Muhammad Siddiqui MSc Accounting with Finance

London South Bank University

Department of Accounting and Finance Faculty of BusinessLondon South Bank University_____________________Impact of Capital Structure on Firm Performance_____________________

Literature ReviewMSc. Accounting with Finance

29th May 2014(Word count circa 4,600 excluding References)

Table of Contents1.CONTEXT41.1INTRODUCTION41.2CRITICAL REVIEW OF THE LITERATURE51.3RESEARCH PHILOSOPHY A GENERAL VIEW61.3.1Evaluation of philosophical implications underpinning the articles61.3.2The theoretical framework61.3.3Positive Accounting Theory61.4RESEARCH APPROACH A GENERAL VIEW71.4.1Assessment of the research approach underpinning the articles71.5RESEARCH STRATEGIES A GENERAL VIEW71.5.1An assessment of the research strategies employed81.6PRINCIPLE DEFINING FEATURES OF THE RESEARCH ARTICLES8This section briefly outlines the identified possible:81.6.1The possible aims of the reviewed articles81.6.2The possible objectives of the reviewed articles91.6.3The possible hypothesis of the reviewed articles91.6.4The possible research questions102.LITERATURE REVIEW102.1EVALUTION OF THE KEY RESEARCH FINDINGS AND EVIDENCE TO SUPPORT THOSE FINDINGS122.1.1The sampling Technique132.1.2The data and related quality issues142.1.3Evaluation of the key research findings and evidence to support those findings142.1.4Reliability and Validity in quantitative research16Validity16Internal validity16External validity16Reliability172.1.5Biasness in data interpretation172.1.6Limitations of research172.1.7Ethical issues172.2CONCLUSION ON RESEARCH182.3FUTURE RESEARCH RECOMMENDATIONS18

MSc Accounting with Finance

1. CONTEXTThe purpose of this literature review is to assess the relationship between capital structure and firm performance. The reason for addressing this phenomenon is that decisions relating to capital structure have always been substantial ones that companies confront and plays an important role in setting financial strategies for the company. This literature review also evaluates the theoretical framework on which the journals were based.

1.1 INTRODUCTIONLiterature review will be based on the relationship between capital structure and firm performance. In so doing it will evaluate the work of the past researchers and will critically evaluate it and at the end of evaluation recommendation for future research work will be made. This literature review is mainly based on the four academic journals but it also includes other relevant articles as well. Following are the journals that have been used for this literature review. See appendices for hard copies of journal. The following journal articles are analysed in this literature review on the theme of capital structure of the firm:

Journal Review 1 (Appendix A)The relationship between capital structure and firm performance: Evidence from Jordan by Khalaf Al-TaaniJournal Review 2 (Appendix B)The effect of capital structure on profitability: an empirical analysis of listed firms in Ghana by Joshua AborJournal Review 3 (Appendix C)Capital structure and financial performance: Evidence from selected business companies in Colombo Stock Exchange Sri Lanka by Puwanenthiren PratheepkanthJournal Review 4 (Appendix D)Relationship between cost of capital and accounting criteria of corporate performance evaluation: Evidence from Tehran Stock Exchange: by Abbasali Pouraghajan, Naser Ail Yadollahzadeh Tabari, Aliakbar Ramezani, Elham Mansourinia, Milad Emamgholipour and Pejman Majd1.2 CRITICAL REVIEW OF THE LITERATUREThis literature review will critically evaluate the above four journals from the research perspective and in so doing evaluate the systematic approach (or otherwise) of the four research articles. Thus, enabling an evaluation of the credibility of their findings/results based on the robustness of the research design. This critical evaluation of the four journal articles is much predicated by Saunders et al (2012, pp. 128-9), specifically using their Research Onion as a guiding tool for the critical appraisal. Accordingly, the literature review will focus on and discuss the following research-related issues:

1. RESEARCH PHILOSOPHY A GENERAL VIEW Evaluation of the philosophical implications underpinning the of journal articles;

1 RESEARCH APPRAOCH A GENERAL VIEW Assessment of the research approach underpinning the articles

2 RESEARCH STRATEGIES AND CHOICES A GENERAL VIEW An assessment of the research strategies and choices employed;

Using the Saunders et al (2012) Research Onion as the guiding tool in evaluating the journal articles of interest, it is hoped that a well round and critical evaluation will be presented. On this basis, and in the above context, issue 1 is first discussed below in Section

1.3 RESEARCH PHILOSOPHY A GENERAL VIEWResearch philosophies are guiding principles that influence the choices in a system research approach. A researcher may be influenced by one of the Positivistic or Interpretivist paradigms. Guba & Lincoln (1994), argue that questions of research methods are of secondary importance to questions of which paradigm is applicable to your research. They note that both qualitative and quantitative methods may be used appropriately with any research paradigm. Questions of method are secondary to questions of paradigm, which are defined as the basic belief system or world-view that guides the investigation, not only in choices of method but in ontologically and epistemologically fundamental ways. In the above context, it is apparent that paradigm inclination by a researcher will greatly influence the research outcome(s).

1 1.1 1.2 1.3 1.3.1 Evaluation of philosophical implications underpinning the articles Each journal has implemented a positivist accounting framework. The philosophical framework takes after an epistemological point of view, which is objective in nature and has an unbiased viewpoint. As we know that epistemology explains the relationship linking the researchers and research, we have a dependant relationship. Whereas Ontological research has multiple realities; and therefore leads to a subjective interpretations of the data by the researchers. All these four journals have an objective interpretation.

1.3.2 The theoretical frameworkThe aim behind this section is to present a detail review of the underpinning accounting theory in context to these four journals.

1.3.3 Positive Accounting TheoryThe positivistic accounting theory developed for the finance sector, proposed after the seminal work of Modigliani and Miller (1958). Their study was strongly criticised due to its unrealistic and impractical assumptions as they ignored some fundamental market realities like transaction costs, bankruptcy costs and taxation costs. However Modigliani and Miller (1963) later re-assessed their Irrelevance theory and concluded that the capital structure of the firm has a positive impact on the corporate firm with higher debt. Subsequently Jensen and Meckling (1976) concluded that there is a relationship between capital structure and firm performance which was a ground-breaking work in the corporate finance field. The four journals examine the conceptual framework of capital structure which is considered to be one of the most important consequential frameworks in relation to firm performance and firm value.

1.4 RESEARCH APPROACH A GENERAL VIEWScientific research approach suggests that there are two competing ways by which research is conducted i.e. deductive reasoning and inductive reasoning. Deductive reasoning in research adopts that involves theory testing, thus a generalist approach leads to a specific outcome on the basis of premises that are predefined and known as hypotheses (Top-Down approach) (Green, 2003). Inductive reasoning adopts an opposite approach to inductive reasoning. A bottom-up strategy is employed whereby the researcher moves from specific issues to more general outcomes, thus, theory creating. How the research approaches re applied to the four journal articles is now discussed below (Babbie, 2010).

1.4 1.4.1 Assessment of the research approach underpinning the articlesAll the four journals have used deductive approach, which takes into account the hypothesis based on existing theory and then design a research strategy to test that hypothesis. The research study has employed positivistic accounting theory, ex post facto research method and correlational research methods of quantitative research. The research is quantitative in nature and all four journals have followed a deductive approach where researchers have employed methods from quantitative research, such as ex post facto research method and correlational methods and conclusion based on the analysis of the data. All four journals have done a detailed navigation at research question & theoretical level.

1.5 RESEARCH STRATEGIES A GENERAL VIEWStrategies in research generally fall under the two competing views, i.e. Quantitative research and Qualitative research. Since the nature of the two types of research differs not only in its philosophical basis, and hence its methodological basis, but also in the intended research outcomes. Qualitative research presents one form of reality that is subjective in nature. On the other hand Quantitative research seeks finite and positive answers that explain a phenomenon (Prior, 1969). Thus, the strategies that are adopted in any research will either seek to understand a phenomenon or explain it. In the latter case, an explanation of a phenomenon generally adopts experimental and/or methods that are highly econometrical and statistical in nature. Accordingly, a particular research that seeks to understand causality will adopt regression analysis techniques as the methodology i.e. the research strategy (Guajarati & Porter, 2004).

1.5 1.5.1 An assessment of the research strategies employedReview of the journal articles suggests that all four journals employ statistical techniques in conducting data analysis. Primarily, the choice of methods is regressions analysis that provides finite answers to the research questions. These are further discussed in the formal literature appraisal in the Literature Review section that follows.

1.6 PRINCIPLE DEFINING FEATURES OF THE RESEARCH ARTICLESThis section briefly outlines the identified possible: Aims; and Objectives; Hypothesis of the reviewed articles; Research questions.

1.6.1 The possible aims of the reviewed articles Impact of capital structure on firm performance of the manufacturing industry listed in Amman stock exchange (Khalaf-Al Tani, 2013). Relationship between capital structure and profitability of listed firms in Ghana stock exchange (Joshua Abor, 2005). Impact of capital structure on firm performance of the companies listed on Colombo stock exchange (Puwanenthiren Pratheepkanth, 2011). Relationship between cost of capital and firm performance of the companies listed on Tehran stock exchange (Abbasali Pouraghajan, 2012).1.6.2 The possible objectives of the reviewed articles To reveal the impact of capital structure on financial performance (Khalaf-Al Tani, 2013). To evaluate the interrelationship between capital structure and performance (Khalaf-Al Tani, 2013). To reveal the impact of short-term debt on firm performance (Joshua Abor, 2005). To determine the impact of Long-term debt on profitability of the firm (Joshua Abor, 2005). To evaluate the impact of total debt on the profitability of the firm (Joshia Abor, 2005). To reveal the impact of capital structure on financial performance (Puwanenthiren Pratheepkanth, 2011). To evaluate the interrelationship between capital structure and performance (Puwanenthiren Pratheepkanth, 2011). To determine the determinants of a capital structure (Puwanenthiren Pratheepkanth, 2011). To identify the impact of cost of capital on firm performance (Abbasali Pouraghajan, 2012). To reveal the impact of firm size on firm performance (Abbasali Pouraghajan, 2012).

2 2.3 1.6.3 The possible hypothesis of the reviewed articles There is a negative relationship between capital structure and financial performance (Khalaf-Al Tani, 2013 & Puwanenthiren Pratheepkanth, 2011). The capital structure has significant impact on financial performance (Khalaf-Al Tani, 2013 & Puwanenthiren Pratheepkanth, 2011). There is a positive relationship between capital structure and financial performance (Khalaf-Al Tani, 2013 & Puwanenthiren Pratheepkanth, 2011). There is a significant relationship between cost of capital and corporate performance (Abbasali Pouraghajan, 2012). There is a significant relationship between firm size and corporate performance (Abbasali Pouraghajan, 2012).

1.6.4 The possible research questionsThe four journals are based on the study of relationship between capital structure and firm performance. Each study has employed its own research methodology and objectives to construct a conclusion on the questions underpinning the work. All the four journals are based on the seminal work of Modigliani and Miller (1963) Corporate income taxes and the cost of capital: A correction- revolutionary work in the corporate finance sector.Jensen & Meckling concluded that the amount of leverage in a firms capital structure affects the agency conflicts between managers and shareholders and therefore, can vary managers behaviours and operating decisions. The main research question in all four journals is that whether there is an impact of capital structure on firm performance. Different time periods have been considered in all the four journals, however all the four journals have their own unique findings and different economies of the world have been considered.

2. LITERATURE REVIEWAll four studies have used quantitative approach to design their research questions. Researchers have employed a method formed from the quantitative approach, such as correlational analysis and ex post facto research method. Khalaf Al-Tani employed multiple regression analysis on performance indicators like Return on Assets and Profit Margin, as well as on short term debt to total assets, long term debt to total assets & total debt to equity as capital structure variables. The data collection methodology was independent and unbiased as the data was secondary. Data collected from these companies were tabulated and analyzed by employing multiple regression models. This statistical technique was employed to identify any relationship between capital structure and firm performance. They collected the data from the financial statements that were published by the companies; in addition to this they also used papers, articles and previous studies as another source of data. The researcher has selected 45 manufacturing firms. Their study was based on the period from 2005-2009, in which they used average values of each item for ratio computation and analysis. Researcher has kept the sample narrow by only choosing only companies from the manufacturing sector. The sample could have been better if it has a mix of companies from different sectors. Joshua Abor employed regression analysis in the estimation of functions relating to the return on equity with measures of capital structure. Data collected was secondary and hence independent and unbiased in nature; however the sample size was small as they only included 22 firms which showed that sample was narrow. Study covered a period of 5 years from 1998-2002. Variables that were employed for analysis were profitability and leverage. Earnings before interest & tax (EBIT) was used as a measure for profitability whereas for leverage Abor used short-term debt to the total capital, long-term debt to total capital and total debt to total capital. They also used firm size and growth as control variable. Panel data methodology was employed, which involves the pooling of observations on a cross section of units spread over several time periods and which gives you results that are not easily identified in pure-cross sections or pure time-series studies. Puwanenthiren Pratheepkanth employed correlation co-efficient analysis, which is used to describe the strength of relationship between two variables. His main focus was to find the strength of relationship between capital structure and firm performance. His study covered a period of five year from 2005-2009. Data collection methodology was secondary and was same as of Khalaf-Al Tani and Joshua Abor. Puwanenthiren Pratheepkanth gathered data from financial statements published by companies and also from review of different articles, papers and relevant previous studies. Puwanenthiren Pratheepkanth considered the average values of each item for ratio computation and analysis. He employed two variables one of leverage & other was profitability. For leverage he used debt to equity and debt to total funds, whereas for profitability he employed gross profit margin, net profit margin, return on asset, return on capital employed and return on investment. Abbasali Pouraghajan et al. used multivariate regression model to test the hypotheses and to estimate regression models he employed consolidated data techniques. A consolidated data technique gives you an advantage that it allows you to see the relationship between variables and even units in a time period and allows you to investigate them. Furthermore it gives you an additional advantage that its utilization from individual effects related to units which arent measurable & observable. His study covers a period of 5 years from 2006-2010. Data collection method was similar to those used by Khalaf-Al Tani, Joshua Abor and Puwanenthiren Pratheepkanth. Data was collected using field method and through financial statements of the companies. Two variables that were used in this study were on was profitability and other was Weighted average cost of capital (WACC). Profitability was represented by return on equity (ROE) and return on assets (ROA). To ensure the accurate estimation size was added to the regression model as a control variable.

2.1 EVALUTION OF THE KEY RESEARCH FINDINGS AND EVIDENCE TO SUPPORT THOSE FINDINGSKhalaf-Al Tani found that there is a negative and insignificant relationship between capital structure and firm performance. This confirmed his null and first hypotheses, however his second hypothesis was rejected as there was no positive relationship found between capital structure and firm performance. He concluded that capital structure which was statistically represented by short term debt to total asset, long-term debt to total assets and total debt to equity is not an important determination of firm performance. He further said that despite of the fact that there is no significant relationship manager still should be cautious while selecting debt as a source of finance because there is a negative relationship between capital structures and profitability variables. Joshua Abor results were different from Khalaf-Al Tani. His study showed that there is a positive relationship between short term debt to total asset (SDA) and return on equity (ROE). However a negative relationship exists between long term debt to total asset (LDA) and return on equity (ROE). The relationship between total debt to total asset and return on equity was found to be positive. So he suggested that profitable firms should use more short-term debt to finance their operations. Results of the study were also affected by the fact that short term debt represents 85% of total debt financing in Ghanaian firms. Overall results suggested that profitable firms rely more on debt to finance their operations. Puwanenthiren Pratheepkanth study showed a mixed result in which he found that there exist a weak positive relationship between gross profit and capital structure, whereas a negative relationship exists between net profit and capital structure. Based on the empirical results the first hypothesis becomes false as the study showed that there is an insignificant negative relationship. As the H1 was rejected therefore null hypothesis was tested for its validity and it was accepted based on the evidence gathered as it has already been showed that there exist a negative relationship between capital structure and corporate financial performance.H2 was also rejected based on the evidence because result showed negative relationship between capital structure and firm performance.It was stated by the researcher that firms in Sri Lanka highly depends on debt as a source of finance and therefore pays a lot of interest expense, which has a huge impact of net profit and hence resulting in a negative relationship between net profit & capital structure. Return on investment (ROI) and Return on equity (ROE) was also negatively related to capital structure. So he concluded that there is a negative and insignificant relationship between capital structure and firm performance. Study of Abbasali Pouraghajan et al. showed that there is a significant and positive relationship between capital structure variables and firm performance variables, which is if there is an increase in cost of capital, there will be an increase in the profitability of the company as well and vice versa. Cost of capital is defined as rate of return expected. Therefore the first hypothesis, which stated that there is a significant relationship between cost of capital and corporate performance variables was accepted. Furthermore there second hypothesis was also confirmed which stated that there is a significant relationship between SIZE and profitability variables (ROE & ROA). Their result showed that there is a significant and positive relationship between these variables, showing that larger companies are more profitable compared to smaller companies. The possible reason for this result would be that larger companies in Tehran could easily generate financial resources compared to smaller companies and by making timely and correct decisions they can make an effective use of that finance to increase their profitability.

2.1.1 The sampling TechniqueSelection of Khalaf Al-Taani was entirely from the manufacturing sector; his population consisted of 45 manufacturing countries from Amman Stock Exchange. His study covers the period of five year from 2005-2009, which makes it a sample of 225 firm-years observation. Joshua Abor sampled all the firms listed on the stock exchange of Ghana Stock Exchange (GSE) but only twenty-two firms qualified to be included in the population. His study covered a period of five years from 1998-2002. So his study included a sample of 110 firm-years observationPuwanenthiren Pratheepkanth selected 30 listed firms traded in Colombo Stock Exchange. His research work was based on the period of five year from 2005-2009. So his study was based on as sample of 150 firm-years observation. Abbasali Pouraghajan et al. selected 70 firms from the Tehran Stock Exchange. His study was based on the period of five year from 2006-2010. His observation was based on the sample of 350 firm-years.

2.1.2 The data and related quality issuesAll the four journals were based on quantitative approach which means that they are based on descriptive research method. Hence, the researchers employed the secondary data to test the existing research and hypotheses. Thus, the data that will be used will already be available and will be objective in nature. Therefore data will be free from personal biasness. Researchers have employed cross-sectional, longitudinal and time-series data technique.

2.1.3 Evaluation of the key research findings and evidence to support those findingsKhalaf-Al Tani found that there is a negative and insignificant relationship between capital structure and firm performance. This confirmed his null and first hypotheses, however his second hypothesis was rejected as there was no positive relationship found between capital structure and firm performance. He concluded that capital structure which was statistically represented by short term debt to total asset, long-term debt to total assets and total debt to equity is not an important determination of firm performance. He further said that despite of the fact that there is no significant relationship manager still should be cautious while selecting debt as a source of finance because there is a negative relationship between capital structures and profitability variables. Joshua Abor results were different from Khalaf-Al Tani. His study showed that there is a positive relationship between short term debt to total asset (SDA) and return on equity (ROE). However a negative relationship exists between long term debt to total asset (LDA) and return on equity (ROE). The relationship between total debt to total asset and return on equity was found to be positive. So he suggested that profitable firms should use more short-term debt to finance their operations. Results of the study were also affected by the fact that short term debt represents 85% of total debt financing in Ghanaian firms. Overall results suggested that profitable firms rely more on debt to finance their operations. Puwanenthiren Pratheepkanth study showed a mixed result in which he found that there exist a weak positive relationship between gross profit and capital structure, whereas a negative relationship exists between net profit and capital structure. Based on the empirical results the first hypothesis becomes false as the study showed that there is an insignificant negative relationship. As the H1 was rejected therefore null hypothesis was tested for its validity and it was accepted based on the evidence gathered as it has already been showed that there exist a negative relationship between capital structure and corporate financial performance. H2 was also rejected based on the evidence because result showed negative relationship between capital structure and firm performance.It was stated by the researcher that firms in Sri Lanka highly depends on debt as a source of finance and therefore pays a lot of interest expense, which has a huge impact of net profit and hence resulting in a negative relationship between net profit & capital structure. Return on investment (ROI) and Return on equity (ROE) was also negatively related to capital structure. So he concluded that there is a negative and insignificant relationship between capital structure and firm performance. Study of Abbasali Pouraghajan et al. showed that there is a significant and positive relationship between capital structure variables and firm performance variables, which is if there is an increase in cost of capital, there will be an increase in the profitability of the company as well and vice versa. Cost of capital is defined as rate of return expected. Therefore the first hypothesis, which stated that there is a significant relationship between cost of capital and corporate performance variables was accepted. Furthermore there second hypothesis was also confirmed which stated that there is a significant relationship between SIZE and profitability variables (ROE & ROA). Their result showed that there is a significant and positive relationship between these variables, showing that larger companies are more profitable compared to smaller companies. The possible reason for this result would be that larger companies in Tehran could easily generate financial resources compared to smaller companies and by making timely and correct decisions they can make an effective use of that finance to increase their profitability.

2.1.4 Reliability and Validity in quantitative researchWinter defined the importance of reliability & validity in quantitative research as Reliability and validity are tools of an essentially positivist epistemology. An explanation of the two concepts is provided below. Additionally, how the two concepts are manifested in the journal articles is also discussed.

ValidityValidity can be described as the confidence in the research having attained what it had aimed to achieve. Thus, a research must exhibit both internal and external validity. These concepts are both discussed below and how they are achieved in the systematic literature review is also discussed.

Internal validityInternal Validity, with regard to causal relationship, is only relevant to research that is steeped in positivism (Denzin & Lincoln, 1998). Thus, a study of cause-and-effect in empirical research would seek answers that are positive in nature and finite value (Hoepfl, 1997; Bogdan & Biklen, 1998). Internal validity in qualitative research assumes a different perspective and must be assessed appropriately. The four journal articles demonstrate, through the statistical methodologies adopted in them, that the research approach is deductive in nature. Accordingly, a causal relationship is being evaluated in all four journals.

External validityExternal validity is the extent to which research can generalise the results/findings to a larger group or other contexts either geographically or temporally. If the research is weak in external validity, the results/findings cannot be extended to domains beyond the current research. Accordingly, if research on capital structure of the firm cannot be extended to other countries outside the UK, then it can be said that the research does not carry external validity (Seliger & Shohamy, 1989). Consequently, this is discussed in relation to the journal articles below. All the four journals are based on prior research of similar nature and dimensions.Reliability Reliability is defined by Joppe (2000), the extent to which outcomes are uniform over time & a precise portrayal of the entire population under study is defined as reliability and if the outcomes of a study can be obtained by applying a similar methodology, then the research instrument in known as reliable.

2.1.5 Biasness in data interpretationAs the nature of the approach is quantitative therefore the data interpretation is free from biasness, as all the conclusion is based on the true realities therefore any biasness in the interpretation is not possible.

2.1.6 Limitations of researchAfter reviewing all four journals we can conclude that there were some similar limitations in the research as all the journals considered small sample size and they were all narrow limited to only specific sectors of the industry. In all the four journals no one specified the sampling method and they totally ignored that a sample size must have represented population from all the sector of the industry.

2.1.7 Ethical issuesAs long as my understanding is concerned I think all four journals have positively taken care of the ethical issues of the professional body of accountancy. And as the source of data was secondary, therefore there was not much ethical issue that must have arisen in the research work.

2.2 CONCLUSION ON RESEARCHAll the journals were identical in their own way considering different economies of the world, however what was similar in all of them was a small sample size and period of study was five years in all four journals. Results of Khalaf-Al Tani and Puwanenthiren Pratheepkanth were same as they concluded that there exist a negative and insignificant relationship between capital structure and firm performance. Whereas the results of Joshua Abor & Abbasali Pouraghajan stated that there exists a significant and positive relationship between capital structure and firm performance. Study of Joshua Abor was considered to be very weak as its sample size was very small consisting of only twenty-two firms, followed by Puwanenthiren Pratheepkanth who selected only thirty firms. All four journals can benefit by improving the sample size and by considering all the sectors of the industry and by strengthening their methodologies. Overall, all the four journals have contributed to the common theme.

2.3 FUTURE RESEARCH RECOMMENDATIONSIt would be beneficial the future researchers could assess the impact of capital structure on financial performance in context of pre and post financial crisis of 2008. However, this study will be more effective if a larger time period and a big sample size are considered. Instead of considering companies from a single country, it would be more effective if the sample is taken from a group of countries like European Union (EU) or members of G7.

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