Research Proposal

Research Topic : IMPACT OF CAPITAL STRUCTURE ON FINANCIAL

PERFORMANCE: EMPIRICAL EVIDENCE FROM MANUFACTURING
SECTOR OF PAKISTAN.

Supervisor : Sir Sanaullah

Submitted By:

Name : ABID RASOOL HAAVi

Roll No : 5504

Class : M.Phil (Commerce)

Semester : 3rd

Session : 2014-2016

COLLEGE OF COMMERCE

G.C UNIVERSITY FAISALABAD

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 1. Abstract

According to corporate governance theory agency cost is affected by leverage and effect firm
performance. We develop a new method to show the truth of this theory at best combination
under exogenous conditions of profit efficiency and firm profit to benchmark. We will use
simultaneous-equations model to show the relationship between firm performances to capital
structure. Our data source will be Pakistan banking industry which relates with the theory. Our
results will be significant statically and economically.
In financial as well non financial sector agency costs highlights important issues in corporate
governance. De segmentation of ownership and control structure is the major cause of agency
problems in a professionally organized firm. Which arise due to lake of manager’s sincerity to
their work, indulging in perquisites and make such decisions that maximize their value rather
than firm’s value.

2. Introduction

According to corporate governance theory agency cost is affected by leverage and effect firm
performance. We develop a new method to show the truth of this theory at best combination
under exogenous conditions of profit efficiency and firm profit to benchmark. We will use
simultaneous-equations model to show the relationship between firm performances to capital
structure. Our data source will be Pakistan banking industry which relates with the theory. Our
results will be significant statically and economically.
In financial as well non financial sector agency costs highlights important issues in corporate
governance. De segmentation of ownership and control structure is the major cause of agency
problems in a professionally organized firm. Which arise due to lake of manager’s sincerity to
their work, indulging in perquisites and make such decisions that maximize their value rather
than firm value.
Firms managed and owned by single person there is no interest conflict and agency problem. In
such conditions manager’s decisions are totally based on to maximize firm’s value, because
firm’s growth is directly linked with his own growth. If business is not totally owned by its
manager and it’s a public corporation, separation of command and control cause agency. The
person who is called manager is basically an agent of shareholders.

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Shareholders of public limited company hire managers to run business on their behalf. Managers
of such corporation have their own incentive like enjoying perquisites or maximize their wealth
(Grossman & Hart, 1982) at the expense of shareholder’s value. If manager’s ownership
interest’s decreases, his remuneration to create value of firm decreases (Florackis, 2008), due to
conflict in managers and owners goals cause agency.
Now, question is how shareholders may make management to perform in their best interest?
How, interest of both management and ownership can be settled? We can different ways for
minimizing the agency problems. Firstly, we’ll have to maximize the managerial ownership,
which helps as a bridge between management and ownership interest. (Ang et al., 2000; Fleming
et al, 2005). Secondly, how efficiently ownership plays his role to reduce agency conflict. It is
understood that as shareholders have more shares more they have power to manage their as well
as interest of management (Jensen & Meckling, 1976) .Third one is to use of debt to commit
managers and minimize agency cost (Franks & Harris, 1989). According to agency theory, the
higher debt ratio decreases agency cost of equity by aligning the interests of managers and
shareholders. Research objective is to test agency cost hypothesis that states that use of debt can
reduce agency.

2.1 Theories Underlying Capital Structure and Firms’ Performance

Modigliani and Miller’s (1958) study gave a substantial boost to the development of a theoretical
framework that has since been used by most financial studies (Abor, 2005) . Modigliani and
Miller (1958) concluded that capital structure is irrelevant to determining a firm’s value (El-
Sayed Ebaid, 2009). Modigliani and Miller’s proposition is built on the assumption of a perfect
market where there is no tax and bankruptcy disasters. As a response to this statement, the trade-
off theory and pecking order theory were introduced. These theories were developed in
opposition to the unrealistic assumption of Modigliani and Miller’s proposition of perfect capital
structure. These theories were developed to explain the rules of debt and equity in firms’ capital
structure performance in the real capital structure market founded on tax and bankruptcy
disasters.
In addition to the theories that explained choices of capital structure, other theories have focused
on ethics and the way managers use capital structure. The main purpose of a manager is to

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maximize the value of the firm. However, issues arise when this central purpose conflicts with
the goals of other involved parties, such as shareholders and stakeholders. This leads to the
question of who should be given more attention when seeking to maximise the value of a firm:
internal parties (such as employees) or external parties (such as society). The following section
introduces the theories that outline capital structure choices and the responsibilities of managers
towards the internal and external beneficiaries of a firm.

2.2 Modigliani and Miller’s Propositions

Modigliani and Miller (1958) concluded that capital structure is irrelevant to determining a
firm’s value (Ebaid 2009). This is known as ‘MM Proposition I’. They believed that a firm’s
value is not related to its mix of debt and equity. They categorically stated that, ‘The average
cost of capital to any firm is completely independent of its capital structure and is equal to the
capitalization rate of a pure equity stream of its class’ (Modigliani & Miller 1958, pp. 268–269).
They believed that the value of a firm is determined by its real assets, and not by the amount of
debt and equity available as part of its capital structure. This was built on the assumption of a
perfect capital market in which there are no taxes, no bankruptcy costs, and disclosure of all
information. They originally focused on the advantages of debt finance through the effects of
corporate tax.
Five years later after MM Proposition I, Modigliani and Miller (1963) modified their conclusion
about the relationship between a firm’s value and its mix of capital structure. They believed that
a tax shield can be generated by using debt. Using more debt will reduce the tax that needs to be
paid. Hence, they suggested that the optimal capital structure for a firm is one that totally uses
debt with no equity. This is known as ‘MM Proposition II’.

As aforementioned, Modigliani and Miller’s propositions were built on the assumption of a

perfect capital market in which there are no taxes, no bankruptcy costs, and disclosure of all
information. Moreover, they originally focused on the advantages of debt finance through the
effects of corporate tax. As these two propositions are unreasonable in the real world, more
theories developed in response to these two propositions—the details of which are outlined
below.

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 3. Literature Review

There is positive relationship between financial performance and financial leverage and also
influence shareholders return (Akhtar, Javed, Maryam, & Sadia, 2012) in their research article
“Relationship between Financial leverage and Financial Performance: Evidence from Fuel &
Energy Sector of Pakistan. Hence, in oil and gas sector companies in the fuel and energy sector
may enhance their financial performance and can play their role for the growth of the economy
while improving at their optimal capital structures. In their study they employed a sample of 20
listed public limited companies from Fuel and Energy sector listed at Karachi Stock Exchange
(KSE). The study aimed at measuring the relationship between financial leverage and the
financial performance. To test the hypothesis, the main variables used in the study consist of a
dependent variable which is financial performance of fuel and energy sector while an
independent variable financial leverage in fuel and energy sector.
(Ojo, 2012) elaborated in his research conducted by the name of “The Effect of Financial
Leverage on Corporate Performance of Some Selected Companies in Nigeria empirically
examines the effect of financial leverage on selected indicators of corporate performance in
Nigeria”. Financial Leverage has significant affects on corporate financial performance in
Nigeria. Researcher examines that how much positively or negatively financial leverage effect
earnings per share and net assets per share of Nigerian corporate firms. The econometric findings
shows in this study that financial leverage effects (debt/ equity ratio) significantly corporate
performance, especially when we use net assets per share (NAPS) as an indicator of corporate
performance in Nigeria. EPS depends upon feedback shock and less on leverage shock. Also, the
outcome exposed that the influence shock on earnings per share indirectly disturb the net assets
per share of firms as the majority of the shocks on the net assets per share was received from
earnings per share of the firms.
(Yoon & Jang, 2005) study presents an empirical insight into the relationship between return on
equity (ROE), financial leverage and size of firms in the restaurant industry for the period 1998
to 2003 using OLS regressions and for this purpose they take 62 Restaurant firms in US.
Research results showed that high leveraged firms were less risky in both market based and
accounting-based measures. There is positive relationship between financial leverage and both
profit measures and positively correlated. Also suggest that at least during the test period firm

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size had a more dominant effect on ROE of restaurant firms than debt use, larger firms earning
meaningfully higher equity returns. Results also suggest that regardless of having lower financial
leverage, smaller restaurant firms were significantly more risky than larger firms.
(Ujah & Brusa, 2011) in their research paper “The Effect of Financial Leverage and Cash Flow
Volatility on Earnings Management.” Took 559 US firms from the period 1990 through 2009
and identify the relationship between Leverage, Cash flow Instability and earning management
variables. The findings of this paper suggest that financial leverage and cash flow impact the
degrees to which firms manage their earnings. That business cycle and not bond or debt ratings
affect firm’s earnings management. Also, we find that depending of economic group or industry
a firm belongs to their degree and extent of managed earnings varies.
An examination of the effect of capital structure on the performance of quoted manufacturing
firms in Nigeria and determines a positive relationship between the value of Leverage and return
on equity, return on assets and return on investment of Nigerian quoted manufacturing firms
respectively. Further suggest that more properly the use justice and debt more the performance
will be better. For this purpose data was collected from textbooks, annual reports, Journals, other
published materials, Nigerian Stock Exchange fact books and the annual financial statements of
the sampled 108 firms for the periods 2000 to 2009 and it was analyzed by statistical techniques.
(ALIU, 2010).
(Long & Malitz, 1985) has written in his research paper “Drivers of profitability and leverage of
Greek firms in the post crisis era” determines overall all firms are showing a dramatically low
net profit margin during the recessionary study period (2008-2010) and a high reliance on debt.
Both liquidity ratios are negatively correlated. The study covering the period 2008-10, Data are
firm level financial data taken from the ICAP database for 3,222 corporate firms from 4 key
sectors of the Greek economy. Two logistic regression models are used to analyze data by taking
financial leverage and firm’s performance as independent and dependent variables.
Similarly (Pouraghajan, Malekian, Emamgholipour, Lotfollahpour, & Bagheri, 2012) also found
a significant relationship between leverage and firm performance.
Negative relationship between profitability and firm financial performance established by
(Olokoyo, 2013).
(Jensen & Meckling, 1976) pointed out that agency cost arising out due to separation of
ownership and control, whereby managers have incentive to maximize their own utility or using

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firm’s resources for personal benefits rather than maximizing value of firm. They identify two
types of agency cost: agency cost due to conflict of interest between shareholders and managers
and agency cost arising out form conflict of interest of shareholders and debt holders. According
to Jensen and Meckling (1976) agency cost is the sum of Monitoring expenditure, bonding
expenditure and residual loss. Grossman and Hart (1982), with assumption that management has
control of financial structure, showed how threat of bankruptcy can bring incentives to improve
management. They argue that managers of equity financed firm don’t have incentives to
maximize profit in particular due to absence of threat of bankruptcy and they may use debt to
commit themselves and signal the market that they will peruse profits rather than wasting
organizational resources for their perquisites. The threat of bankruptcy will put more pressure on
managers if bankruptcy results in loss of perquisites that they enjoy.
The research provides measures of absolute and relative equity agency costs for corporations
under different ownership and management structures. Our base case is Jensen and Meckling's
(1976) zero agency-cost firms, where the manager is the firm's sole shareholder. We utilize a
sample of 1,708 small corporations from the FRB/NSSBF database and find that agency costs (i)
are significantly higher when an outsider rather than an insider manages the firm; (ii) are
inversely related to the manager's ownership share; (iii) increase with the number of nonmanager
shareholders, and (iv) to a lesser extent, are lower with greater monitoring by banks (Ang, Cole,
& Lin, 2000).
(Berger, 1993) find that the distributional assumptions usually imposed in the literature are not
very consistent with these data.
After conversion and the expiration of ownership-structure restrictions, firm performance
improves significantly, and the portions of the firm owned by managers and the firm's employee
stock ownership plan increase. Changes in performance are positively associated with changes in
ownership by managers, but negatively associated with changes in ownership by employee stock
ownership plans (Cole & Mehran, 1998).
(Stulz, 1990) developed theoretical model to investigate how financing policies can be used to
manage agency problem of manager control on free cash flow in the presence of information
asymmetry. In a firm with excessive cash flow and poor investment opportunities, manager have
incentive to invest even in negative NPV projects because perquisites increase with firm size. He
demonstrated in his model that debt can be used to scounter overinvestment problem by bonding

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managers to pay out excess cash to debt holders. The debt can also create problem of
underinvestment when firm has good opportunities to invest in positive NPV projects. Hence,
debt impact shareholders wealth both positively and negatively. Haris and Raviv (1990)
presented theoretical model to investigate the ability of debt to allow investors to gather
information useful for monitoring management and allows investors to discipline managers.
They argue that manager wants to continue operations of firm even if liquidation is in the interest
of investors. That’s why managers are reluctant to provide detailed information that could result
in liquidation. As debt holders have legal rights, they force managers to provide detail
information. This information is also helpful for investors to monitor activities of managers.
By using data of small business studied the effect of ownership structure on agency cost. They
demonstrated that agency cost decreases with external monitoring by banks. This puts pressure
on managers to run business profitability and report the real picture of business to such financial
institution investors (Ang et al., 2000).
(Berger & Di Patti, 2006) finds that the US banking industry consistent with the theory and the
results are statistically significant, economically significant, and robust.

4. Purpose of Study

Specifically, the aims of the study were:

1. To calculate firms’ capital structure mix indicators. This calculation included the debt
and equity percentage used in the capital structure and debt ratio to total assets (leverage);
2. To calculate the financial performance of Pakistani financial (Banks) firms by using
profitability indicator measurements—namely, net profit margins (NPM), gross profit
margins (GPM), return on assets (ROA) and return on equity (ROE);
3. To empirically examine the relationship between debt levels and financial performance
(profitability), including determining whether:
(a) Higher financial performance levels are related to lower leverage levels;
(b) Lower leverage levels lead to higher profit margins;
(c) Lower leverage levels lead to higher GPM;
(d) Lower leverage levels lead to higher ROA; and
(e) Lower leverage levels lead to higher ROE;

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 4 To formulate a conclusion about the best balance between debt and equity that can be
seen to improve corporate profit performance.

4.1 Contribution

The outcomes of this study will help firms choose the most suitable capital mix in order to
improve their financial performance in the presence of low agency cost applications. This study
will provide a new theoretical view on the traditional capital structure theories—most notably,
the trade-off and pecking order theories—that are most frequently studied in Western models
that have tax-shield benefits.

4.2 Motivation and Significance of the Study

Hence, the primary significance of the study lies in its focus on measuring financial performance by using
financial statements about capital structures. In particular, it focuses on the debt to total assets structure
for publicly trading financial firms listed on the exchanges in Pakistan. Pakistan is studied because of its
particular capital market environment, taking into account the low agency cost application. This study
was developed to examine two relationships involved in influencing financial performance in the Pakistan
economic environment: leverage and financial performance. To the researcher’s knowledge, this is the
first study to use this methodology to examine the relationship between capital structure and financial
performance in Pakistan.

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 5. Methodology

Conceptual Frame Work

Financial Leverage Financial Performance

DEBT/EQUITY

EPS

Net Profit
Margin

Return on
Asset
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 Return on
Equity

Sale
Growth

6. Sample and Data

Our target population will be Financial Sector of Pakistan. We will analyze Secondary panel
Data from 2009-13 and source of data is FINANCIAL STATEMENT ANALYSIS OF
FINANCIAL SECTOR. Ratio analysis and 2SLS Panel data regression models will be used.

6.1Variables Used

6.1.1 Independent Variables and Proxies

In our research we will use Leverage/Long term debt/Short term debt/Equity as an Independent variable.
Proxies we will use are following.

1) Debt equity ratio

2) Debt to asset ratio

3) Degree of financial leverage

4) Degree of operating leverage

5) Long term debt ratio

6) Short term Debt ratio

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7) Total Debt Ratio

6.1.2 Dependent Variables and Proxies

Performance will be our dependent variable which we represent by “Agency Cost” and will be
measured by following proxies.

1) Return On Investment.

2) Return on Asset

3) Earnings per Share

4) Net asset per share

5) Free cash flow per share

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7. Variables Presentation

Independent Variable Dependent Variable

Capital Structure Financial Performance

Debt equity ratio Return on Investment

Debt to asset ratio Earnings per Share

Degree of financial leverage Net asset per share

Degree of operating leverage Free cash flow per share

Long term debt ratio Return on Asset

Short term Debt ratio Net profit margin

Total Debt Ratio Sale growth

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 8. References
Abor, J. (2005). The effect of capital structure on profitability: an empirical analysis of listed firms in
Ghana. The journal of risk finance, 6(5), 438-445.
Akhtar, S., Javed, B., Maryam, A., & Sadia, H. (2012). Relationship between financial leverage and
financial performance: Evidence from fuel & energy sector of Pakistan. European Journal of
Business and Management, 4(11), 7-17.
ALIU, N. O. (2010). EFFECT OF CAPITAL STRUCTURE ON THE PERFORMANCE OF QUOTED
MANUFACTURING FIRMS IN NIGERIA. AHMADU BELLO UNIVERSITY, ZARIA.
Ang, J. S., Cole, R. A., & Lin, J. W. (2000). Agency costs and ownership structure. the Journal of
Finance, 55(1), 81-106.
Berger, A. N. (1993). “Distribution-free” estimates of efficiency in the US banking industry and tests of
the standard distributional assumptions. Journal of productivity Analysis, 4(3), 261-292.
Berger, A. N., & Di Patti, E. B. (2006). Capital structure and firm performance: A new approach to
testing agency theory and an application to the banking industry. Journal of Banking & Finance,
30(4), 1065-1102.
Cole, R. A., & Mehran, H. (1998). The effect of changes in ownership structure on performance:
Evidence from the thrift industry. Journal of financial economics, 50(3), 291-317.
El-Sayed Ebaid, I. (2009). The impact of capital-structure choice on firm performance: empirical
evidence from Egypt. The journal of risk finance, 10(5), 477-487.
Florackis, C. (2008). Agency costs and corporate governance mechanisms: evidence for UK firms.
International Journal of Managerial Finance, 4(1), 37-59.
Franks, J. R., & Harris, R. S. (1989). Shareholder wealth effects of corporate takeovers: the UK
experience 1955–1985. Journal of financial economics, 23(2), 225-249.
Grossman, S. J., & Hart, O. D. (1982). Corporate financial structure and managerial incentives The
economics of information and uncertainty (pp. 107-140): University of Chicago Press.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and
ownership structure. Journal of financial economics, 3(4), 305-360.
Long, M. S., & Malitz, I. B. (1985). Investment patterns and financial leverage Corporate capital
structures in the United States (pp. 325-352): University of Chicago Press.
Ojo, A. S. (2012). The effect of financial leverage on corporate performance of some selected companies
in Nigeria. Canadian Social Science, 8(1), 85-91.
Olokoyo, F. O. (2013). Capital structure and corporate performance of Nigerian quoted firms: A panel
data approach. African Development Review, 25(3), 358-369.
Pouraghajan, A., Malekian, E., Emamgholipour, M., Lotfollahpour, V., & Bagheri, M. M. (2012). The
Relationship between Capital Structure and Firm Performance Evaluation Measures: Evidence
from the Tehran Stock Exchange. International Journal of Business and Commerce, 1(9), 166-
181.
Stulz, R. (1990). Managerial discretion and optimal financing policies. Journal of financial economics,
26(1), 3-27.
Ujah, N. U., & Brusa, J. O. (2011). Earnings Management, Financial Leverage, and Cash Flow Volatility:
Do Economic Conditions Matter? Financial Leverage, and Cash Flow Volatility: Do Economic
Conditions Matter.
Yoon, E., & Jang, S. (2005). The effect of financial leverage on profitability and risk of restaurant firms.
The Journal of Hospitality Financial Management, 13(1), 35-47.

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