Literature Review on Increasing the Wealth of Shareholders

INTRODUCTION

Financial decision making moves around “increasing the wealth of shareholder’s” and these financial decisions can be very tricky sometimes. One basic question “proportion of debt to equity?” and there could be hundreds of options but to decide which option is best in firm’s particular circumstances. It is effective to use more portion of Debt for the purpose of financing as it is less costly then equity but there are also some limitations and in the case of bank it has restrictions imposed by regulatory authority and after the certain limit it will affect company’s leverage (traditional theory of Capital Structure). Financially troubled or risky companies could face severe consequences as they normally are charged more interest rates on debt. So there should be a balanced proportion of securities mix in firm’s capital structure. Capital structure affects leverage and consequently profitability of firm. Firms with low earnings and high leverage are more exposed to risk and less attractive for investors. Most of these statements are true for banks also but capital structure of banks is a bit different from firm’s perspective. So far there is no clear understanding about combination of financing options and this is because of regulations from government/ regulatory body, banks have to follow them and they have to adjust theirs source of financing accordingly. All the banks are regulated by the State Bank and rules of SBP are same for all the banks but still these banks have different levels of profitability. Research paper aims to observe Banking sector of Pakistan (population) during this research because this sector has a major impact on the economy of Pakistan. Objective of this research is to investigate the relationship between capital structure and profitability of Banks regulated by the State Bank of Pakistan because one of the main factors that effect profitability is capital structure decision. For this research paper sample of 20 banks is taken and their 5 years financial data i.e. 2004-2008.

Idea for this paper is taken from a research article written by Joshua Abor (2005). The variables used by Prof. J. Abor in that study are different from those used for this paper. These variables are taken after going through the literature. Gearing ratio and Equity Multiplier are taken as an independent variable and dependent variables are Return on Equity (ROE), Return on Assets (ROA), Net Interest Margin (NIM), Efficiency ratio, Burden ratio, Earning Base and Spread ratio. For better analytical results, Size (log of Total Assets) is used as control variable.

This study has certain limitations like full access to the data related to this research is a problem, sample selected can be constraint to the research, data is gathered through published financial reports and data shown in the reports might or might not represent the actual picture. This research is helpful for further studies in a way that now one doesn’t need to find the profitability of banks in Pakistan and one can focus on certain broad areas like profitability interrelationship of local and multinational banks, determinants of capital structure of the banks, liquidity position and so on.

LITERATURE REVIEW

Capital is the engine of the economy and the financial information is the oil that keeps the engine running smoothly (R.S Raghavan). For banks Capital is the total Owned Funds available to the Institution for a reasonably long time. ICCMCS (2004) divided this capital into Core capital (basic equity) and Supplementary capital and classified in Tier I, Tier II and Tier III Capital.

Tier 1 capital consists of common stock and disclosed reserves like retained earnings and is the core measure of a bank’s financial strength.

Tier II capital is also used to measure the financial strength of a bank and is the second most reliable form of financial capital which includes Revaluation of assets, Undisclosed reserves (Reserves that are not burdened to any liabilities), General Provision, Hybrid instruments which are the capital instruments having the debt & equity characters and Subordinated debts.

Tier III capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier II capital and is used to support market risk, commodities risk and foreign currency risk.

According to Asli Demirgiu-Kunt and Harry HuizIi (2000) banks play a major role in capital allocation, to mobilize savings, to manage investment decisions of corporate managers and provide risk management guidance.

Capital structure is the combination of a firm’s debt (long-term debt and short-term debt) and equity (common equity and preferred equity). Firm uses its various sources of funds to finance its overall operations and growth. Debt can be in the form of issuance of bonds or long-term notes payable, while equity consists of issuing common stock, preferred stock, or having retained earnings. Joshua Kennon stated advantages and disadvantages of each financing option and management always tries to find out the best combination to finance their capital and lower the cost of financing. As Eugene F. Brigham stated, there is an optimal capital structure which is the best combination of equity and debt financing. On this level of optimization, cost of the capital is lowest and value of the firm is highest. J.Abor (2005) believed that there is no universal theory for debt-equity choices, different combination are used in different situations to achieve the desired outcome.

Capital structure is very important for any firm. It not only helps in determining the return a company earns for its shareholders and also shows how a firm will behave in recession or depression (Joshua Kennon).

One of the financing options is Equity financing which is composed of funds that are raised by the business itself. This financing can be raised by the owners of the firm or by adding more peoples in the ownership i.e. issuing the shares of the company. There is certain amount paid against these share and the shareholders get dividend against those shares or against that money they have invested in the company. It depends on the company’s policy that how much capital they need and how much of that capital should be raised through shares. Mostly companies with high growth rate use equity financing because they can give high return to the investors. Equity capital is considered to be the expensive type of capital because its “cost” is the return the firm must earn to attract investment (Joshua Kennon)

Debt financing, second choice of financing means borrowing money to run the business. The amount of debt that a firm uses to finance its assets is also called leverage. Debt financing constitutes of long term debt and short term Debt based on the type of money one borrows. Interest rates for long term debt and short term are different and vary from situation to situation and firm to firm.

Long term debt refers to the money one borrows for financing the assets which can be used by the firm for longer periods. E.g. Purchase of Assets, machinery, land etc. The scheduled payment of long term loan is usually extended for more then 1 year. In the case of Banks their sub-ordinate loans and fixed deposits are long term in nature because they are held for more then one year depending on their nature.

Short term debt is the debt taken for meeting the daily basis business requirements like purchasing of inventory or paying the wages. Its scheduled payment takes place within the year. Usually short term loan is taken for some days or 3-6 months. Banks usually take loan from other financial institutions for very short period just to fulfill their daily requirement.

There are different theories of capital structure, traditional theory of Capital Structure says that use of more proportion of debt in capital structure can be effective as it is less costly then equity but it also has some limitations and after the certain limit it will affect company’s leverage. Debt financing also has an advantage of tax benefits, and this is choice of company in which combination debt: equity financing is used to balance the cost and benefits (Trade off theory). Stewart C. Myers and Nicolas Majluf (1984) stated that companies prioritize their sources of financing (from internal financing to equity) according to the Principle of least effort, According to them, internal funds are used first, and when there are no more benefits from internal funding then debt should be taken, and as a last option equity should be issued. (Pecking Order Theory)

In the light of these theories and literature there are pros and cons for both debt and equity financing. With debt financing company can retain maximum control over their business and debt financing has tax benefit as interest on debt financing is tax deductible but too much debt can cause problems if company begin to depend on it and do not have the amount to pay it back. High proportion of debt will make the company unattractive to investors because of leverage problem and cost of issuing debt will increase.

While talking about equity financing, this appears to be “easy money” because there is not debt involved it and no need to worry about scheduled repayment of loan, when business will makes profit the lenders will be repaid. Problem with this option is that company can lose its complete control and autonomy, now investors can have participation in decision making. High amount of equity in capital structure is indication for potential funders that company is willing to take the necessary personal risks, which could be a sign of lack of confidence in your own business venture.

Banks and financial institutions are specialized and unique businesses whose capital structure decision is affected by the factors specific to the banking industry like federal bank’s regulations. If government lowers the discount rate then according to tradeoff theory, banks will try to get loan from central bank and their debt portion will rise, so to handle this situation central bank enforces banks to hold more capital to balance the position. If central bank makes change in regulations like decrease in SLR and CRR requirements then more money will be available for lending and it will affect capital structure and profitability accordingly. Capital structure theories help the banks to make choices for raising capital during the financial crisis. According to pecking order theory, to overcome undervaluation problem, banks should choose to issue debt before equity if they have private information about their assets. But, during the financial crisis, financial information about the bank’s assets is readily available so instead of debt, equity could be issued at discount. In this situation, if debt is issued then there will be high probability of default and issuing common stock at discount will transfer the wealth from existing shareholders to new one, so preferred stock should be issued because unlike debt repayments, preferred stock dividends can be suspended without causing bankruptcy.

To raise capital, from any source there is some cost associate with it which helps in determining how the capital should be financed? Separate option of debt and equity or combination of these two. Cost of raising money can be reduced with the best combination of equity and debt financing.

In the case of banks there are some regulations from the central bank related to the minimum requirement of holding the capital. Despite of the cost of holding that capital banks have to fulfill that requirement.

Mishkin (2000) stated that most of the bank managers want to hold less capital than is required by the regulatory bank, because high cost is associated with holding capital.

There are many variables that can be used to investigate the relationship between Capital Structure and Profitability of Banks. J. Abor, Chin and A. Fu used Gearing ratio and Equity multiplier to measure capital structure. Kunt and HuizIi took Return on Asset and Net Interest Margin to measure the profitability of banks. Chin, Ai Fu (1997) while finding the connection between capital structure and profitability focused on Debt to equity and Return on Investment. During the analysis of financial ratios of major commercial banks, conducted in Oman, Murthy (2003) focused on Return on Equity, Return on Assets, Net Interest Margin and burden ratio. These ratios are linked with the financing decision of the Bank i.e. Capital Structure

According to Athanasoglou, Brissimis and Delis (2005) expanses of the bank are very important factor to measure profitability.

Choice of capital structure influences Return on Assets because of the behavior of interest in calculating taxes. Company with low debt pays high taxes (due to low interest expense) compared to a company with more leverage.

ROA also resolves a major shortcoming of return on equity (ROE). ROE is the most commonly used ratio to analyze profitability but it doesn’t show the true picture as the company can have excessive debt and is using debt to drive returns. This information can be gathered through ROA. Since ROA is divided by total assets and Asset is equal to debt plus shareholder equity. So lower the debt, higher the ROA.

This equation also shows that if a company carried no debt, their ROE and ROA would also be the same because its shareholders’ equity and its total assets would be the same.

As the company start taking debt, it increases its assets because of the cash inflow but at the same time equity shrinks, and since equity is the ROE’s denominator, ROE will rise.

ROE is subjected to capital structure decision. According to DuPont, ROE is linked with Equity Multiplier and Capital Structure. So if there is any change occurs in the proportion of debt and equity, this measure will be affected.

Net Interest Margin is used to measure the performance, as debt is issued for financing purpose and to balance the net affect that debt is used to generate some returns as well. A negative value indicates that the firm did not make an optimal financing decision and because of that interest expenses are greater than the amount of returns generated by funds.

Efficiency Ratio is metric used for analyzing the interest expanses and interest earnings. This is typically applied to banks as they are interest based businesses, their income and expanses both are related to amount of interest.

Interest spread is very similar to interest margin. If a bank’s lending is equal to its borrowings, the two numbers would be the same but in reality these can not be equal because there are some regulations of federal bank, banks have to follow.

Michealas, Chittenden and Poutziouris (1998) consider various non-financial and behavioral causes which persuade capital structure decisions. Interviews are conducted for collection of the concerned data. They found that there are some factors like need for control, knowledge (experience), mind perception and social model etc which made certain belief about debt and this belief make their approach toward use of debt in their capital composition. There are also huge numbers of small firm owners who choose to rely on internal generated funds rather than raising external finance.

Groth and Anderson (1997) described capital structure and observed its influence on the cost of capital and the value of a company. There is no equation exist to determine the optimal capital structure for firm. Proper use of debt and equity in capital structure lowers the weighted cost of capital and this low weighted cost of capital helps in increasing the value of the firm.

Upneja and Dalbor (2001) studied the capital structure decisions of restaurant firms in USA. Pecking-order theory and position of the firm in the financial growth cycle are the basis for their study. Their results showed that both pecking-order and financial growth cycle influence capital structure decision of the restaurant firms. They found some separate factors which influence long term and short term debt decisions of the restaurant firms

Amidu (2007) determined the factors involved in the determination of capital composition of banks in Ghana. The variables that are covered by him are profitability, growth, tax, asset structure, risk and size. This study highlighted the association between long and short forms of debt while making capital structure choice. It is found that long-term debt structure is positively and statistically related to operating assets. While short-term debt and leverage move in same direction. The study suggested that profitability, size of the bank, their asset structure and corporate taxes are important variables to influence banks’ capital composition.

Chaganti and Damanpour (Oct 1991) tried to answer two main questions. One, what is the relationship between outside institutional shareholdings and a firm’s capital structure and performance? And secondly, does the size of stockholdings by corporate executives, family owners, and insider-institutions modify those relationships? They have collected data from forty pairs of manufacturing firms and found that the size of outside institutional stockholdings has a significant effect on the firm’s capital structure and family and inside institutional owners’ shareholdings moderate the relationship between outside institutional shareholdings and capital structure.

Jamal (1994) examined the influence of capital structure, particularly in the presence of market imperfections on firm’s profitability. The effect of corporate taxes, interest expense, debt level and equity size was also analyzed by him. The findings of this research paper are that higher debt level results in a lower profitability and higher profitability associates positively with taxation expense but negatively with interest expense.

F. Voulgaris, D. Asteriou and G. Giomirgianakis (2004) investigate the determinants of capital structure of Large Size Enterprises (LSEs) in the Greek manufacturing sector. The findings show that asset utilization, total assets growth and net profitability have a major impact on the capital structure of LSEs. Greek LSEs will face higher debt levels in the future that will arise mainly from higher short-term debt ratios. The ratios such as asset profitability, asset structure, return on equity, inventory turnover and liquidity which came out as significant determinants of capital structure in other empirical studies did not prove to be significant in this study.

Guorong Jiang, Nancy Tang, Eve Law and Angela Sze (2003) have tried to answer the question of “whether both bank-specific as well as macroeconomic factors are important determinants in the profitability of banks” and “A profitable banking sector is better to resist against negative shocks and contribute to the stability of the financial system or not”. They conclusion of their study is that a profitable banking sector can better resist against negative shocks and can help in stable financial system. In terms of bank-specific factors, operational efficiency is the most important factor in explaining differences in profitability and macroeconomic developments have also an important effect on bank’s profitability.

Chiang Yat Hung, Chan Ping Chuen Albert, Hui Chi Man Eddie (2002) shows the inter-relationship between cost of capital, capital structure and profitability among property developers and contractors in Hong Kong. The data for this research paper was collected from Datastream, an electronic financial database. The analysis of this paper shows that gearing is generally higher among contractors than developers and capital gearing is positively related with asset but negatively with profit margins.

Panayiotis P. Athanasoglou, Sophocles N. Brissimis, Matthaios D. Delis (2005) found the determinants of profitability in banking sector. According to their study size of the bank, financial strength, ownership status, operating expanse, cost decisions of bank’s management are the major factors influencing the profitability of Banks.

Methodology

This study sampled 20 banks (list of banks will be provided on request), mostly from private sector. This study is based on quantitative data analysis. Financial data was collected from annual reports of the banks. The proposed period is from 2004 to 2008. Independent variable is Capital structure which is analyzed through gearing ratio and equity multiplier. Gearing ratio and equity multiplier are used to investigate the relationship of long term liabilities and total assets with shareholder’s equity. Profitability is dependent variable which is measured through commonly used Return on Assets and Return on Equity. Expanses of the bank are very important factor to measure profitability according to Panayiotis P. Athanasoglou (2005). Net Interest Margin, Efficiency ratio, burden ratio, spread ratio are taken for analysis which are linked with bank expanses, some variables are used in relation with earning assets and interest bearing liabilities. Along with these variables earning base is also used for measuring profitability. Size is taken as control variable in this research.

In the first phase financial data is collected from the annual reports of banks and is analyzed through above mentioned ratios in the second phase. Collected data was in the form of panel data which allows the use of panel data methodology. Panel data refers to two-dimension data containing observations on multiple phenomena observed over multiple time periods. This dataset have data on i cases, over t time periods, for a total of i × t observations. Third phase is comprised of analysis of this panel data with the help of regression tool.