Impact of Capital Structure on Firm’s Profitability: A Study on Financial Sector in

Bangladesh

A Research Proposal

Researcher

Ganesh Chandra Dey

Lecturer
Department of Accounting
Govt. Ashek Mahmud College, Jamalpur

Department of Accounting & Information System

Business Studies Group
National University
Gazipur-1704

1. Statement of Problems:

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With the change of technology and other factors, the corporate environment of
Bangladesh is changing day by day along with the rest of the world. Adapting to
changing circumstances is important for the profitability of the organization. Today's
business world is competitive and dynamic. In this competitive and dynamic
environment, financial decisions for a company are extremely challenging for financial
managers. The financial decision of a company must influence the overall performance
and the profitability of the company. The capital structure consists of various long-term
sources of finance such as share capital, preferred capital, debt capital, and retained
earnings. Therefore, capital structure is the main issue of minimizing the overall cost of
capital and maximizing share value.
Increasing the overall performance of the company is the main objective of the capital
structure. Overall performance measures through the various issues like Profit ratio,
Return on Equity, Return on Assets, Earning per share. The capital structure influence
the firm’s performance. That the question arises; what are the impacts of the capital
structure of a firm’s performance? And how are the impacts of capital structure on firm’s
performance?

2. Review of Related Literature

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In 1959, the American economist David Durand introduced the method of net income
(NI) for the decision of the capital structure. According to the NI approach, the decision
on the structure of capital is relevant to the value of the firm and the overall cost of
capital. In this way the share of debt in the capital structure can be increased, the value
of the firm can be increased and the overall capital expenditure can be reduced. The
overall cost of capital means the average cost of equity capital and debt capital.
Increasing the amount of debt in the capital structure can increase the value of the firm
and reduce the overall cost of capital (WACC). On the other hand, reducing the amount
of debt in the capital structure can reduce the value of the firm and increase the overall
cost of capital (WACC). The basic premise of this theory is to maximize the value of the
firm by increasing the share price and reducing the overall cost of capital by increasing
the debt-to-capital ratio in the capital structure.
Assumptions of NI approach
a) There is no tax.
b) The cost of debt is less than the cost of equity and their cost are fixed.
c) Using different debt ratios does not change the risk perception of the firm's investors.

David Durand introduces another capital structure theory called the net operating
income method (NOI). The net income approach he introduced in 1959 is the opposite.
According to the NOI approach, the decision on the structure of capital is irrelevant to
the value of the firm and the overall cost of capital. In this approach, the overall cost of
capital and the degree of financial leverage are independent. That’s why the degree of
leverage will not affect the firm’s share price and market value firm.

Assumptions of NOI approach

a) The overall cost of capital (WACC) remains constant for using financial leverage.
b) There is no tax.
c) The cost of debt remains constant.
d) Using debt will increase the risk.
e) The increased risk will increase the expected return of shareholders.
f) Equity will have a residual value.

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The overall cost of capital and the cost of equity capital appear to be changeable in the
NI approach and the NOI approach, respectively. But these assumptions are not realistic
in practice. In order to remove these limitations, Ezra Solomon has introduced the
traditional approach which is a compromise between the NI and NOI methods. According
to the traditional approach, since the cost of debt is lower than that of equity, it is
possible to increase the value of the firm and reduce the overall cost of capital by using
a reasonable portion of the debt. According to Van Horne and Wachowicz, the traditional
method is a theory of capital structure so that an optimal capital structure exists and
where the total value of the organization can be increased through the use of rational
financial leverage.

In June 1958, American economists Franco Modigliani and Marton H. Miller wrote an
article in the American Economic Journal entitled "The Cost of Capital, Corporation
Finance, and Theory of Investment. In this article, they explain the theory of capital
structure formation. This theory is well known as M-M theory after its name. The basic
idea of M-M theory is that there is no relation between the value of the firm and the
cost of capital. Financial leverage also does not affect the cost of capital and value of
the firm and dividend policy irrelevant to determine the value of the firm. In MM
methods, it seems that earnings from any company's investment policy largely affect
the company's share price.

Assumptions of MM approach
a) There are no personal and corporate taxes
b) Similar companies deal with the same amount of business risk.
c) All current and potential investors have estimates of the future EBIT of each firm.
d)The capital market may perfect and remain constant
e) Debt is risk-free for companies and investors
f)In this approach, the overall cost of capital and cost of debt are fixed in the capital
structure.
g) Based on the above conditions, Modigliani and Miller think that the value of the firm
is determined by the NOI approach and the overall cost of capital. The value of the firm

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will remain the same for any level of financial leverage and it is not related to the capital
structure.

In 1963, Modigliani and Miller modified their previous theory to suit tax elements, and
this theory contained all previous assumptions. The value of the firm (v), cost of equity
(Ke), and the overall cost of capital (Ko) are valued by considering income tax. The
value of a levered firm is higher than that of an unlevered firm for existing corporate
taxes. There is an opportunity to get a tax shield on interest. As the tax increases along
with the growing debt, the value of the assigned firm also increases. Thus, the value of
the levered firm can be determined by adding the tax shield with the value of the
unlevered firm.

In 1977, Merton H. Miller introduced a theory of capital structure considering corporate

tax and personal income tax. This article titled "Debt and Taxes" has been published in
"Journal of Finance". The idea of this theory is that for existing corporate and personal
income taxes, the financial leverage can be used to increase the value of the firm that
means by using the debt of the capital structure. Tax-deductible income increases
shareholders' dividends. If the firm uses less debt capital, the EPS may decrease. Thus,
the value of the unlevered firm may be reduced. On the other hand, for the huge use
of debt, the EPS of the levered firm will increase as the EPS increases.

M-M’s capital structure irrelevant theory relies on some assumptions that do not include
bankruptcy expenses. However, going bankrupt in practice is costly. Bankruptcy
problems can arise when a firm uses more debt in its capital structure.
When there is a possibility of bankruptcy, key employees are transferred to new jobs,
suppliers oppose credit, customers look for more stable suppliers, and lenders demand
higher interest rates. According to Warner (1977) and Brealey & Myers (1992), the large
use of debt money reduces the firm's profitability and value of the firm by increasing
bankruptcy costs. Titman (1984) shows that when stakeholders may not be willing to
do business with a high-levered firm, bankruptcy costs occur and this affects the firm's
profitability.

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By adapting financial distress and agency cost with M-M/Miller theory without changing
any assumption, the trade-off theory is introduced in capital structure decisions. In this
model, the optimum capital structure may be achieved as a trade-off between the
benefit of debt (i.e. interest tax shelter) and the cost of debt (financial distress and
agency cost). For using debt the financial risk increases. But, the value of a firm
increases for the benefit of a tax shelter of debt. Through analyzing the benefits for debt
and cost of debt, if income and expenses may be equal then the optimum capital
structure is formed. To equalize the marginal income and expenses by using financial
leverage is the main concept of the trade-off theory. By considering the various
opportunity and the threats caused by debt financing, Trade-off theory (Myers 1984)
gives priority on debt financing.
Pecking Order Theory has been formulated by Myers and Majluf in 1984. According to
pecking order theory, firms have to accumulate funds as following order: a) internal
equity means retained earnings, b) new debt, and c) external equity means issuing new
equity shares. The cost of equity means the combination of the cost of newly issued
equity and the cost of retained earnings. The cost of debt is lower than the cost of both
these sources of an equity fund. In the case of the cost of new issuing equity funds and
retain earnings, the cost of retaining earnings is cheaper, because of paying personal
taxes in retain earnings distribution while no taxes are no paid on retaining earnings
also no flotation costs occur when earnings are retained. As a result of two sources of
equity fund (internal and external), the internal sources are preferred. If the internal
fund is not sufficient for the required investment opportunity, then the firms go to
external finance issuing debt or various hybrids securities then issue new equity shares.
The pecking order theory states that negative relation exists between Capital Structure
and profitability. Because the more profitable firm generally it borrows lower and vice
versa.
The relationship between capital structure and the profitability of an organization is an
important issue for researchers and practitioners for financial decision making. Much
research has been conducted to analyze the impact of capital structure on profits around
the world. Some studies interpret the experience literature as an experience in the
following table:

Authors Empirical evidence

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 Country 10Developing countries

Periods 1980 to 1991

Methods Cross-sectional Regression

Booth & others.
(2001)  A negative effect of profitability on leverage is
found.
Findings  Higher performance is not essentially being lead
towards by leverage.

Mendell & others Country United States

(2006) Periods 1994 to 2003
Methods Dynamic panel mode
The study finds that:
Findings  A negative relationship between profitability and
debt.
 A positive relationship between non-debt tax
shields and debt.
 A negative relationship between firm size and
debt.
Abor (2005) Country Ghana
Periods 1998 to 2002
Methods Regression analysis
The Result reveals that
Findings  a significantly positive relationship between the
ratio of short-term debt to total assets and
ROE
 a negative relationship between the ratio of
long-term debt to total assets and ROE.

Gill, et al. (2011) Country United State

Periods 2005 to 2007

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 Methods Correlations and regression analysis
Findings  There is a positive relationship between

 shortterm debt to total assets and profitability

and between total debt to total assets and
profitability
 This research show a positive relationship
between short-term debt to total assets and
profitability, long-term debt to total assets and
profitability, and between total debt to total
assets and profitability.

Rafiu Oyesila Country Nigeria

(2009) Periods 1990 to 2004
Methods Ordinary Least Squire (OLS),Fixed Effect Model
(FEM) and Random Effect Model (REM)

Findings The research shows

 a positive correlation between profitability and
short-term debt-equity ratio and a negative
correlation between profitability and long- term
debt-equity
 a negative association between the ratio of total
 debt to total assets and profitability.

Fawzi et al (2012) Country Jordan

Periods 2004 to 2009
Methods Correlation and multiple regression analysis

 They state that a significantly negative

Findings relationship between debt and profitability.
 This suggests using equity capital as their first
choice of financing for profitable firm.
T. Velnampy & Country Sri Lanka
J.Aloy Niresh Periods 2002 to 2009

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(2012) Methods Descriptive statistics & correlation analysis
A negative association is exists between capital
Findings structure and profitability.

Dr. Khalid Asraf Country India

Chisti, et al, Periods 2007-2008 to 2011-2012 correlation
(2013) Methods analysis

 The researchers conclude that debt to equity is

Findings negatively correlated to profitability.
 Debt to assets ratio and interest coverage ratio
is positively and significantly correlated with the
profitability.

Mohamed M. Country America

Khalifa Tailab Periods 2005 to 2013
(2014) Methods Multiple Regression (Partial Least Squire)

 Research explains that capital structure affects

Findings profitability.
 There is a significant negative impact of total
debt on ROE and ROA.
 The firms size (in terms of sales) has significant
negative effect on ROE
 There is a significant a significant positive
 effect of short debt on ROE.
 There is an insignificant (negative or positive)
relationship between long-term debts, debt to
equity and size (in terms of total assets) and
profitability.

Charles Yegon, et Country Kenya

al. (2014) Periods 2004 to 2012
Methods Dynamic panel data technique

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  There is a significantly positive relation between
Findings short term debt and profitability.
 On the other hand, there is a significantly
negative relation between profitability and long
term debt.

D.K.Y Country UK
Abeywardhana Periods 1998 to 2008
(2015) Methods Two Stage Least Squire
Findings  The results show a significant negative

 relationship between capital structure and

profitability.
 The firm‟s size is an important factor for
measuring profitability.

Rathiranee Country Sri Lanka

Yogendrarajah Periods 2008 to 2012
(2015) Methods Descriptive Statistics, Correlation analysis and
Regression analysis
Findings Research found
 significant impact of debt to equity on net profit
and ROE

 Insignificant impact of debt to equity on gross

profit, ROA and return on capital employed.

 Insignificant impact of debt to total assets on

gross profit, net profit, ROE, ROA and return on
capital employed.

Anandasayanan Country Sri Lanka

s Periods 2008 to 2012

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& Methods Correlation and fixed effect regression analysis
Subramaniam A significant negative relation is shown between
V.A. Findings debt and profitability.
(2015)
S. Revathy & Dr. Country India
V.Santhi April,1991 to March, 2012
(2016) Periods Structural Equation Modeling (SEM)
Methods There are a strong negative relationship between
capital structure and profitability.
Findings

Tariku Negasa Country Ethiopian

(2016) 2006/07 to 2010/11
Periods Linear regression model
Methods The research shows the significant positive
Findings relation between total debt ratio and profitability.

Alhassan Musah Country Ghana

(2018) 2010 to 2015
Periods Multiple regression model
Methods  There is a negative relation between short term
Findings debt and long term debt with profitability
 There is a positive association of total debt with
profitability.

 Firm‟s size, foreign ownership, and age of the

firm are positively associated with

profitability.
Growth rate of customer deposit is negatively
associated with profitability.

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 Peter Njagi Kirmi Country Kenya
(2018) Periods 2012 to 2016
Methods Correlation and regression analysis
Findings The study shows
 The significant positive relation between short
term debt and ROA.
 Long term debt is average negatively related
with ROA.
Md. Ataur Country Bangladesh
Rahman, Periods 2013 to 2017
Md. Sadrul Methods Multiple linear regression model
Islam & Findings The research shows that
Md. Joyen Uddin  There is a significantly positive impact of debt
(2019) ratio and equity ratio on ROA.
 There is a significantly negative impact of Debt
to equity ratio on ROA.
 Equity ratio has a significantly positive impact on
ROE.
 Debt to Equity ratio has a significantly negative
effect on ROE & EPS.
From the above empirical literature review, we see that the authors give several
different
Findings based on their research work. Some of them state that there is a significantly
positive impact of capital structure on profitability. The other group states that there is
a significantly negative impact of capital structure on a firm‟s profitability. There is
another group they show there is an effect of capital structure on profitability. Now, the
main hypothesis of this research that will be tested is as follows:

H1: There is some effect of capital structure on the profitability of a company.

H2: There is no effect of capital structure on the profitability of a company.

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2.2 Determinants of Firm`s Profitability:
Some variables may be associated to determine the profitability of a company. In this
chapter, such types of variables are mentioned.

1 Liquidity:
Liquidity means the ability of a company to meet the short term liability. Liquidity risk
may be identified by calculating the liquidity ratio and liquidity gap. The liquidity gap is
the difference between liabilities and assets based on present and future data. Liquidity
directly affects the investment capacity of the company. If the company wants to
increase its liquidity position, it should keep more unused cash. The investment also
directly affects the profitability of the company. So, it can be said that liquidity is an
important determinant of a company’s profitability.

H2: There is a strong association of liquidity on the profitability of a company.

H3: There is no association of liquidity on profitability.

2 Firm’s Size:
Mohamed M. Khalifa Tailab, (2014) states that the firm’s size (in terms of sales) has a
significant negative effect on ROE. The firm size may be explained in terms of sales or
terms of total assets. The firm is profitable means it uses its assets effectively for
generating income that is important for investment and meeting short term financial
obligations. Large firms buy a large number of units at a time, for this reason, it gets a
discount opportunity from suppliers. Discount minimizes the operational cost and
directly affects profitability.

H4: There is an association of the firm’s size on the profitability of the firm.
H5: There is no association of the firm’s size on the profitability of the firm.

4 Managerial Efficiency:

Efficiency means the ability to earning the best output by providing a minimum effort.
The managerial efficiency of performing required activities may be varied the

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profitability of the firm by firm. The managerial efficiency may an important determinant
of the profitability of the company.

H6: There is an association of managerial efficiency on the profitability of the company.

H7: There is no association of managerial efficiency on the profitability of the company.

3. Conceptual Framework:
The summary of the conceptual framework of this study is mention below:

Independent Variable
a) Short term debt ratio
b) Long term debt ratio
c) Equity ratio
d) Debt to equity ratio
Dependent Variable
a) Gross profit ratio
b) Net profit ratio
c) Return on equity
d) Return on assets
e) Earning per share
Controling variable
a) Liquidity
b) Firm size
c) Managarial efficiency

4. Objectives of the study:

Every study has some objectives. The objectives of this study are as follows:

1. To analysis relationship between capital structure and profitability of companies

listed in Dhaka Stock Exchange in Bangladesh.

2. To find out the effect of capital structure on profitability.

3. To identify an optimum capital structure that may maximize the profitability of
the company.
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 4. To provide some recommendations to the respective persons that will be helpful
to make decision in capital structure for maximizing the profitability of the
company.

5. Methodology of the study:

To perform any research work researcher has to follow a systematic way to solving
research problem. This chapter includes research design, population, sampling design
& data collection, time period of the study, data analysis and analytical model that will
be applied for conducting this study.

5.1 Research Design:

The quantitative research design is applied for this study. Descriptive, correlational,
quasi-experimental and experimental are the four types of quantitative research
designs. For calculating profitability and ratio of capital structure the descriptive design
will be used and for determining the relationship between capital structure and
profitability, the correlation design will be used.

5.2 Population:
Population refers all the people, proceedings and objects that may be observed and
measured for any research. At present, 578 listed companies in Dhaka Stock Exchange
are treated as population of this study.

5.3 Sampling Deign:

Since, the population size is known; the following Yamane’s formula will be used for
determining the sample size in this study:

Here, n= sample size, N= population size, and e= Margin of error

The total companies listed in Dhaka Stock Exchange will be classified into three types
as manufacturing, merchandising and service rendered. After that, by using above

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formula sample size will be determined. The random sampling technique will be used
for selecting sample. But the personal judgement may be used for omitting the selected
companies which may have possibility to affect the result by marginal values.

5.4 Data Collection:

Data may be collected from secondary source for this study. The main source of data
will be the audited financial statements of the companies. The audited financial
statement may be collected from website of DSE or website of selected companies.

5.5 Time Period of the study:

Five years (2014 to 2018) audited financial statements of selected listed companies in
DSE will be collected and analyzed.

5.6 Data Analysis:

To analysis the data inferential statistics & descriptive statistics will be used. Pearson‟s
coefficient of correlation and regression analysis is inferential statistics that will be used
for determining the relationship between capital structure and profitability. To establish
the trend and patterns of the variables descriptive statistics (mean, standard deviation,
minimum and maximum value) will be sued.

5.7 Analytical Model:

Multiple regression models will be used to determine the effects of capital structure and
profitability. In multiple regression equation capital structure variables (Short term debt
ratio, long term debt ratio, equity ratio and debt to equity ratio) and control variables
(liquidity, firm‟s size in terms of sales, firm‟s age and managerial efficiency) will be
treated as independent variables. On the others hand, the profitability (Gross Profit
Ratio, Net Profit Ratio, return on Capital Employed, ROE, ROA, and EPS) will be treated
as dependent variables. A sample of multiple regression models is as follows:
Yˆ = A + B1(X1) + B2(X2) + B3(X3) + B4(X4) + ε
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Yˆ = Predicted Value of the dependent variable A
= Constant
B1 = Slope of Variable 1 X1 = Chosen value of Variable 1
B2 = Slope of Variable 2 X2 = Chosen value of Variable 2
B3 = Slope of Variable 3 X3 = Chosen value of Variable 3
B4 = Slope of Variable 4 X4 = Chosen value of Variable 4
ε=is the error term within a confidence interval

6. Plan of the study:

It is proposed that the study to be presented as per following plan. It may be changed.
Chapter 1 : Introduction
1.1: Statement of the problem
1.2: Scope of the study
1.3: Objectives of the study
1.4: Significance of the study
1.5: Limitations of the study
1.6: Hypotheses of the study
Chapter 2: Historical background & present situation of Dhaka Stocks Exchange.
Chapter 3: Review of the related literature
Chapter 4: Methodology of the study
Chapter 5: Theoretical Framework
Chapter 6: Analysis and Interpretation of data
Chapter 7: Conclusion, Suggestions and Policy Implications
Bibliography
Appendix

7. Expected Contributions towards the study:

It is hoped that an effective and fruitful result would be come through this study. The
expected important contributions of the study are given below:

1. The findings will be helpful for the policy maker like Securities &b Exchange
Commission for ensuring that the listed companies maintained for optimum
structure.

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 2. This will be helpful for the companies to collect cheaper funds for maximizing its
profitability.

3. The findings of this study may be used as a reference by the researcher who will
conduct further research in this filed.

8. Time Schedule

SL Particulars month
1. Literature review 1
2. Development of Theoretical Framework 1
3. Collection of Data 3
4. Analysis of Data 3
5. Draft report writing 2
6. Finalization of report 2
Total 12

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