Capital Structure

&
Stock Market
Price
The impact of Capital Structure on
Financial Performance of the firms:
Evidence From Borsa Istanbul
WHY THIS CHAPTER MATTERS TO YOU
• ACCOUNTING You need to understand how to calculate and analyze operating and
financial leverage and to be familiar with the tax and earnings effects of various capital
structures.
• INFORMATION SYSTEMS You need to understand the types of capital and what capital
structure is because you will provide much of the information needed in management’s
determination of the best capital structure for the firm.
• MANAGEMENT You need to understand leverage so that you can control risk and
magnify returns for the firm’s owners and to understand capital structure theory so
that you can make decisions about the firm’s optimal capital structure.
• MARKETING You need to understand breakeven analysis, which you will use in pricing
and product feasibility decisions.
• OPERATIONS You need to understand the impact of fixed and variable operating costs
on the firm’s breakeven point and its operating leverage because these costs will have a
major impact on the firm’s risk and return.
LEVERAGE
• Refers to the effects that fixed costs have on the returns that shareholders
earn.
• By “fixed costs” we mean costs that do not rise and fall with changes in a
firm’s sales.
• These fixed costs may be
• operating costs, such as the costs incurred by purchasing and operating plant and
equipment, or
• financial costs, such as the fixed costs of making debt payments.

• Generally, leverage magnifies both returns and risks. A firm with more
leverage may earn higher returns on average than a firm with less leverage, but
the returns on the more leveraged firm will also be more volatile.
DIFFERENT SOURCES OF LEVERAGE
• Operating leverage
When costs of operations (such as cost of goods sold and operating expenses) are largely
fixed, small changes in revenue will lead to much larger changes in EBIT.
• Financial leverage
On the income statement, you can see that the deductions taken from EBIT to get to EPS
include interest, taxes, and preferred dividends.
Taxes are clearly variable, rising and falling with the firm’s profits, but interest expense and
preferred dividends are usually fixed.
When these fixed items are large (that is, when the firm has a lot of financial leverage), small
changes in EBIT produce larger changes in EPS.
• Total leverage
It is concerned with the relationship between the firm’s sales revenue and EPS.
DIFFERENT SOURCES OF LEVERAGE
FINANCIAL LEVERAGE
• The use of fixed financial costs to magnify the effects of changes in
earnings before interest and taxes on the firm’s earnings per share.
MEASURING THE DEGREE OF FINANCIAL
LEVERAGE (DFL)
• Whenever the percentage change in EPS resulting from a given
percentage change in EBIT is greater than the percentage change in
EBIT, financial leverage exists.
• This means that whenever DFL is greater than 1, there is financial
leverage.
WHAT IS CAPITAL STRUCTURE?
• What is Capital Structure?
• Capital Structure refers to the amount
of debt and/or equity employed by a
firm to fund its operations and
finance its assets. The structure is
typically expressed as a debt-to-
equity or debt-to-capital ratio.
• There are tradeoffs firms have to
make when they decide whether to
raise debt or equity and managers
will balance the two try and find the
optimal capital structure.
OPTIMAL CAPITAL STRUCTURE
The proportion of debt and equity that minimize weighted average cost of capital
(WACC) for the firm and maximize the company value by reducing the expected level
of financial risk considering the pros and cons.
WHAT IS CAPITAL STRUCTURE? (CONT.)
Cost of capital
A firm’s total cost of capital is a weighted average of the cost of equity and the cost of
debt, known as the weighted average cost of capital (WACC).
The formula is equal to:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
Where:
E = market value of the firm’s equity (market cap) | D = market value of the firm’s debt
V = total value of capital (equity plus debt) | E/V = percentage of capital that is equity
D/V = percentage of capital that is debt
Re = cost of equity (required rate of return)
Rd = cost of debt (yield to maturity on existing debt)
T = tax rate
ASSESSMENT OF CAPITAL STRUCTURE
• Debt ratio (total liabilities / total assets): to what extent I am using loans to finance my
projects. The higher this ratio is, the greater the relative amount of debt (or financial
leverage) in the firm’s capital structure.
• TIE ratio, times interest earned ratio (EBIT / interest): While taking loans, start to get
warry when TIE ratio is decreasing.
&
• Fixed Payment Coverage ratio: to be more conservative all fixed financial costs are
considered (Interest payments, Dividends for preferred stocks & Lease)

Measures of the firm’s ability to meet contractual payments associated with debt. The
smaller these ratios, the greater the firm’s financial leverage and the less able it is to meet
payments as they come due.
HIGHLIGHT
• PROBLEM happens:
When interest increase (debt ratio) while TIE ratio decrease …
here is an expectation to face a financial distress
>> if profitability is decreasing, you can’t cover interest payments … debt
ratio is increasing.
IMPORTANT CONSIDERATIONS
IMPORTANT CONSIDERATIONS
CAPITAL STRUCTURE BY INDUSTRY

Capital structures can vary significantly by industry.

Cyclical industries like mining are often not suitable for debt, as their cash flow
profiles can be unpredictable and there is too much uncertainty about their ability to
repay the debt.
Other industries like banking and insurance use huge amounts of leverage and are
their business models require large amounts of debt.
Private companies may have a harder time using debt over equity, particularly
small business which are required to have personal guarantees from their owners.
CAPITAL STRUCTURE BY INDUSTRY
HOW TO RECAPITALIZE A BUSINESS

A firm that decides they should optimize their capital structure by changing the mix
of debt and equity has a few options to effect this change.
• Issue debt and repurchase equity
This has the effect of increasing the amount of debt and decreasing the amount of
equity on the balance sheet.
• Issue debt and pay a large dividend to equity investors
This has the effect of reducing the value of equity by the value of the divided. This is
another method of increasing debt and reducing equity.
• Issue equity and repay debt
Since equity is costlier than debt, this approach is not desirable and often only done
when a firm is overleveraged and desperately needs to reduce its debt.
PROS & CONS
Characteristics of equity: Characteristics of debt:

• No interest payments • Has interest payments

• No mandatory fixed payments • Has a fixed repayment schedule

• No capital repayment • Has a lower cost than equity

• Has ownership and control over the business • Requires covenants and financial
and has voting rights performance metrics that must be met

• Has last claim on the firm’s assets in the • Has first claim on the firm’s assets in the
event of liquidation event of liquidation

• Expects a high rate of return • Expects a lower rate of return than equity

• Provids maximum operational flexibility • Contains restrictions on operational

flexibility
CAPITAL STRUCTURE THEORIES
• Modigliani and miller (mm) theory (1958, 1963)
• 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.
>> Under certain assumptions of “Perfect Market” include:
• no taxes,
• homogenous expectations,
• perfect capital markets,
• no transaction costs,
• rational investments,
• matching capability between loans and equity at any time,
• no taxation across countries,
• board of directors are 10/10
Capital structure theories (cont.)
• Modigliani and miller (mm) theory (1958, 1963), visualized

Assets Debt Assets Debt Assets Debt

0% 20% 60%
100% 100% 100%
Equity Equity Equity

100% 80% 40%

Value of Unleveraged Firm (VU) = Value of Leveraged Firm (VL)

Capital structure theories (cont.)
• Modigliani and miller (mm) theory (1958, 1963), practice on STOCK PRICE

An all equity firm has a market value of $300,000 and 50,000 shares outstanding. It is thinking
of changing its capital structure by borrowing $120,000 in debt and repurchasing shares.
Ignore Taxes.

Assets Debt VU = V L Assets Debt # of Shares repurchased =

$120,000/$6=20,000 shares
$0 $120,000
$300,000 $300,000 # of Shares remaining =
Equity Equity 50,000-20,000 = 30,000 shares
$300,000 $180,000
Equity =
50,000 30,000
shares shares $300,000-$120,000 = $180,000
Share Price= Share Price= Share Price is CONSTANT
$300,000/50,000=$6 $180,000/30,000=$6 (in no tax world)
RELAXED CAPITAL STRUCTURE THEORIES
Why companies may use a high debt ratio? >>> to get advantage of tax
benefits.
Taxes are payable >>> then benefits of using loans will come up (tax
shield). A theory named “Tax Theory”.
On the other hand: more interest payments higher probability for
financial distress. The “Trade Off Theory”.
Try to use loans that maximize the firm value while you have to consider
the interaction between the debt level and level of financial distress
(measured by financial risk).
RELAXED CAPITAL STRUCTURE THEORIES (cont.)
Why to use one source than another??
“Pecking order theory” is the valid theory to explain the capital structure at the
Egyptian market.
Peck the internal resources first. Second try to use loans.. why loans? Because it
has fixed payments with lowest cost. Last option is to issue stocks in the stocks
market (it has a transaction cost and raise risk of being overpriced or
underpriced.)
Optimal order:
1. Internal funds
2. Loans
3. New stocks
RELAXED CAPITAL STRUCTURE THEORIES (cont.)
We assumed a board of directors who are efficient. Let’s relax this assumption.
More loans puts more restrictions on the company and may cause “Signaling”.
SIGNAL: A financing action by management that is believed to reflect its view of
the firm’s stock value; generally, debt financing is viewed as a positive signal that
management believes the stock is “undervalued,” and a stock issue is viewed as a
negative signal that management believes the stock is “overvalued.”
The agency problem could explain: The lender–borrower relationship,
therefore, depends on the lender’s expectations for the firm’s subsequent
behavior. The borrowing rates are, in effect, locked in when the loans are
negotiated.
After obtaining a loan at a certain rate, the firm could increase its risk by
investing in risky projects or by incurring additional debt. Such action could
weaken the lender’s position in terms of its claim on the cash flow of the firm.
HIGHLIGHT
Each company according its industry regulations and its board
composition can follow a certain capital structure.
CAPITAL STRUCTURE BY BUSINESS LIFE CYCLE
Refer to firm life cycle (phases)
• Launch
• Growth
• Maturity
• Decline
Each phase has characteristics… each phase has optimal debt and optimal
dividends.
CAPITAL STRUCTURE BY BUSINESS LIFE CYCLE
Launch stage

Small company (new in the market):

small size – small assets >> low opportunity to get loans from bank.
Privet ownership depending on owners.
Highest business risk (no sales yet).
Stability of earnings >> unexpected.
So, optimal here is internal resources (pecking order). All profits to be
reinjected again in investments.
CAPITAL STRUCTURE BY BUSINESS LIFE CYCLE
Growth stage

The company get bigger and its growth get higher:

Go to be registered in NILEX stock market.
More stability in earnings.
Business risk still exist but little less.
Ownership structure changed by being in the stock market.
If went to the bank with good projection about its business then it may
take loan.
CAPITAL STRUCTURE BY BUSINESS LIFE CYCLE
Maturity stage
Getting bigger.
Become a cash cow. More stability. Banks like them.
Growth rate is stable (if remained stable it will decline.)
Profitability more stable. High cash flow.
Business risk is minimum.
Why not to increase the debt ratio in order to increase the company value.
Cash will be spent in Social Responsibilities or pay dividends. Decrease internal
funds. Use more loans.
Diversification will appear more at this phase.
CAPITAL STRUCTURE BY BUSINESS LIFE CYCLE
Decline stage
At the decline: all go down.
Has to increase the opportunities.
Business risk start to increase again.
Profitability start to decrease.
Can’t raise capital form stock market because investors are reluctant towards the
company’s stocks.
Bank is not firm about the profitability.
Then at decline stage we have to restructure. Like holding companies. Valuate
the unutilized assets. Sell them. It was risky inventory. Sell.. get the cash.. pay
part of the liabilities and reinvest part. Merging could be a solution too. Leasing
too.
WHAT ARE THE FACTORS THAT AFFECT THE
OPTIMAL CAPITAL STRUCTURE?
Optimal capital structure is the mix of long-term financial resources that
minimize the cost of capital and maximize the firm value also controlling the
level of financial risk.
The theories of capital structure are valid to be explained depending on your
firm characteristics.
Factors affecting the capital structure:
1. Industry type which reflects the business risk.
2. Type of Diversification.
3. Stability of earnings.
4. Company size.
5. Business life cycle.
6. Financial flexibility (less DR higher TIE from high profits = high Fin. Flex.)
THESIS
The impact of Capital Structure on Financial
Performance of the firms:
Evidence From Borsa Istanbul
Abstract
• The paper tries to examine the impact of capital structure on the financial firm performance of
industrial companies in Turkey.

• The annual financial statements of 136 industrial companies listed on Istanbul Stock Exchange
(ISE) were used for this study which covers a period of 8 years from 2005-2012.

• A multivariate regression analysis is applied to test the relationship between capital structure
and firm performance.

• To measure firm performance used indicators such as Return on Asset (ROA), Return on Equity
(ROE) and Earning per Share (EPS)

• as well as Debt Ratio (DR) as capital structure variable.

• The results show that there is a negative significant relationship between capital structure and
firm performance.
Literature review
• 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.

• Salteh paper explores the impact of capital structure on firm performance in Iranian corporations
listed as a vehicles and parts manufacturing economic sector in Tehran Stock Exchange (TSE).

• 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.

• Iorpev and kwanum study investigates the relationship between capital structure and firm
performance of manufacturing companies listed on the Nigerian Stock Exchange. They covered a
period of five (5) years from 2005-2009.

• Onaolapo and Kajola study investigates the influence of capital structure on financial firm
performance, applied on non-financial firms listed in Nigerian Stock Exchange according the period
from 2001 to 2007.
Variables measurement and empirical model
Dependent Variable  Firm Performance Independent Variable  Capital Structure

• Earnings per share (EPS) Capital structure of a firm is measured by

different accounting based methods like short
• Return on equity (ROE) term liability to total assets, long term liability
to total assets and total debt to total assets.
• Return on assets (ROA)

Debt Ratio = Total Debt ÷ Total Assets

Hypotheses
The following hypothesis is formulated for the study:

• H1:

There is a negative relationship between capital structure (DR) and financial performance (ROE).

• H2:

There is a negative relationship between capital structure (DR) and financial performance (ROA).

• H3:

There is a negative relationship between capital structure (DR) and financial performance (EPS).
Results and Discussions
Descriptive statistics
Correlation analysis
Regression analysis
Descriptive statistics
• Table 1 gives the detail of descriptive
statistics of the variables used in this
paper.

• First row of the table shows the mean of

the variables including debt Ratio (DR),
earnings per share (EPS), return on assets
(ROA), and return on equity (ROE).

• The respective mean values are 46.528,

0.619, 4.455, and 7.881
Correlation analysis
• Table 2 shows the relationship between Performance
variables (EPS, ROE, and ROA) and capital structure
variable (DR).

• The correlation between DR and EPS is -0.088.

Significant level is 0.01. The co-efficient of
determination is 0.0077. That is 0.7% of variance in
the capital structure is accounted by the EPS.

• The correlation between DR and ROE is -0.287.

Significant level is 0.01. The co-efficient of
determination is 0.015. That is 1.5% of variance in the
capital structure is accounted by the ROE.

• The correlation between DR and ROA is -0.124.

Significant level is 0.01. The co-efficient of
determination is 0.082. That is 8.2% of variance in the
capital structure is accounted by the ROA.
Regression analysis
• Regression analysis is used to examine the impact of
capital structure on financial performance of the
listed companies traded in Istanbul stock exchange
(Table 3).

• The result indicates a negative significant relation

between DR and all financial performance variables
(EPS, ROE, and ROA).

• This means an increase in DR by one dollar will

increase EPS, ROE, and ROA by 0.009, 0.12, 0.12
dollar respectively.

• R2 in average is 3.4%; means only 3.4% of variance of

performance variables is accurate by these factors.
But, remaining 86.60% of variance with performance
variables is attributed to other factors.
Findings
• Based on the empirical results of this study, we accept all of three hypotheses (H1, H2,
and H3) which referred to a negative relationship between capital structure and
financial firm performance (EPS, ROE, ROA).
• These results are consistent with Mumtaz, Le and Phung, Salteh, Ahmad and
Onaolapo, Kajola [8-11,13], who pointed to the negative relationship between
capital structure and financial firm performance.
• While inconsistent with Badar and Saeed who found a significant positive relation
between capital structure and firm performance [7].
• As well as Iorpev and kwanum, who found that capital structure and firm
performance have insignificant negative relation [12].
Conclusion
• This study investigates the impact of capital structure on firm performance in
Istanbul’s stock market, particularly on industrial sector companies listed under
XUSIN index.
• Our results suggest that firm’s capital structure is negatively and significantly
associated with financial firm performance which defined by (EPS, ROE, and ROA
variables).
• That mean using a high level of debt negatively affects a firm’s return on assets,
earnings per share, and return on equity.
References
• Corporate Finance Institute® (CFI) https://corporatefinanceinstitute.com/

• Journal of Business & Financial Affairs; Nassar, J Bus Fin Aff 2016, 5:2 DOI: 10.4172/2167-
0234.1000173

• American Economic Association https://www.jstor.org/stable/1809766

• Emerald Publishing
https://www.emeraldinsight.com/doi/abs/10.1108/15265940510633505?journalCode=jrf

• EBSCOhost® Connection
http://connection.ebscohost.com/c/articles/83517884/comprehensive-review-capital-
structure-theories

• The Journal of Online Education, New York

http://www.nyu.edu/classes/keefer/waoe/roshanb3.pdf

• The Academic Informa http://academicinforma.com/pdf-files/ech/517/78-

86%20Vol%205,%20No%205%20(2013).pdf
‫!‪Thank you‬‬
‫محمد عادل محمد سليم‬ ‫‪.1‬‬

‫محمود أحمد محمد صالح‬ ‫‪.2‬‬

‫محمد منير محمد متولي‬ ‫‪.3‬‬

‫يحيى محمد عبد الجواد عبد هللا‬ ‫‪.4‬‬

‫هشام حسام الدين محمد عبد الرحمن‬ ‫‪.5‬‬

‫محمد عبد المحسن عالء الدين القيسي‬ ‫‪.6‬‬