Page 1 of 15

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 02

March 2015

Available online: http://internationaljournalofresearch.org/ P a g e | 209

Capital Structure Effect on Firm’s Profitability

(A case of service industries listed in KSE Pakistan)

1. Dr. Naveed Mushtaq;

(Assistant Professor, Department of Business Administration, University

Muhammad Naoman Razzaq, Usman Ashraf, Irfan Haider

of Sargodha, Pakistan).

E-mail: elahimx@yahoo.com

ABSTRACT

This study examines the effect of capital

structure on firm profitability. The sample

data started from 2010 to 2013 is collected

form Karachi stock exchange Pakistan. In

this study least square regression is used to

test the relationship between capital

structure and firms’ profitability. The result

shows that the Short term liabilities to Total

Assets have positive and significant

relationship with Return on Equity and

Return on Capital and have negative and

significant relationship with Net profit

Margin and have insignificant relationship

with Return on Assets. Long term liabilities

to total assets have insignificant relationship

between Return on Equity, Return on

Capital and Net profit Margin and have

positive and significant relationship with

Return on assets. Total liabilities to total

assets have positive and significant

relationship with Return on Equity and

Return on Capital and have negative and

significant relationship with Net profit

Margin and have insignificant relationship

with Return on Assets. These results, in

general, lead to the conclusion that capital

structure choice is an important determinant

of profitability of firms

Keywords: Capital structure, Firms

profitability, service sector, Pakistan.

Introduction

The main objectives of the firm are to

maximize the wealth of owners and

shareholders. To achieve this objective by

taking financing decisions regarding optimal

capital structure which would minimize its

cost of capital. According to pecking order

theory by Myers and Majluf (1984) Capital

structure include three types of financing

Page 2 of 15

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 02

March 2015

Available online: http://internationaljournalofresearch.org/ P a g e | 210

first one is through retain earning, second is

through debt financing and finally is done

by equity. At this case, firms select the best

financing source to get the optimal capital

structure according to the firm’s

requirements to take suitable financing

decision and then reflect positively on their

performance.

Capital structure theory was introduced first

by Modigliani and Miller in 1958, capital

structure has generated great interest among

financial researchers. They argued that in

efficient markets the debt-equity choice is

irrelevant to the value of the firm and

benefits of using debts will compensate with

decrease of companies stock. Prior to MM

theory, conventional perspective believed

that using financial leverage increases

company’s value.

What is the effect of capital structure on

firm performance? to answer this question

there are three scenarios first one there is

positive relationship between capital

structure and firm performance which

indicates that when the firm depend on debt

financing then there performance will

increases. The manager prefer debt

financing then equity financing for two

reason first one is tax advantage and second

is equity cost is more than debt cost. Second

scenario is that there is negative relationship

between capital structure and firm

performance when the firm depends on debt

financing and investing less profitable

projects. Thus the cost of debt will exceed to

return which firm obtains through

investment that’s lead to bankruptcy risk

which affects the firm performance. Finally,

third scenario is that, there is no relationship

between capital structure and firm

performance .Since this scenario supposes

that cost of debt is relatively stable and the

cost of equity is not constant. When the debt

reaches to certain level, any additional

borrowing will lead to inability of firm to

meet its financial obligations. Therefore;

owner’s equity will be exposed to operating

risks and they will require additional

compensation. This might proof that capital

structure is not linked to the performance of

the firm.

It is quite problematic to design specific

general Optimal Capital Structure for the

firms that maximize the firm’s performance

regardless of their size and other factors.

In Pakistan many researcher work on this

relationship by using different dependent

variable and in few sector but we find out

the gap that is we use service sector as a

whole listed in KSE and use four dependent

Page 3 of 15

Journal for Studies in Management and Planning

Available at http://internationaljournalofresearch.org/index.php/JSMaP

e-ISSN: 2395-0463

Volume 01 Issue 02

March 2015

Available online: http://internationaljournalofresearch.org/ P a g e | 211

variable that is different to other studies

which is done in Pakistan.

In developing economies common problems

of market includes less efficiency,

incomplete information and irregularities as

compared to developed economies

Therefore it is mandatory to investigate the

impact of financial leverage level on

financial performance in Pakistan as an

exemplar of developing economies.

Objectives of the study

The relationship between capital structure

and profitability cannot be ignored because

the improvement in the profitability is

necessary for the long-term survival of the

firm. Because interest payment on debt is

tax deductible, the addition of debt in the

capital structure will improve the

profitability of the firm. Therefore, it is

important to test the relationship between

capital structure and the profitability of the

firm to make sound capital structure

decisions.

Significance of the study

The significance of this study is that it will

help the investors to create such a portfolio

that yield them maximum profit. It will also

enable them that how a choice of capital

structure effects the financial performance

of the company. This study is a first effort to

study the impact of capital structure on

firms’ profitability in Pakistan that examines

the service sector companies listed in KSE

Pakistan.

Literature Review

Financing of mostly firms is done by equity,

debt or securities. Firms capital structure

composed of equity and debt (.Modigliani

&miller 1958) provide ground for research

on capital structure. MM-I proposition states

that under specific conditions of no taxes, no

bankruptcy cost, an efficient market, and in

asymmetric information, the worth of firm is

irrelevant that how the firm is financed. It

does not matter that what is the dividend

policy and how the capital of the firm is

raised. In other words, value of the firm

totally depends upon the real assets not on

the capital structure.

MM-II proposition (1963), however,

concludes that required rate of return, debt- equity ratio and cost of debt provide bases of

firm’s value. This MM-II recognizes that

firm value is relevant to its capital structure.

In fact MM-II concluded that with 100 %

debt, the capital structure of a firm is

optimum due to interest and tax shield.