................... 14

3.2.

Population.................................................................................................... 14

3.3.

Sample Size and Sampling Frame.......................................................................14

3.4.

Data Collection Tools...................................................................................... 14

3.5.

Operationalization of Concepts..........................................................................15

3.5.1.

Profitability Dependent Variable................................................................15

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3.5.2.

Financial Leverage Independent Variable.....................................................15

3.5.3.

Control variable....................................................................................... 15

3.6.

Data Analysis................................................................................................ 16

REFERENCES............................................................................................................. 17

CHAPTER ONE

1. INTRODUCTION

1.1.

General Information

The capital structure decision is crucial for any business organization. The decision is important
because of the need to maximize returns to various organizational constituencies, and also
because of the impact such a decision has on a firms ability to deal with its competitive
environment. The capital structure of a firm is actually a mix of different securities issued by a
firm. In general, a firm can choose among many alternative capital structures. It can issue a large
amount of debt or very little debt. It can arrange lease financing, use warrants, issue convertible
bonds, sign forward contracts or trade bond swaps. It can issue dozens of distinct securities in
countless combinations; however, it attempts to find the particular combination that maximizes
its overall market value. A number of theories have been advanced in explaining the capital
structure of firms. Despite the theoretical appeal of capital structure, researchers in financial
management have not found the optimal capital structure. The best that academics and
practitioners have been able to achieve are prescriptions that satisfy short-term goals. For
example, the lack of a consensus about what would qualify as optimal capital structure has
necessitated the need for this research. A better understanding of the issues at hand requires a
look at the concept of capital structure and its effect on firm profitability. This study will
examine the relationship between capital structure and profitability of companies listed on the
Dar es Salaam Stock Exchange during the period 2005-2009. The effect of capital structure on
the profitability of listed firms in Tanzania is a scientific area that has not yet been explored in
Tanzania finance literature.

1.2.

Background to the Study

The theory of capital structure and its relationship with a firms value and performance has been
a puzzling issue in corporate finance and accounting literature since the seminal work of
(Modigliani & Miller, 1963) (MM-1958). MM-1958 argue that under very restrictive
assumptions of perfect capital markets, investors homogenous expectations, tax-free economy,
and no transactions costs, capital structure is irrelevant in determining firm value. According to
this proposition, a firms value is determined by its real assets, not by the mix of securities it
issues. If this proposition does not hold then arbitrage mechanisms will take place, investor will
buy the shares of the undervalued firm and sell the shares of the overvalued firm in such a way
that identical income streams are obtained. As investors exploit these arbitrage opportunities, the
price of overvalued shares will fall and that of the undervalued shares will rise, until both prices
are equal. However, these restrictive assumptions do not hold in the real world, which led many
researchers to introduce additional rationalization for this proposition and its underling
assumptions showing that capital structure affects firms value and performance, especially after
the seminal paper of Jensen and Meckling (1976) which demonstrate that the amount of leverage
in a firms capital structure affects the agency conflicts between managers and shareholders by
constraining or encouraging managers to act more in the interest of shareholders and, thus, can
alter managers behaviors and operating decisions, which means that the amount of leverage in
capital structure affects firm performance.

1.3.

Statement of the Research Problem

Since, Jensen and Meckling (1976) argument regarding the possibility of capital structure
influence on firm performance, several researchers have followed this extension and conducted
numerous studies that aim to examine the relationship between financial leverage and firm
performance over the last decades. However, empirical evidence regarding this relationship is
contradictory and mixed. While a positive relationship between leverage level and firm

performance had been documented in some of these studies (Taub, 1975; Roden and Lewellen,
1995; Champion, 1999; Hadlock and James, 2002). Other studies document a
negative relationship between leverage level and firm performance (Fama and French, 1998;
Gleason et al., 2000; Simerly and Li, 2000).
While the literature examining the performance implications of capital structure choices is
immense in developed markets (e.g. USA and Europe), little is empirically known about such
implications in emerging or transition economies such as Tanzania. In such a country as
Eldomiaty (2007) argued capital market is less efficient and incomplete and suffers from higher
level of information asymmetry than capital markets in developed countries. This environment of
the market may cause financing decisions to be incomplete and subject to a considerable degree
of irregularity. It is, therefore, necessary to examine the validity of corporate leverage levels
impact on a firms performance in Tanzania as an example of emerging economies.

1.4.

Research Objective

The main aim of this study is to examine the relationship between financial leverage and
profitability of non financial companies listed on Dar es Salaam stock exchange during a five
year period (i.e. 2005 2009).

1.4.1. Specific Objective

To examine the relationship between Short term Debt and firm Profitability.
To examine the relationship between Long term Debt and firm Profitability.
To examine the relationship between Total Debt and firm Profitability.

1.4.2. Research Questions

1.5.

Does level of Short term Debt has effect on firm Profitability?

Does level of Long term Debt has effect on firm Profitability?
Does level of Total Dept has effect on firm Profitability?

Significance of the Study

The capital structure decision is crucial for any business organization. The decision is important
because of the need to maximize returns to various organizational constituencies, and also
because of the impact such a decision has on a firms ability to deal with its competitive
environment. Thus the findings of this study will assist financial managers in deciding the
optimal mix of capital structure. This study will produce information which will be useful to
them when choosing financing sources (for this case debt) and in deciding the level of debt to
acquire.

1.6.

Scope of the Study

This study will focus on non financial firms listed on the Dar es Salaam Stock Exchange (DSE)
basing on their accessibility and availability of data for the period under the study.

1.7.

Definition of Terms

Financial Leverage is the proportion of debt in the capital structure. There two ways
of putting into perspective the levels of debt that a firm carries i.e. Capital leverage
focuses on the extent to which a firms total capital is in the form of debt and Income
leverage is concerned with proportion of the annual income stream which is devoted
to the prior claims of debt holders. (Arnold, 2008)

CHAPTER TWO

2. LITERATURE REVIEW

2.1.

Theoretical Framework

The linkage between capital structure and firm value has engaged the attention of both academics
and practitioners. Throughout the literature, debate has centered on whether there is an optimal
capital structure for an individual firm or whether the proportion of debt usage is irrelevant to the
individual firms value. The capital structure of a firm concerns the mix of debt and equity the
firm uses in its operation. Brealey and Myers (2003) contend that the choice of capital structure
is fundamentally a marketing problem. They state that the firm can issue dozens of distinct
securities in countless combinations, but it attempts to find the particular combination that
maximizes market value. According to Weston and Brigham (1992), the optimal capital structure
is the one that maximizes the market value of the firms outstanding shares.

2.1.1. Capital Structure Irrelevance Theory

The seminal work by Modigliani and Miller (1958) in capital structure provided a substantial
boost in the development of the theoretical framework within which various theories were about
to emerge in the future. Modigliani and Miller (1958) concluded to the broadly known theory of
capital structure irrelevance where financial leverage does not affect the firms market value.
However their theory was based on very restrictive assumptions that do not hold in the real
world. These assumptions include perfect capital markets, homogenous expectations, no taxes,
and no transaction costs. The presence of bankruptcy costs and favorable tax treatment of interest

payments lead to the notion of an optimal capital structure which maximizes the value of the
firm, or respectively minimizes its total cost of capital.
(Modigliani & Miller, 1963) reviewed their earlier position by incorporating tax benefits as
determinants of the capital structure of firms. The key feature of taxation is that interest is a taxdeductible expense. A firm that pays taxes receives a partially offsetting interest tax-shield in
the form of lower taxes paid. Therefore, as Modigliani and Miller (1963) propose, firms should
use as much debt capital as possible in order to maximize their value. Along with corporate
taxation, researchers were also interested in analyzing the case of personal taxes imposed on
individuals. (Miller, 1977) based on the tax legislation of the USA, discerns three tax rates that
determine the total value of the firm. These are:
(1) the corporate tax rate;
(2) the tax rate imposed on the income of the dividends; and
(3) the tax rate imposed on the income of interest inflows.
According to Miller (1977), the value of the firm depends on the relative level of each tax rate,
compared with the other two.

2.1.2. Trade off Theory

Bankruptcy costs are the cost directly incurred when the perceived probability that the firm will
default on financing is greater than zero. The bankruptcy probability increases with debt level
since it increases the fear that the company might not be able to generate profits to pay back the
interest and the loans. The potential costs of bankruptcy may be both direct and indirect.
Examples of direct bankruptcy costs are the legal and administrative costs in the bankruptcy
process. Examples of indirect bankruptcy costs are the loss in profits incurred by the firm as a
result of the unwillingness of stakeholders to do business with them (Myers S. C., The Capital
Structure Puzzle, 1984). The use of debt in capital structure of the firm also leads to agency
costs. Agency costs arise as a result of the relationships between shareholders and managers and
those between debt-holders and shareholders (Jensen & Meckling, 1976). The need to balance
9

gains and costs of debt financing emerged as a theory known as the static trade-off theory by
Myers (1984). It values the company as the value of the firm if unlevered plus the present value
of the tax shield minus the present value of bankruptcy and agency costs.

2.1.3. The Asymmetry of Information Theory

The concept of optimal capital structure is also expressed by (Myers S. C., The Capital Structure
Puzzle, 1984) and Myers and Majluf (1984), based on the notion of asymmetric information. The
existence of information asymmetries between the firm and likely finance providers causes the
relative costs of finance to vary between the different sources of finance. For instance, an internal
source of finance where the funds provider is the firm will have more information about the firm
than new equity holders; thus, these new equity holders will expect a higher rate of return on
their investments. This means that it will cost the firm more to issue fresh equity shares than
using internal funds. Similarly, this argument could be provided between internal finance and
new debt holders. The conclusion drawn from the asymmetric information theories is that there is
a hierarchy of firm preferences with respect to the financing of their investments (Myers &
Majluf, Corporate Finance and Ivestment decisions when firms has information that investors do
not have, 1984)

2.1.4. The Pecking Order Theory

This pecking order theory suggests that firms will initially rely on internally generated funds,
i.e. undistributed earnings, where there is no existence of information asymmetry, and then they
will turn to debt if additional funds are needed and finally they will issue equity to cover any
remaining capital requirements. The order of preferences reflects the relative costs of various
financing options.
The pecking order hypothesis suggests that firms are willing to sell equity when the market
overvalues it (Chittenden, Hall, & Hutchson, 1996; Myers S. C., The Capital Structure Puzzle,
1984). This is based on the assumption that managers act in favor of the interest of existing
10

shareholders. As a consequence, they refuse to issue undervalued shares unless the value transfer
from old to new shareholders is more than offset by the net present value of the growth
opportunity. This leads to the conclusion that new shares will only be issued at a higher price
than that imposed by the real market value of the firm. Therefore investors interpret the issuance
of equity by a firm as signal of overpricing. If external financing is unavoidable, the firm will opt
for secured debt as opposed to risky debt and firms will only issue common stocks as a last
resort. Myers and Majluf (1984), maintain that firms would prefer internal sources to costly
external finance. Thus, according to the pecking order hypothesis, firms that are profitable and
therefore generate high earnings are expected to use less debt capital than those that do not
generate high earnings. Several researchers have tested the effects of profitability on firm
leverage. (Friend & Lang, 1988) and (Kester, 1986) find a significantly negative relation
between profitability and debt/asset ratios.
Based on the above analysis, one may argue that firms financing decision is influenced by many
factors, and explaining that decision by one theory may be short of providing a complete
diagnosis of that decision. In fact, each capital structure theory works under its own assumptions
and so does not offer a complete explanation of financial decisions. This means that searching
for an optimal capital structure is not one-way to go (Myers S. , 2001); (Eldomiaty, 2007) This
could explain the mixed and contradictory results of the studies that empirically tested the
predictions of these theories (i.e. relationship between leverage and firms profitability). Jermias
(2008) argue that prior studies have examined only the direct effect of financial leverage on
performance wheres this leverage-performance relationship may be contingent upon some
factors such as competitive intensity and business strategy, he provides empirical evidence that
the effect of leverage on performance is more negative for firms attempting to be differentiators
than those attempting to be cost leaders, also competitive intensity negatively affects the
leverage-performance relationship.

2.2.

Empirical framework

Most of the research concerning the relationship between capital structure and firms
performance was conducted in developed countries and markets. A few studies empirically
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examined this relationship in emerging (transition) economies. For instance, Majumdar and
Chhibber (1999) examine the relationship between capital structure and performance of Indian
firms showing that debt level is negatively related with performance (i.e. return on net worth).
Chiang et al. (2002) examine the relationship between capital structure and performance of firms
in property and construction sector in Hong Kong showing that high gearing is negativity related
with performance (i.e. profit margin). Abor (2005) investigates the relationship between capital
structure and profitability of listed firms in Ghana showing that STD and TTD are positively
related with firms profitability (i.e. ROE), whereas LTD is negatively related with firms
profitability (i.e. ROE). Kyereboah-Coleman (2007) examines the relationship between capital
structure and performance of microfinance institutions in sub-Saharan Africa showing that high
leverage is positively related with performance (i.e. ROA and ROE). Zeitun and Tian (2007)
examine the relationship between capital structure and performance of Jordan firms showing that
debt level is negatively related with performance (both the accounting and market measures).
Finally, Abor (2007) examines the relationship between debt policy (capital structure) and
performance of small and medium-sized enterprises in Ghana and South Africa showing that
capital structure, especially long-term and total debt level, is negatively related with performance
(both the accounting and market measures).
In summary, empirical studies regarding the relationship between capital structure and firms
performance in developed countries provided mixed and contradictory evidence, on the other
hand there is a few studies empirically examine this relationship in emerging (transition)
economies. The present study extends the literature on the impact of capital structure on firms
performance by empirically examining the relationship between capital structure and firms
performance in Tanzania. In fact, Tanzania is a unique case because; capital market in Tanzania
is less efficient and incomplete and suffers from higher level of information asymmetry than
capital markets in developed countries. Also, the capital market in Tanzania is still to now an
equity market, the debt market structure is still very immature. This environment of the market
may cause financing decisions to be incomplete and subject to a considerable degree of
irregularity. It is important, therefore, to explore the validity of debt financing firms
performance relationship under this unique economic setting.

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2.3.

Conceptual Framework

Short

Term

Debt
Long

Firm
Firm Size

Term

Profitability

Debt
Total Debt

2.4.

Hypotheses

The study will be tested by the following hypotheses

The level of short term debt has positive effect on firm profitability.
The level of long term debt has positive effect on firm profitability.
The level of total debt has positive effect on firm profitability.

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CHAPTER THREE

3. RESEARCH METHODOLOGY

3.1.

Research Paradigm

Both qualitative and quantitative research approach will be used to examine the impact of capital
structure on firm profitability.

3.2.

Population

The population for this study will be all publicly traded firms on DSE because they are more
likely to be informed on issues concerning capital structure decision i.e. they can use internal
funds, issue shares or use debt in financing their operations and also.

3.3.

Sample Size and Sampling Frame

The sampling frame of this study will be the list of all the listed firms on DSE. The listed firms
will then be screened against several factors; financial services institutions (banks) will be
deleted from list, and remaining firms will then be purposely selected due to availability of
financial data during the test period (2005-2009) and accessibility.

3.4.

Data Collection Tools

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The data will be collected via interviews, questionnaires and firms website. I will send
questionnaires to employees who are in the Finance Departments and I will interview finance
managers. Both questionnaires and interviews will measure how the financing decisions are
made and the determinants of capital structure composition.

3.5.

Operationalization of Concepts

3.5.1. Profitability Dependent Variable

Literature uses a number of different measures of firms profitability; but for the purpose
of this study the common accounting-based profitability measure (i.e. ROE) will be used.
This measure will be calculated from the firms financial statements. ROE is computed as
the ratio of net profit to average total equity.

3.5.2. Financial Leverage Independent Variable

Financial leverage will be measured in the study by three accounting ratios:

short-term debt to the total capital;

long-term debt to total capital; and
total debt to total capital

3.5.3. Control variable.

Prior research suggest that firms size may influence its performance, larger firms have a
greater variety of capabilities and can enjoy economies of scale, which may influence the
15

results and the inferences (Ramaswamy, 2001) (Frank & Goyal, 2003); (Jermias, 2008).
Therefore, this study will control the differences in firms operating environment by
including the size variable in the model. Size is measured by the log of total assets of the
firm and included in the model to control for effects of firm size on dependent variable
(i.e. profitability).

3.6.

short-term debt to the total capital;

long-term debt to total capital; and
total debt to total capital.

Data Analysis

The relationship between financial leverage and a firms performance will be tested by the
following regression models:
1. ROE I; t = 0 + 1STDI; t + 2log SI; t + eiI; t
2. ROEI; t = 0 + 1LTDI; t + 2log SI; t + eiI; t
3. ROE I; t = 0 + 1TTDI; t + 2log SI; t + eiI; t
Where:
ROE I, t

= Net profit to equity for firm I in year t

STD I, t

= short-term debt to total assets for firm I in year t.

LTD I, t

= long-term debt to total assets for firm I in year t.

TTD I, t

= total debt to total assets for firm I in year t.

Log S I, t

= logarithm of total assets for firm I in year t.

ei I, t

= the error term.

16

REFERENCES

Arnold, G. (2008). Corporate Financial Management. England: Financial Times

Pitman Publishing.
Brealy, R., & Myers, S. C. (2003). Principles of Corporate Finance (International
Edition ed.). Boston MA: McGraw-Hill.
Chittenden, F., Hall, G., & Hutchson, P. (1996). Small Firm growth, access of Capital
Markets and Financial Structure. Small Business Economy , 8, 59-57.
Eldomiaty, T. (2007). Determinants of Capital Structure. Journal of Business Resarch
, 17, 25-40.
Frank, M., & Goyal, V. (2003). Testing the Pecking Order Theory of Capital Structure.
Journal of Financial Economics , 67, 217-248.
Friend, & Lang. (1988). An Empirical Test of the impact of Managerial self inerest on
corporate capital structure. Journal of Finance , 43, 271-281.
Jensen, M., & Meckling, W. (1976). Theory of the Firm, Managerial Behaviour, agency
costs and ownership Structure. Journal of Financial Economics , 3, 305-360.
Jermias, T. (2008). British Accounting Review , 40, 71-80.
Kester, W. C. (1986). Capital and Ownership Structure. Financial Management , 15,
5-16.
Miller, M. H. (1977). Debt and Taxes. Journal of Finance , 32, 261-276.
Modigliani, F., & Miller, M. (1963). Corporate Income Tax and the Cost of Capital: a
correction. American Economic Review , 53, 443-453.
Myers, S. C. (1984). The Capital Structure Puzzle. Journal of Finance , 39, 575-592.
Myers, S. C., & Majluf, N. S. (1984). Corporate Finance and Ivestment decisions
when firms has information that investors do not have. Journal of Financial
Economics , 12, 187-221.
Myers, S. (2001). Capital Structure. Journal of Economic Perspectives , 15, 81-102.
Ramaswamy, K. (2001). Organization Ownership, Competition Intensity and Firm's
Performance. Strategic Management Journal , 22, 989-998.

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