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Capital Structure and Profitability CAPITAL STRUCTURE & PROFITABILITY By (Insert Name Here) Course Professor’s Name University’s Name City and State Date 1 Capital Structure and Profitability 2 Introduction The capital structure can be defined as a mix of all the financial instruments that are used to finance the real investments by corporations. There have been assumptions set to show that the value of any particular firm is greatly independent of its capital structure. These assumptions were put forward by Modigliani and Miller in 1958. The cornerstone of capital theory is the basis of the irrelevance proposition of these assumptions. The theories dealing with financial structure try to give an explanation of the propositions of financial instruments as observed on the righthand side of the balance sheet. There are several questions that the capital structure literature try to address. These questions include; how firms do finance their operations, factors influencing the choices, the possibility of increasing firm’s value and the availability of the optimal debtequity combination that can maximize the firm’s value. Theories There are three leading theories of capital structures. These include;  MM Irrelevance Propositions  Trade-off Theory  Pecking Order Theory MM Irrelevance Propositions MM Irrelevance Propositions has several assumptions that must be considered for its applicability. These are;  No transaction costs  No bankruptcy costs  There are only two types of claims: risk-free debt and equity  Bo, the firms, and individuals, have the same information  The capital markets are entirely complete  While firms are competitive, the individuals and firms are price takers  There are zero taxes From the assumptions of MM Irrelevance Propositions, Modigliani and Miller showed two propositions. First, they proposed that a firm's total market values do not depend on its Capital Structure and Profitability 3 market structure. Second, the cost of a firm’s equity increases linearly with the increase in its debt-equity ratio. Proving the first proposition Suppose any two firms A and B generate the same profit as expected i.e. profit X at t=1 and at t=0 firm A is all-equity while firm B has certain risk-free debt. From the proof it will be possible to show that the total market value of firm A is not equal to the total market value for firm B. This can explain that if a firm selects to use any proportion of debt and equity for financing its assets, the cash flows it has is divided into "pie" between all the claim holders. The size of the "pie" is held constant since it does not change. The value of the firm is determined from the left-hand side of the balance sheet. This is not done by the propositions of debt and equity securities but rather by real assets. The second proposition is considered an implication of the first because the market value does not depend on debt-equity ratio and its weighted average cost of capital (WACC). This proposition is not considered as a result but rather benchmark. The aim of this theory is not aimed at finding how firms finance their operations but they show why financing an operation is important. Suppose all the conditions that make capital structure irrelevant are identified, then through inference, it is possible to know what makes it relevant. Trade-Off Theory Static Trade-Off Theory If the firm’s leverage is determined by the trade-off between the tax benefits of debt and the expected costs of bankruptcy, then the firm is said to follow the static trade-off theory. When the debt is used, it can either lead the firm to cost or benefit. For instance, it has a benefit to the company in that it has a tax advantage over equity and it also has a cost if the debt establishes the possibility of incurring costly bankruptcy. The assumptions made by MM for both corporate taxes and bankruptcy cost can be relaxed. Benefits of debt The corporate income tax was introduced in the first proposition by MM in 1963. It was concluded that all the interests that are paid on debts are tax deductible while both dividends and Capital Structure and Profitability 4 retained earnings must be taxed. After each period, the tax cash flow for all the claim holders is given by cash flow to equity holders + cash flow to debt holders. It was therefore concluded that for every levered firm, its value is equivalent to the sum of the PV of the interest tax shield and that if an unleveraged firm. When the stockholders exercise their right to default, the result is the corporate bankruptcy. This gives the creditors legal authority to take over the moment the firm defaults. When this legal mechanism is used, the cost is referred to as bankruptcy. Bankruptcy cost can either be direct or indirect. Direct bankruptcy cost involve; • Both administrative and court costs • Fees for lawyers, advisors and accountants • Time and resources spent while dealing with bankruptcy Indirect bankruptcy cost, on the other hand, involves; • loss of physical assets • loss of important stakeholders such as suppliers, customers, and employees • sale of assets below their replacement value • constraint capital investment Costly Adjustment (Dynamic Trade-off) Firms only allow their leverage to flow within a given range about both the optimal leverage ratio and rebalance only because of the transaction costs. This, however, happens when the benefits of adjustment to target have the possibility of exceeding the costs. The actual debt ratios must have a mean-reverting behavior near the target ratios. Pecking order Theory The main idea of this theory lies in the fact that firm owners and managers are aware of their firms' prospects, values, and risk than how the outside investors do. This information is asymmetrical and creates adverse selection issues the moment firms get financing from external sources. The implication is that there is mispricing of the securities given by the firms; there are also firms that do not accept positive NPV investment projects; high-quality firms have very low Capital Structure and Profitability 5 possibilities of getting funded compared to low-quality firms, and financing choices can either mitigate or eliminate adverse selection cost. This implies that capital structure is only considered under asymmetric information. A firm that prefers internal financing to external financing and debt to equity in the event the firm uses external financing. Such firms are said to follow pecking order theory. In this case, equity is always used as the last option. This theory is based on the idea that good firms are required to give securities with the value which has a minimum information sensitive because they are not minimally underpriced. The theory dictates that the firms should not have a target debt-equity ratio. This is because of the presence of two types of equity; internal at the top and external at the bottom and vice versa. However, the cumulative requirement for external financing for every observed ratio. The ten companies listed on the Muscat Securities market are; • Abrasives Manufacturing • Al Anwar Ceramic Tiles Co. • Sweets Of Oman • Galfar Engineering & Contracting • Areej Vegetable Oils & Deriv. • Gulf Plastic Industries • National Biscuit Industries • Omani Euro Foods Industries • A Saffa Foods • Gulf Mushroom Products Abrasives Manufacturing The company depends on external sources of funds as compared to the internal ones. This is seen from the Total Debt to Total Capital of 258.65 and Total Debt to Total Assets of 203.31 as given by the Wall Street Journal. The sources of funds which mainly come from the financial institutions for it to finance its operations makes it impossible to realize the required profit margin. Regarding profitability, Return on Total Capital was -23.78 while Return on Assets was -17.99. This shows that the company made a loss since it relies on the external sources. Capital Structure and Profitability 6 Al Anwar Ceramic Tiles Co. The main sources of finance for Al Anwar Ceramic Tiles Co. is the internal sources. The company finance most of its operations from the internal funds that they get from the profits and savings of their proceedings. The remaining funds come from other sources such as borrowing from other institutions. From the analysis, as given by the Street Wall Journal, the profitability is as follow; Gross Margin +46.71 Operating Margin +25.50 Pretax Margin +27.03 Net Margin +23.82 Return on Assets 13.77 Return on Equity 15.77 Return on Total Capital 15.77 Return on Invested Capital 15.77 From this, it can be seen that the company has made a profit as all the returns are positive. It has no negative return on both internal and external sources of funds. Sweets of Oman The data provided by the market shows the following on Profitability; Gross Margin 28.59 Operating Margin 6.62 Pretax Margin 6.63 Net Margin 5.86 Return on Assets 9.01 Return on Equity 16.12 Return on Total Capital 13.15 Return on Invested Capital 16.04 Capital Structure Total Debt to Total Equity 6.04 Capital Structure and Profitability Total Debt to Total Capital 5.69 Total Debt to Total Assets 3.72 Long-Term Debt to Equity 0.16 Long-Term Debt to Total Capital 0.1 The data shows that the company has a lot of external sources of funds than the internal one. It is clear that the company has a lot of liabilities than assets. Galfar Engineering & Contracting According to the Wall Street Journal, the company depends heavily on the external sources of funds as opposed to the internal sources. This has made their profitability to be very low. The following data was provided by the Wall Street Journal; Profitability Gross Margin +4.86 Operating Margin -7.00 Pretax Margin -9.09 Net Margin -8.37 Return on Assets -5.76 Return on Equity -33.32 Return on Total Capital -10.16 Return on Invested Capital -17.95 Capital Structure Total Debt to Total Equity 267.59 Total Debt to Total Capital 72.80 Total Debt to Total Assets 38.42 Interest Coverage -2.55 Long-Term Debt to Equity 104.34 Long-Term Debt to Total Capital 28.38 Long-Term Debt to Assets 0.15 7 Capital Structure and Profitability 8 Areej Vegetable Oils & Deriv. The company depends on both external and internal sources of funds for financing its operations and activities. The following data are provided by the Wall Street Journal. Profitability Gross Margin +11.33 Operating Margin +3.96 Pretax Margin +3.61 Net Margin +3.14 Return on Assets 5.18 Return on Equity 20.30 Return on Total Capital 8.18 Return on Invested Capital 11.54 Capital Structure Total Debt to Total Equity 156.08 Total Debt to Total Capital 60.95 Total Debt to Total Assets 39.66 Interest Coverage 10.18 Long-Term Debt to Equity 82.82 Long-Term Debt to Total Capital 32.34 Long-Term Debt to Assets 0.21 Gulf Plastic Industries The data given by Wall Street Journal shows that the company depends most on the external sources of funds. The following data shows both capital structure as well as profitability. Capital Structure and Profitability 9 Profitability Gross Margin +15.49 Operating Margin +6.33 Pretax Margin +7.96 Net Margin +7.07 Return on Assets 9.94 Return on Equity 14.71 Return on Total Capital 13.82 Capital Structure Total Debt to Total Equity 3.35 Total Debt to Total Capital 3.24 Total Debt to Total Assets 2.31 Interest Coverage 22.35 National Biscuit Industries Founded in 1982, National Biscuits Industries has always made a profit though varying from smaller to a wider margin. According to the, the company depends on the internal sources of income and its profitability data is as shown below; Profitability Gross Margin 20.94 Operating Margin 6.69 Pretax Margin 6.84 Net Margin 5.93 Return on Assets 9.42 Return on Equity 16.30 Return on Total Capital 16.30 Return on Invested Capital 16.30 Capital Structure and Profitability Omani Euro Foods Industries The company depends on both external and internal sources of funds. The data about profitability and capital structure as provided by the is as follow; Profitability Gross Margin 7.08 Operating Margin -7.82 Pretax Margin -13.81 Net Margin -13.81 Return on Assets -5.75 Return on Equity -55.52 Return on Total Capital -6.68 Return on Invested Capital -7.84 Capital Structure Total Debt to Total Equity 1,103.70 Total Debt to Total Capital 91.69 Total Debt to Total Assets 85.17 Long-Term Debt to Equity 839.94 Long-Term Debt to Total Capital 69.78 A Saffa Foods The company depends on both external and the internal sources of funds. However, the fraction taken from the external sources is much greater compared to that from the internal sources. According to Wall Street Journal, the following data on profitability and capital structure are true; Profitability Gross Margin +40.83 Operating Margin +22.01 Pretax Margin +21.51 10 Capital Structure and Profitability Net Margin +18.71 Return on Assets 12.36 Return on Equity 17.03 Return on Total Capital 13.97 Return on Invested Capital 14.87 11 Capital Structure Total Debt to Total Equity 19.43 Total Debt to Total Capital 16.27 Total Debt to Total Assets 14.33 Interest Coverage 19.18 Long-Term Debt to Equity 13.71 Long-Term Debt to Total Capital 11.48 Long-Term Debt to Assets 0.10 Gulf Mushroom Products The company is also one of those that depends on the external sources of funds as compared to the internal sources. The following data about profitability and capital structure are drawn from The Wall Street Journal; Profitability Gross Margin +29.63 Operating Margin +6.26 Pretax Margin +5.67 Net Margin +5.07 Return on Assets 3.58 Return on Equity 5.65 Return on Total Capital 4.21 Return on Invested Capital 4.59 Capital Structure and Profitability 12 Capital Structure Total Debt to Total Equity 33.40 Total Debt to Total Capital 25.04 Total Debt to Total Assets 20.74 Interest Coverage 11.65 Long-Term Debt to Equity 21.79 Long-Term Debt to Total Capital 16.33 Long-Term Debt to Assets 0.14 Conclusion The study tries to find the relationship between capital structure and profitability of the ten quoted companies that are listed on Muscat Securities Market over a long period. From the results obtained, it shows that profitability has suffered a downward trend in growth. The current growth rate has been found to stand at 20.12%. The results also show a great disparity in profitability from a maximum of 46.71% to a minimum of 8.07%. This shows a relatively larger difference between firms’ profitability. The effect of the capital structure on profitability is not huge and therefore not significantly felt. However, the association between short-term debt and profitability is positive. It is clear from the result that the firms in Oman depend on the external sources of financing. In Oman case, the highest production is shown in short-term debt. There is, however, a positive correlation between the participation of equity (PL) as seen in the capital structure and profitability. The results also show that Oman companies use long-term debt in slightly conservative manner. This might be as a result of the favorable interest rates in the financial market in Oman. This is brought about by favorable political and economic factors. Both the economic and political factors give operational and financial risks that help in managerial planning as well as the adoption of a complex debt policy. Therefore, the results presented in this study give significant propositions for the financial stability as the ratios of short-term debt to total debt makes the business sector to be affected by the economic conditions. This can have an impact on the financial crisis. For the Oman financial market to grow the following recommendations are counted valid; first, the optimal capital structure of the firms should be identified and maintained as it represents the point of market value maximization. Capital Structure and Profitability 13 Second, an effective and efficient credit policy should be implemented so as to improve both the performance and growth. Lastly, the top level management should have all the issues of capital structure at their interest by having a robust way of monitoring both its adaptability and form. References Miglo, A., 2010. The pecking order, tradeoff, signaling, and markettiming theories of capital structure: a review. s.l.:s.n. Muscat Securities Market, 2016. Cash Flow. [Online] Available at: [Accessed 7 November 2016]. Capital Structure and Profitability Sbeiti, W., 2010. The determinants of capital structure: evidencefrom the GCC countries. ,International Research Journal ofFinance and Economics, Volume 47, p. 54–79. The Wall Street Journal, 2016. Cash Flow. [Online] Available at: [Accessed 7 November 2016]. Wahab, R. A., Mohd , A. & Yusop, K., 2012. Determinants of capital structure of Malaysian property developers,. Middle East Journal of Scientific Research, 11(8), p. 1013–1021. 14

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