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Literature Review EDITED - LAST
Literature Review EDITED - LAST
0 Literature Review
Based on the review of previous researches there are many researches which
intend to find the relationship between financial structure & firm’s performance. There is
a lot of empirical evidence some researches have found positive & negative effect of
financial structure on firms’ performance[ CITATION Muh14 \l 1033 ].
Various researches are done on financial structure & research scholars have
addressed about financing as it’s an integral part of business in present world, a lot of
research scholars have done different researches on the impact of financial structure on
firm’s performance by changing the industrial sectors in different countries and in
different regions. In previous researches firms performances are measured by accounting
techniques such as return on equity, return on asset, gross profit margins, net profit
margin these variables are used as dependent variables. However, to measure the impact
of capital structure there are many ratios used like debt to equity ratio, debt to asset ratio,
financial leverage ratios as independent variables and it has been found through different
researches that there is positive relation present between performance and growth of the
firm with respect to financial structure[ CITATION Sal12 \l 1033 ].
It was identified by Ross & Jaffe.J, (1999) that to expand the overall worth of
firm management personnel’s should do efforts to expand the market worth and share of
both money debt & equity. An inadequate mixing of these two options of financing can
increase the charges of cost obtaining from these sources of finance [ CITATION Ros99 \l
1033 ].
Recent work has helped management personnel’s to determine the mix of debt
and equity and because of optimal mix many firms have expanded their performance.
Contrary to this many researchers have investigated that many firms are not using the mix
approach of debt and equity [ CITATION Sim00 \l 1033 ].
Financial managers always face the issues while making the decision on equity or
debt or both financing to polish up debt-equity ratio, regardless of firm’s size this
decision does create a lot of stress and pressure. Mostly small sized firms are financed by
equity and their liabilities are towards their suppliers or borrowings from banks, but when
it comes to large sized firms like Multinational Corporations (MNC’s), then they need to
look upon short and long term borrowings or bonds and stock market[ CITATION Kli14 \l
1033 ].
Is the mixture of long and short term financing through debt and equity. It
represents the entire right side of balance sheet[ CITATION SMy00 \l 1033 ]. Financial
structure includes capital structure, cost of capital and financial leverage[ CITATION PSR141
\l 1033 ]. Financial structure is measured by using ratio and trend analysis. Financial
structure most of the time is different from one country to another country according to
their economic conditions and business operations[ CITATION Koe13 \l 1033 ].
2.1.2 Theories
Pecking Order Theory of financial structure states that firm’s decisions are
based upon their preferred pecking order. When a firm will not have sufficient cash flow
available internally then they will switch towards borrowing instead of issuing equity. As
internal funds do not require any additional exposure of financial information and
flotation cost that’s why internal financing is preferred upon external sources of funds.
Exposure of financial information may lead towards a possibly less favorable or superior
business position[ CITATION SMy84 \l 1033 ]. Decisions pertaining to finance depends upon
the cheapest sources which are available, financing can be through equity or debt, the
only thing which is considered is to maximize the value of firm, if a firm doesn’t have
funds to finance themselves through equity then the next option is to finance through debt
and if the firm chooses to finance through debt then the firm will consider different
sources of debt financing. Financing would be based upon the minimum additional cost
of asymmetric information [ CITATION Lui09 \l 1033 ]. According to this theory financial
structure decisions are completely based upon the financing cost whether its equity or
debt, but pecking order theory more prefer equity financing more than the debt. Debt is
considered as the last option to go with and if they would be needing to issue new shares
for internal (equity) financing they would prefer debt over equity[ CITATION She10 \l
1033 ].
Trade off Theory is the most well-known theory among the theories of financial
structure. This theory is a modified version of MM-Theory. This theory proposes that
financial structure does impact on firm’s performance but with some costs and benefits
pertaining to both the sources of financing equity (internally) or debt (externally).
Therefore, firms need to create a balance between cost and benefits. This theory further
elaborates that to overcome upon the market imperfections firms need to choose a
financial structure that will create a balance between the benefits and cost or which will
minimize the cost and in return it will lead to maximize the value of a firm. It accepts the
fact that both the sources of financing have their owns costs and benefits and they are
linked with the earning capacity of firms, nature of the business and risk insolvency
involved according to nature of different business. Those firms which focus on debt
financing will reap the benefits of tax advantages & those who are financing through
equity will reap the advantages by protecting themselves from the cost of financial
distress and bankruptcy[ CITATION Awa14 \l 1033 ]. Mainly this theory focuses on the debt
financing and holds an assumption of tax shield which means that through debt financing
firms gets an advantage over tax.
Agency Theory states that both equity and debt financing hold their own costs
and firms financial structure should be determined by the agency cost of both equity and
debt. It creates a bond between finance personnel and the owners of firms. This bond is
created whenever an owner hire some finance personnel and distribute responsibilities
among them and give them an authority to take financial decisions related to firms.
Problem arises when these personnel’s start considering about their benefits rather about
holistic benefit of firm. In the context of this, the optimal financial structure of firm is
determined through understanding the financing choices and understanding between the
owner and personnel’s hired for financial decisions. It has foreseen that advantage of tax
trough debt financing greater than the cost benefit of shareholders, consequently debt
financing reduces the conflicts between owners and personnel’s which reduces the
agency cost[ CITATION Par99 \l 1033 ].
This research is a quantitative study as it’s based on stats obtained from annual
financial reports of the 15 out of 20 companies of food & personal care sector in Pakistan
registered in Karachi Stock Exchange, for the period of 2012-2016. These 5 companies
(Rafhan Maize Products Limited, Al Shaheer Corporation Limited, Matco Foods
Limited, Nirala MSR Foods Limited and Murree Brewery Company Limited) are
excluded due to unavailability of data, therefore this study is targeting the entire Food &
Personal Care Sector of Pakistan.
Although a lot of work was done in different industrial sector of Pakistan such as
cement, sugar, and textile etc. but these researches were not capturing the financial
structure’s impact on firm’s financial performance. In Food & Personal Care Sector of
Pakistan this might be the first research which will capture the financial structure impact
on firm’s financial performance.
This study is analyzing the validity of all the dependent variables (ROE, ROA,
EPS, GPM, NPM and T.Ass-T) & independent variable (D-E Ratio) through unit root by
applying 5 tests (Levin, Lin & Chu Test, LM, Pearson & Shin W-Stat, ADF - Fisher Chi-
Square, PP - Fisher Chi-Square and Hadri Z-Stat) on each dependent and independent
variable. Previous researches did not worked on the validity of their dependent and
independent variables.
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