BM410 FINANCIAL MANAGEMENT

INDIVIDUAL ASSIGNMENT

NAME: Angeline Janet Virima

REG NUMBER: R1856221W

PROGRAMME: BUSINESS MANAGEMENT

MODE OF ENTRY: PARALLEL

LEVEL: 4.2

LECTURER: MUFARO DZINGIRAI

QUESTION:

Discus any 5 key determinants of the capital structure of construction companies in Zimbabwe.
The capital structure is the combination of internal financing and external financing of the firm.
According to Sugiarto (2009) internal financing composed of equity, preference share capital and
shareholder's funds and external financing composed of long-term debt and short-term debt of
the firm. Internal financing using profits as a source of capital for new investment rather than
obtaining capital elsewhere distributed as dividends to firm's owners or other investors. External
financing is the phrase used to describe funds that firms obtain from outside of the firm.

Capital structure is an important topic in corporate finance for practitioners and academic
researchers. A number of capital structure theories have been proposed in the recent years to
explain the variation in debt ratios across firms. Capital structure theory suggests that firms
determine what is often referred to as a target debt ratio; which is based on various trade-off
between the costs and benefits of debt versus equity. The modern theory of capital structure was
established by Modigliani and Miller (1958). Following on from this pioneering work of
Modigliani and Miller on the capital structure, three conflicting theories of capital structure have
been developed. They are namely: static trade-off theory (Bradley et al., 1984), pecking order
theory (Myers and Majluf, 1984), and agency cost theory (Jensen and Meckling, 1976).

The capital structure decision is one of the most important decisions made by the Financial
Management. It is center of many other decisions in the area of corporate finance. Capital
structure is one of the effective tools of management to manage the cost of capital. In this study,
we examine the factors that determine the capital structure of the manufacturing companies.

Profitability has both negative and positive effect on capital structure. This can be shown in the
study that follows. The larger the firm size, the easier it will be for the company to get an
external loan, both in the form of debt and share capital. Trade-off theory introduced by Kraus
and Litzenberger (1973) is the one that provides the sign of the relationship between size and
capital structure. It is because generally large companies have a pretty good reputation in the
public perspective (Ernayani & Robiyanto, 2016). Meanwhile, small companies have limited
access to capital, especially through the capital market, which makes them unable to involve
third parties as their partners. In addition, small companies with low cash inflows will find it
more difficult to obtain debt because creditors consider it is riskier compared to large companies.
Therefore, it can be concluded that the larger the firm size, the higher the capital structure.
Empirically, this has been proven by Eriotis, Vasiliou, and VentouraNeokosmidi (2007), Kayedi,
Ghahramanizady, and Jafarzadeh (2013), Murhadi (2011), Nnadi (2016), Utomo, Wahyudi,
Muharam, and Taolin (2018). The empirical studies that have examined the impact of
profitability on capital structure decisions have found mixed results. Myers (1984) found that
firms that are profitable and having the capacity to generate high earning use less debt capital to
equity than those which do not generate high incomes. This negative relationship between debt
ratio and profitability is supported by Titman and Wessels (1988) Rajan and Zingales (1995),
Mutenheri and Green (2003) and Mazhar and Naser (2007). However, Huang and Sang (2002)
Sarkar and Zapatero (2003) and Chidoko et al (2012) found a positive relationship between
profitability and debt ratio in manufacturing firms.

Non debt tax shield and Taxation have mixed effects. In their seminal paper Modigliani and
Miller (1963) asserts that interest tax shields create strong incentives for firms to increase
leverage. The Non debt tax shield decrease the earnings of the firm and this result in the
reduction of expected level of interest tax savings which later reduces the advantage of using
high debt financing (Ahmad et al, 2011). The Non debt tax shields are regarded as substitutes for
the tax benefits of debt financing (Kuczynski, 2005). Therefore, the tax advantages of leverage
decrease when other tax deductions like depreciation increase. The empirical evidence suggests a
negative relationship between non debt tax shield and debt ratio (Titman and Wessels,1988;
Saltang and Sang, 2002; Mutenheri and Green, 2003)

In addition, the impact of taxation on leverage is mixed. Little support is found in the empirical
analysis about the relevance of tax to capital structure decision. Titman and Wessel (1988)
reported an insignificant relationship between effective tax rate and debt ratio, while Mackie
(1990), Mutenheri and Green (2003), Huang and Sang (2006) and Chidoko et al (2012) reported
a negative relationship.
Company’s size has a positive effect on capital structure. According to the Tradeoff theory,
larger firms can borrow at relatively lower rates than smaller firms due to high level of
noncurrent assets, economies of scale, stable cash flow and credit worthiness (Marsh, 1982).
Several studies have found a positive relationship between size and leverage, for example,
Mutenheri and Green (2003) and Chidoko et al (2012). The agency theory suggests a significant
positive relationship between tangibility and debt ratios since tangible assets can be used as
collateral. This relationship is supported by empirical evidence, for example, Titman and
Wessels (1988), Shar and Hijazi (2000) and Shar (2007).

Asset structure is one of the important factors in the capital structure. When a company faces
financial difficulties in repaying its obligations, the tangible assets or fixed assets owned by the
company can be used as collateral for external parties who can provide loans. In line with the
trade-off theory, companies with large assets will have a larger DER because they have assets as
part of their collateral. They will also be able to obtain large amounts of debt because they are
expected to be better in accessing the external fund sources compared to small companies.
Companies also can use fixed assets as collateral (Handriani & Robiyanto, 2019; Sartono, 2001),
which, according to the agency cost theory, will lead to the conflict between management and
shareholders. According to Joni and Lina (2010), procurement for fixed assets requires
substantial funds and could cause additional debt burden for the company. Thus, it is not
surprising that the ownership of large fixed assets is often followed by a large amount of debt.
Empirically, this has also been proven by Handoo and Sharma (2014), Karadeniz, Kandir,
Balcilar, and Onal (2009), Nhung et al. (2017), Nnadi (2016) who found the positive effect of
asset structure on the capital structure. In this study, the asset structure was measured by the
proportion of fixed assets toward total assets. Based on this reason, the following third
hypothesis is formulated:

Asset structure has a positive effect on capital structure. Several previous types of research
showed that commodity prices could have a positive effect on company returns. For example,
Hersugondo, Robiyanto, Wahyudi, and Muharam (2015), Putra and Robiyanto (2019),
Robiyanto (2018a, 2018b, 2018c) found that the increased in commodities could actually
increase the stock returns. In relation to the capital structure, the price of this commodity would
encourage the company to seek funding (Kurronen, 2018). Therefore, it could increase its
production capacity and provide greater results. Nhung et al. (2017) also suggested that the type
of industry would affect the capital structure. In the industries that depend on commodity prices,
it was found that the higher the price of commodities, the higher the capital structure would be.
Kurronen (2018) stated that “the trade-off theory argues that firms find the right balance between
equity and debt to maximize firm value.” The costs and benefits of borrowing thus affect the
optimal capital structure. When the commodity price is high, a company will try to boost the
sales in order to maximize the firm value by using both internal and external sources. When the
commodity price is high, the company encourages to borrow more because of low probability of
financial distress. This conforms with the signaling theory. This is also supported by Enakirerhi
and Chijuka (2016), Eviani (2015), Haryanto (2016), Huang and Ritter (2004). For this study
specifically examines coal mining sector companies, the higher coal price will encourage coal
mining companies to borrow more funds.

Tangibility and Growth opportunities; it is believed that in an uncertain world, with asymmetric
information, the asset structure of a firm has a direct impact on its capital structure since a firm’s
tangible assets are the mostly widely accepted sources for bank borrowing and raising secured
debt.

Moreover, myers (1977) suggested that firms with future growth opportunities should use more
equity financing. The argument is based on the view that a higher leveraged manufacturing
company is more likely to pass up profitable investment opportunities. On the same note, the
Perking order theory asserts that internal funds are not sufficient for growing firms to meet the
requirements of growth; hence external borrowed funds are needed. The Pecking order theory
assumes a positive relation between debt ratio and growth. The manufacturing firms with higher
growth opportunities may invest in high risk projects increasing the chances of bankruptcy and
thus lowering the opportunity of growth. Empirical studies by Myers (1984), Marsh (1982) and
Cassar and Holmes (2003) have reported a positive relationship between leverage and firm
growth.
Liquidity from the perspective of the Pecking order theory states that firms prefer internal
financing to external financing. Following this argument, it therefore means firms have to create
liquid reserves from retained earnings. If the liquidity reserves become or continuously become
suitable and enough for investments the firm will less likely need to raise external funds. Hence
liquidity is negatively related to debt ratio. Mutenheri and Green (2003) reported a negative
relationship on liquidity and debt ratio which is in line with the arrangements of Pecking order
theory.
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