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Financial Management - Assignment 1

Name: Roll number: Course:

Pratap Kulhari 50 EPGDIB VSAT Batch 7

Topic:

Capital structure and its effect on corporate performance

Reference Articles: 1. The impact of capital structure on profitability with special reference to it industry in India 2. Impact of debt structure on profitability in textile industry of Pakistan 3. The effect of financial leverage on corporate performance of some selected companies in Nigeria

Abstract of Findings:

The general findings are that while financial leverage offers tax advantages and cheaper source of finance, the profitability has a significant negative relationship with debt ratio.

1. The impact of capital structure on profitability with special reference to it industry in India

The journal article is aimed to find out The impact of capital structure on profitability with special reference to it industry in India. In their study, the authors have used the data from 102 IT sector companies listed on the stock exchange. The data were collected from CMIE (Centre for Monitoring Indian Economy) Prowess Package. Statistics such as Mean, Standard Deviation, and Ratios has been used. The study proves that there has been a strong one-to-one relationship between CS (Capital Structure) variables and Profitability variables, Return on Assets (ROA) and Return on Capital Employed (ROCE) and the CS has significant influence on Profitability, and increase in use of debt fund in CS tends to minimize the net profit of the it firms listed in Bombay Stock Exchange in India. The article refers to various prior studies on the topic. One of the interesting facts covered in the study is the possible bankruptcy risk while using extra debt. The higher the debt ratio, the greater the risk, and thus higher the interest rate will be. At the same time, rising interest rates overwhelm the tax advantages of debt. If the firm falls on hard times and if its operating income is insufficient to cover interest charges, then stockholders will have to make up the short fall, and if they cant, the firm may be forced into bankruptcy. Good times may be just around the corner. But too much debt can keep the company wipeout shareholders in the process. In terms of preferred order of financing, the issue of external equity is seen as being the most expensive and also dangerous in terms of potential loss of control of the enterprise by the original owner-managers. The study has divided the sample data based on two parameters i.e. Income Groups (Low, Medium and High) and Size of Total Assets (Small, Medium and Large). The study results show that there is no significant relationship between selected CS variables and ROA of low income IT firms, while there is an inverse relationship between these variables for the medium and high income group firms. Also, there is a clear inverse relationship between CS and ROA variables for all the three groups of firms under Asset size category i.e. small, medium and large firms. The study concludes that overall there has been a strong one-to-one relationship between CS variables and Profitability variables (ROA and ROCE), and the CS has a significant influence on Profitability, and increase in the use of debt fund in CS tends to reduce the net profit of the it firms listed in Bombay Stock Exchange in India.

2. Impact of debt structure on profitability in textile industry of Pakistan

The journal article is aimed to find out Impact of debt structure on profitability in textile industry of Pakistan. In order to do so, the authors have used the data from 17 companies from the industry. The article refers to Modigliani and Miller (1958) which states that any firms market value and its cost of capital were free of its capital structure in the perfect market conditions. However, according to the authors, the basic assumptions behind this study never hold true in the real markets. Through references to various studies, the article points out to some of the important findings related to the subject. One such finding indicates that an increase in the long-term debt position is linked with a decrease in profitability. As per the pecking order theory, any organization and industry would first prefer using internal available funds, then debt and finally external equity. The authors of the study have also defined the key variables used in their study. According to them, profitability is calculated by frequently used ratio by many researchers i.e. return on equity (ROE). It is calculated by dividing the net profit before interest and taxes by the shareholders equity, stating the result in percentage (however, usually the net income i.e. net profit after interest and tax is used for ROE calculation). Return on equity reveals the percentage earnings of the funds of a shareholder. From the their research, it can be seen from the results that the debt levels affect the profitability of the firm only when the sales are high (i.e. in Billions of rupees in their sample) and has no impact on the companies which have low sales (i.e. in Millions of rupees in their sample). Further it is also suggested that the companies with huge sales should not go for the short term debts, as short term debts have less potential for profit for them. However, the companies having small sales should go for the short term debts viz-a-viz long term debts. As the latter have negative relationship with the profitability.

3. The effect of financial leverage on corporate performance of some selected companies in Nigeria

The journal article is aimed to find out What is the effect of introduction of fixed- interestbearing funds (debts) on the return to the firms shareholders. It is done by examining the impact of leverage on the earnings per share and net assets per share of corporate firms in Nigeria. Few of the prior studies referred in the article state that debt magnifies the earnings available to shareholders. However, this assertion will only be valid if the return on assets (ROA) is higher than the cost of debt. In this case the more the debt, the higher the return on equity (ROE). The implication of this is that Earnings per Share and of course, Net Assets per Share will fall if the company obtains debt at a cost higher than the rate of return on the companys assets. The article also explains the concept of financial leverage and its various effects on the companys performance. The degree of financial leverage is defined as the change in a companys profit after tax due to changes in its EBIT. Financial leverage increases the potential reward to shareholders, but it also increases the potential for financial distress and business failures. It is therefore enough to note that financial leverage increases the firms (financial) risk and hence, the equity beta of the firm. The article concludes that leverage changes (debt/ equity ratio) have substantial effect on corporate performance especially when the net assets per share (NAPS) is used as an indicator of corporate performance in Nigeria over the period covered by the study. Earnings per share depend on indirect effects of leverage changes and less on direct effects. Also, the finding revealed that the leverage effect on earnings per share indirectly affect the net assets per share of firms as the bulk of the effects on the net assets per share was received from earnings per share of the firms.

REFERENCES:

The impact of capital structure on profitability with special reference to it industry in India By: Ramachandran Azhagaiah, Candasamy Gavoury Volume 9 Number 4 Winter 2011 - Managing Global Transitions http://www.fm-kp.si/zalozba/ISSN/1581-6311/9_371-392.pdf

Impact of debt structure on profitability in textile industry of Pakistan By: Wali ur Rehman, Goher Fatima, Dr. Mehboob Ahmad International Journal of Economics and Research, 2012, v3i2, 61-70 http://www.ijeronline.com/documents/volumes/Vol%203%20issue%202/ijer20120301MA(5).p df

The effect of financial leverage on corporate performance of some selected companies in Nigeria By: Akinmulegun Sunday Ojo Canadian Social Science, vol. 8, no. 1, 2012, pp. 85-91 http://cscanada.net/index.php/css/article/view/j.css.1923669720120801.700

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