The Relationship between Capital Structure & Stock Returns

The Relationship between Capital Structure & Stock Returns

Overview

The theory of capital structure and its relationship with a firm’s value and performance has been a puzzling issue in corporate finance and accounting literature since the seminal work of Modigliani and Miller (1958) (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 firm’s 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.

After Modigliani and Miller, Jensen and Meckling discussed the agency cost theory which refers to the potential conflict between managers and shareholders in one side, and between shareholders and debtors in another side.

Since Jensen and Meckling’s argument the relationship between capital structure and firm performance, many researchers have begun to study the relationship between capital structure and firm performance.

The main objective of this paper is to examine the impact of capital structure measured by debt ratio (DR) on financial performance measured by earning per share (EPS), return on equity (ROE), and return on assets (ROA).

The paper proceeds along the following lines. Presents the theoretical framework, discusses review of literature, discusses the research methodology, hypothesis, data, and variables, discusses data analysis and results and  offers findings and conclusions.

Problem Definition

Is there any relation between Capital structure and performance of the stock returen in the stock change, the effect of the capital restructure on the stock return.

Capital structure refer to its debt level relative on the balance sheet and of a company finance its assets through a combination of debt, equity or mixture between securities and that a company`s capital structure is then the figuration or structuring its liabilities.

Theoretical Framework

To perform our analysis to the research under study we will depend on the annual reports of the company to find the Capital structure results and the financial results, in which the content analysis for the Capital structure as the independent variables in which the researcher believes that it is the most suitable method.

Concerning the financial performance it will be measured using return on equity and the return on assets results to assess the dependent variables.

Dependent Variable

Firm Performance

Earnings per share (EPS): is    Net income – Dividends on preffered stock

                                                                    Average Outstanding share

Return on equity (ROE): is the net profits after tax divided by the total equity

Return on assets (ROA): is the net profits after taxes divided by total assets.

Independent Variables

Capital Structure 

Capital structure of a firm is measured by different accounting based methods like short term liability to total assets, long term liability to total assets and total debt to total assets.

Debt Ratio = Total Debt

                    Total Assets

Moderating Variables

The Financial leverage is calculated by dividing the total long term debt of the company to the total assets

Research assumption

Assumption 1: All companies under the study have a social responsible teams

Assumption2: There is no Governmental intervention in CSR

Thesis Structure:

The research is delivered in three chapters. The first chapter will give a brief introduction providing an overview of the research, problem definition, and research objective. Then, a brief description of the theoretical framework, its components, research major and minor questions. Finally the research type, sampling, and data analysis method used in the research are mentioned. Chapter two will introduce the previous researches that talked about the CSR and Company’s performance. Chapter three is the theoretical framework: it covers the research design, explained briefly in Chapter one, variables, measurement and the sampling design and correlation model.

Capital Structure Definition

Capital structure has been defined by many authors and scholars. However, these definitions are explicit and have the same meaning. This research work adopts that of Pandey which says “a company’s capital structure refers to its debt level relative to equity on the balance sheet.

It is a snapshot of the amounts and types of capital that a firm has access to, and what financing methods it has used to conduct growth initiatives such as research and development or acquiring assets”.

The relationship between Capital Structure &Stock Return (Financial Performance)

From this definition, we can say that capital structure is a trend at how a company finances its assets through a combination of debt, equity or mixture between securities and that a company’s capital structure is then the figuration or structuring its liabilities.

The capital structure indicators refer to long-term debt, short-term debt; total debt and total equity, while return on assets and return on equity are the performance proxies.

The Theoretical Axis:

. Modigliani and miller (mm) theory (1958, 1963): In Modigliani and Miller provided the seminal in capital structure under certain assumptions include no taxes, homogenous expectations, perfect capital markets, and no transaction costs [1]. This theory which called “capital structure irrelevance” states that the relationship between capital structure and cost of capital is irrelevant, that mean the increases in debt does not effect on cost of capital. In a result, the investor’s expectations of future benefits are totally effect on firm value and cost of capital.

Latterly, Modigliani and Miller introduced new evidence that cost of capital effect on capital structure, and thus effect on firm value with taking taxes as assumption into consideration, which refer that borrowing give tax advantage, because the interest will deduct from the tax which result what is known as tax shields, which in turn reduce the cost of debt and then maximize the firm performance.

Pecking order theory: Pecking order theory is the result of Asymmetric information. The pecking order model does not discuss the optimal capital structure as significant point, but states that firms have two main sources to fund its financial needs which are internal and external finance; the theory claims that firms prefer to use firstly internal finance such as excess liquid assets or retained earnings then external finance. If internal financing is not enough to fund investment projects, firms may or may not obtain external financing, and if they do, In order to minimize additional costs of asymmetric information, the managers head for choosing between the different sources of external finance, firms prefer to use debt leverage firstly, secondly issuance of preferred stock and finally issuance of common stock.

Trade-off theory: Trade off theory is an extension of the MM theory developed by Miller. The theory proposes that the firm’s optimal capital structure include the tradeoff among the influences of firms and personal taxes, agency costs and bankruptcy costs, etc. Tradeoff theory expect that corporations choose levels of debt in order to achieve a balance among the benefits from the interest tax shield with the costs related to a future financial distress or with current financial inflexibility

The agency theory: Agency cost theory which provided by Jensen and Meckling is discussing the conflict of interest between principals (shareholders) and decision makers (agents) of firms (managers, board members, etc), this conflict stems from the differences in behavior or decisions by point out that the parties (agents and shareholders) often have different goals, and different tolerances toward risk. In this case, the managers whom are responsible of guiding the firm toward to achieve them personal goals rather than maximizing benefits to the shareholders. Hence, the main conflict that shareholders face is to ensure that managers (agents) do not invest the free cash flow in unprofitable projects. In another hand, increasing the debt to equity ratio would assist firms to make sure that managers are running the firm more efficiently.

Badar and Saeed study showed the impact of using leverage in firm’s capital structure on firm’s performance [7]. They applied study on all firms of food sector listed on Karachi stock exchange. The paper covered a period of five years from 2007-2011. The capital structure variables were three variables, long term debts to total assets (LTDTA), Total debt to Equity (TDE), and Short-term debts to Total assets (STDTA). and they measured firm performance by Return on Assets (ROA) and Assets Turnover Ratio (ATO), they found that long term debts has a positive and significant impact on firm performance, while, short term debts has negative significant impact of on firm performance.

Since Modigliani and Miller’s theory has been published many of the researchers are still studying the relationship between capital structure and firm performance, some of them found that there is a negative relation between capital structure and firm performance, while others found a positive relation between capital structure and firm performance. In another hand many papers referred to a significant relation between structure and firm performance, while some of them referred to an insignificant relation between structure and firm performance

Mumtaz study seeks to investigate the relationship between capital structure and firm performance in the context of large private companies in Pakistan. To measure capital structure they used Debt to Equity ratio (DR), while ratios such as, Return on Asset (ROA), Earning per Share (EPS), Return on equity (ROE), Operating profit Margin, Price to Earnings Ratio are used to measure firm performance. Moreover, the relationship between capital structure of a firm and market value of the firm is significant and negative.

Ahmad study discussed the influence of capital structure on firm performance of Malaysian firms listed as consumers and industrials sectors in Malaysian equity market from 2005 to 2010, to measure firm performance they use return on equity (ROE) and return on asset (ROA), and to measure capital structure they use long-term debt (LTD), short-term debt (STD), and total debt (TD). The study results that each of debt level has significant negative relationship with ROE, while ROA has significant positive relationship only with STD and TD.

 

Iorpev and kwanum study investigates the relationship between capital structure and firm performance of manufacturing companies listed on the Nigerian Stock Exchange [12]. They covered a period of five (5) years from 2005-2009. The study used multiple regression analysis to examine firm performance indicators such as Profit Margin (PM) and Return on Asset (ROA), while, the capital structure variables were, Long term debts to Total assets (LTDTA), Short-term debts to Total assets (STDTA), and Total debt to Equity (TDE). They found that STDTA and LTDTA have insignificant negative relationship with ROA and PM; while TDE has positive relationship with ROA and negative relationship with PM. STDTA is significantly related with ROA while LTDTA is significantly related with PM. The study concludes that capital structure is not a main determinant of firm performance.

The Imperial axis

The results of empirical studies on the nature of the relationship between Capital structure and Stock Return (Financial Performance)

Since Modigliani and Miller’s theory has been published many of the researchers are still studying the relationship between capital structure and firm performance , some of them have been found a negative relation between capital structure and firm performance such as Mumtaz,  Ahmad and while; Badar and Saeed found a significant positive relation between capital structure and firm performance . As well as Iorpev and kwanum found that capital structure and firm performance have insignificant negative relation

History for stock Market in EGPT

To give a historical background about the Egyptian stock market, it began its activities in the year 1883. At that time, there was only one stock exchange in Alexandria, and then Cairo Stock Exchange began its operations in the year 1903. Focusing mainly from the mid of the last century, the stock market was badly affected by the series of nationalization that began during the late fifties. The government acquisition of ninety three of the most active companies in the stock market at that time and transferring their shares into government bonds led later on to a decrease in the number of listed companies and the number of stockbrokers. Market Capitalization, which is the number of listed shares times the current market price, decreased as a percentage of GDP from 13% in 1958 to only 1% in 1974. Also, the number of listed companies decreased from 275 in 1958 to 55 in 1974. The number of stockbrokers declined as well from 55 to 15 during this same period. Moreover, at the level of market activity, the value of trade declined sharply from 66.7 million pounds in 1958 to only 4 million pounds in 1974. In conclusion, during Nasser’s era nationalization affected the stock market negatively. It was open but witnessed a significant slowdown during this period until its revival after implementing the Open Door policy.

During Sadat’s era, the stock market was free from the government regulations to encourage both domestic and foreign investment. Under the Open Door policy, the Capital Market Authority (CMA) was established to supervise the activities of the stock market. Unfortunately, due to several reasons, such as: the unavailability of securities laws and the protection of small investors, the stock market was dormant for about 20 years from 1970- 1990. Added to the above, the weakness of the economy was something that led to the underdevelopment of the securities industry until 1992 (Capital Market Authority 1996b).

With the introduction of the economic reform program at the beginning of the 1990s, a new capital market law was enacted encouraging the investment by the private sector with more protection granted to investors and more involvement of the banks in encouraging the capital markets through mutual funds.

Based on the quarterly report of EGX, in the last quarter of the year 2010, the total value of shares traded reached L.E. 72.4 Billion. While, the total volume traded reached 7,879 million securities done over 2,366 thousand transactions. A drop was witnessed in the first quarter of the year 2011 because of the political instability associated with the 25th of January revolution, and its consequences. The total value of traded shares reached L.E. 37.7 Billion, while the total volume traded was 3,387million shares over 986 thousand transactions. A drop of 16% in market capitalization was also witnessed by the end of the first quarter of 2011, with a total of L.E. 408 billion. Egypt is considered the second in rank after South Africa with regards to market capitalization

Based on the IFC sustainable investment country report, the market capitalization of the Egyptian stock market was 75,212 million US dollars in 2010. In January 2011, the market capitalization dropped to 69,661 million US dollars. During the period from July 2007 to June 2008, Egypt was ranked number eight of 28 emerging countries with respect to returns, and 18 out of 28 in terms of risk ranked from high to low. The annual market return was 29.7%, while the market risk was 6.94% for the same period. By the end of June 2008, Standard and Poor’s and IFCG Indices for the price – earnings ratio (P/E) for Egypt was 15.7 compared to an average P/E ratio of 26.4 for emerging markets. This indicates that the prices of stocks in the Egyptian market on average are relatively low compared to other emerging markets. While developed stock markets can perform efficiently as they possess sound,

Based on the IFC sustainable investment country report, the market capitalization of the Egyptian stock market was 75,212 million US dollars in 2010. In January 2011, the market capitalization dropped to 69,661 million US dollars. During the period from July 2007 to June 2008, Egypt was ranked number eight of 28 emerging countries with respect to returns, and 18 out of 28 in terms of risk ranked from high to low. The annual market return was 29.7%, while the market risk was 6.94% for the same period. By the end of June 2008, Standard and Poor’s and IFCG Indices for the price – earnings ratio (P/E) for Egypt was 15.7 compared to an average P/E ratio of 26.4 for emerging markets. This indicates that the prices of stocks in the Egyptian market on average are relatively low compared to other emerging markets. While developed stock markets can perform efficiently as they possess sound,

Theoretical Framework

To perform our analysis to the research under study we will depend on the annual reports of the company to find the Capital Structure results and the financial results , in which the content analysis for the Capital Structure as the independent variables in which the researcher believes that it is the most suitable method .

Firm performance it will be measured using return on equity and the return on assets results to assess the dependent variables.

Figure 3.1 reflects the Independent, Dependent & Moderating Variables

Data Analysis Method

There many ways to measure the corporate social responsibility in which we can use the  Kinder, Lydenberg, Domini (KLD) database which use the database from more than 650 companies in the US stock markets or we can use the Survey method by using a questionnaire to ask a number of participants about the social responsibility issues .

However the researcher will use the content analysis method used by (Mahoney, L.S. and Roberts, R.W., 2007) in which he believes that it will most participate in accurate results.

The method to collect the data will be using the content analysis.  Unit analysis to be used is sentences.  The Procedures will include the following: each annual report was traced for the sentences on each component of the CSR.  The number of sentences for each annual report is then calculated for each component and for total to get the CSR index (composite).

The procedures will go as follows: as per (Mahoney, L.S. and Roberts, R.W., 2007) & (Fauzi H. M., 2007).   We will use the guideline as indicated in the following in which the corporate social responsibilities will be assessed on a scale of zero to two for both strength and weakness for each dimension. . -2 rating will be granted for any dimension indicates major concern, -1 indicates a notable concern, 0 indicates no notable or major strength and concern, +1 indicates a notable strength and +2 indicates a major strength . The CSP index will be then calculated by summing all dimensions scores for each company.

Table 3.1 here show the corporate social performance measure according to  Michael Jantzi Research Associates, Inc.  (Modified for the purpose of our research)

Dimension

StrengthConcern
Community Issues-Generous Giving

-Innovating Giving

-Community consultation/     Engagement

-Strong aboriginal    Relationship

Lack of Consultation/   Engagement

-Breach of Covenant

-Weak aboriginal relation

Workplace-Strong Employment Equity   Program

-Woman on board of   directors

-Women in senior    management

-Work/family benefit

-Minority/women   Contracting

Lack of employment equity initiative

-Employment equity   Controversies

EnvironmentEnvironmental   management strength

-Exceptional environment   planning and impact    assessment

-Environmentally sound   resource use  

-Environmental impact reduction

–Beneficial product and   service

-Environment management concern.  

-Inadequate environmental   planning or impact   assessment

-Unsound resource use

-Poor compliance record

-Substantial emissions/discharges

-Negative impact of   operation

-Negative impact of   Products

 

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